How do VCs Make Money & Venture Capital Business Model – Unicornomy
Ever wondered, how startups splurge so much money and where the f this money comes from and why do they have zero guilt of wasting so much money on useless advertising and marketing campaigns?
Lets take this one step ahead. Where exactly does this money come from.
Venture Capitalists – Right!
This money comes from wealthy individuals and money management funds present throughout the world with a pile of cash with absolutely zero knowledge of what to do with the money so that it earns a decent sum of returns for the VC money. This VC money can also come from internal accruals to the Fund, for e.g. SoftBank the Goliath of an investor, has accrued majority money as returns from Alibaba’s Successful IPO which was a direct effect of How does Alibaba Make Money
Well they place that money with Hedge Funds, Venture Capitalists, Private Equity Funds, Mutual Fund Houses, etc. etc. and expect to earn a decent 8-9% on that money. Lets move on to how do investors make money.
How do Investors Make Money
Everyone knows venture capital firms are behind mammoth organizations that are known not to make money for decades but I am sure no one ever really understood how investors make money or more importantly how venture capital firms make money.
Essentially what ever money VC Firms make are not for them, it is for their investors, called limited partners ( in an Limited Liability Company – LLC ) or LPs.
Before we move on to how investors make money, lets first understand a venture capital firms legal structure and how does venture capital work.
How does Venture Capital Work
Venture capital firms are mostly firms in India or are SPV (special purpose vehicles) created for purely investment into start-ups via FDI route (automatic route).
They have overseas (mostly Mauritius, Cayman Islands, BVI etc.) registered parent companies where they park money and use that company to invest in the start-up directly efficiently making that foreign entity as the shareholder in the start-up (thus foreign direct investment).
This foreign entity is registered in such countries because these countries are tax friendly and are under some kind of DTAA (dual tax avoidance act / treaty) with India and thus don’t get taxes for the gains that they make in the country on exits from start-ups (if any).
These entities get this huge load of money from around the world from various ultra-high net worth individuals, pension funds, investment trusts, family offices etc. (basically they get these funds from any one with spare capital north of 10$ million for investment in riskier assets).
As to why would any one give their hard earned money to these vultures is the questions, I prefer not to answer that (duh!).
Now that you know how these funds work (this is just the tip of the ice berg), lets move on to how do venture capital firms make money.
Venture Capital Business Model
Venture Capital Firms are in the business of investing money! Venture Capital Business Model is a risky business model.
Yes you heard me right, the business model of venture capital firms is to invest money, come what may! That is why you saw the entire start up bubble burst in late 2015 when the blind money costed them their Jobs!
Yes many VCs were thrown out of their cushy jobs either full time or were asked to go and get some more money for their burnt startups!
Venture capital firms don’t make any money apart from the returns that they generate on the fund and a small fund management fees.
Consider this example:
Lets say JEXUS VENTURE PARTNERS is a VC fund worth 500$ million. They go out to the world and announce that they have brilliant minds and blah blah to build credibility to raise money. They pitch to 1000 investors with minimum 5$ million dollar commitment each. The fees for managing the fund is 2.5% upfront and 20% of any profit above 8% pa with a fund life of 5 years. Only 10 LPs partner up to provide that kind of money. Following is the snap shot of the earnings for that VC of how it would look like.
How do VCs make money would be clear from the Following which would be the source of revenue for the VCs:
- Venture Capital Business Model from Fund Management Charge – Upfront : Charged Upfront for the first year and the rest is allocated for investment into the startups.
- Venture Capital Business Model from Fund Management Charge – After Investment : Block of 4 Years charged at once on the exit value of the investment.
- Returns Promised at 8% are subtracted from the total returns generated and the balance over 8% is paid out to VCs at 20% profit share.
- After Subtracting 1, 2 and 3 from the total size at the end of fund life is proportionately paid out to limited partners.
Please note that this is a purely hypothetical example where the VC has generated massive return of 20% on its investment. This does not happen at all!
Here is how it would look like really at the end of the fund life of 5 years. Many will go bust and some one will outshine every one else and will get most of the fund money back.
This is the most extreme example of the pareto principle or the 80 20 rule, where only 5% of their total investment makes 99% of the money for them and the rest goes bust.
Well this was an over view of Venture Capital Business Model. Now go out there and demand some investment.
Disclaimer: Use caution while using this information. Completely personal Views.