How do venture capital firms make money by investing in startups?

David S. Rose , Founder and CEO , GUST INC.

8 May 2014

The venture capital fund itself makes money…

…by investing early in a startup company’s life, when success is not at all assured. In exchange for investing capital to help the company grow, the fund receives an ownership interest in the company. Because in the early days a company will not be worth very much, the fund’s ownership interest will be worth exactly what it paid. But as the company grows and becomes more valuable, the value of the fund’s corresponding percentage grows as well.

Ultimately, the company will be either sold to a larger company (at a higher price) or begins to sell shares through the public stock market (going public with an IPO). In either case, the venture capital fund sells the shares that it owns, for more money than it originally paid for them.

The general partners of a venture capital fund make money…

…by raising the bulk of the capital that the fund’s investable capital from “Limited Partners”, usually institutions such as university endowments, insurance companies, and pension funds. This is the money that is invested in the startups. When the fund itself makes money from a successful exit (as above), the first thing that happens is that the original investments are returned to the Limited Partners, and then after that, 80% of profits are paid to the LPs, but 20% of the profits are retained by the General Partners (known as “GPs” who run the fund.

In addition, every year, the managers of the fund (the GPs), are entitled to pay themselves 2–3% of the total amount of the fund to pay their expenses and salaries. (In many, if not most, cases, this management fee can significantly exceed the “earned” amount from the “carried interest”).

*original post can be found on Quora @ http://www.quora.com/David-S-Rose/answers *

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