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A Laconic Breakdown of How VC Funds Earn Money by Artur Kurasiński

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The post was originally published in Polish on Artur’s LinkedIn profile. Artur kindly agreed that we repost what we think is of great value to our readers.

A lot of Polish startup founders have no idea what the work of a VC fund is and how the funds earn. I come across a lot of half-truths about funds all the time, and they lead to false assumptions and decisions by startups. Here is a simple explanation of the VC fund’s operating model.

A VC is a firm that invests money received from investors, institutional and private. Such persons are called Limited Partners. In addition to them, there are General Partners, i.e. people who manage the fund (and also chip in with their savings).

The naming varies depending on the fund, but the role of these people is the same – they are to work so that the money entrusted to them brings as much profit as possible. Fullstop. This is the only purpose of the VC fund – the rest is pure PR and making up a philosophy (e.g. ‘we want to create a better future…’)

Now the most important thing – the economics of a VC fund, i.e. how it makes money. The fund in Poland usually operates for 7-10 years. From the money it obtained from investors, it spends about 2-3% annually on the so-called management fee (i.e. the costs of the fund’s operation – including the salaries of the fund’s employees, fees for legal services, etc.)

How does a VC fund make money? On the so-called carried interest, i.e. a share in the fund’s profit. It is assumed that such a share is 20-30%. For a better understanding, here’s a generalized example. Let’s say the fund raises USD 100M. After 10 years, the cost of the management fee must be subtracted from this amount (10 x 2% for an equal bill, i.e. 20%).

From the initial USD 100M, only USD 80M remains (and this is the real amount invested). If we assume that the fund’s investments generated a return x4, it means that the VC at the end has $320 million ($80 million x4) on its account.

So what is the fund’s profit? USD 320M minus investment costs (USD 80M) – or USD 240M. This is how much the VC fund has earned on its investments in 10 years.

We know the amount of profit. And what about carried interest? If we assume the carried interest at the level of 20% for simplicity’s sake, the share in profit will amount to USD 48M (20% of USD 240M).

This is the basic goal of the fund and the greatest motivation of its shareholders. The average rate of return on VC in Europe is around 15% per annum. The best funds have x1.5 – x2 capitalization. The top funds are tripling. Unfortunately, most VCs can’t even return the collected capital. This is a risk inherent in their operating model (aggressive investments in technology companies).

This is how VC funds work in a nutshell. They invest to increase the value of the company and sell it further at a profit. Very simply put, VCs have a clear interest in investing in your company when its valuation is low and lead to a situation where they can sell shares in it when the valuation is high.

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