How Does VC Funding Work? And Where Does The Money Come From?

If you’re launching a startup and looking for funding, you’ve probably come across venture capital (VC). From the outside, it can seem like a mysterious world filled with big cheques, fast-growth and raises reaching billions.

But if you’re building a startup that you want to scale fast, understanding the inner workings of VCs is not only important, it’s crucial for growth.

Here’s how it works.

What Is Venture Capital?

It’s probably a good idea to start with the basics of what venture capital actually is. Venture capital, or VC for short, is a type of private equity investment for young companies with high growth potential.

But VCs don’t lend money in the same way that banks do. With a VC, funds are exchanged for equity, meaning investors actually get a piece of the business.

But one of the most appealing parts of getting investment from a VC isn’t just the money. VCs are expert venture builders. In exchange for equity, they don’t just give cash, they also provide expertise, guidance, connections and credibility. After all, if your startup has a big VC backing it, it’s likely other investors will want a piece of the action too.

And if things go well, both sides win. If they don’t, founders don’t need to pay back the capital. As a form of investment, whilst it might seem risky, VCs are experts in picking out the ventures that they believe have real potential.

Where Does VC Money Come From?

When it comes to venture raises, it might seem like VC firms have infinite amounts of cash to invest. But where it it all coming from?

The truth is, most VCs don’t invest their own money. They actually invest on behalf of others. Typically, this happens in one of 2 structures:

Venture Capital Funds

A VC fund is a large pool of money that has been raised from investors, institutions and wealthy individuals. The term used to describe this collection of people is ‘Limited Partners’ or LPs for short.

Examples of limited partners can be a range of institutions, like pension funds, universities, insurance companies, banks and wealthy individuals and family offices.

Once the money is handed over, the VC firm decides how the money is invested. The Limited Partners pool in under the assumption that the investments made will yield high returns, hopefully 50x+.

When it comes to most of the big VC firms you know, this is the model they operate under.

Angel Syndicates

A syndicate is a slightly different structure. Instead of raising one big fund, the syndicate leader finds a startup that they think is worth backing and then sends it to a group of angels to invest in together.

Because each deal pools in a different pot of money, every investment kind of acts as its own mini fund.

For investors that don’t have as much spare money as funds require, but do want a hand in investing, syndicates can be a great option. They also provide a level of control, as the investors choose each deal individually.

Syndicates are popular for very early stage deals, sometimes pre-launch and many times pre-traction.

How Do VCs Make Money?

Whilst different structures make money in different ways, VCs usually have two income streams:

Management fees: Where they are paid a % of the total fund to manage their employee salaries, legal costs and other admin. For syndicates, this might be more like a ‘membership fee’ where angels pay a certain amount per year in order to receive deals from the VC.

Carried interest: Known as ‘carry’, which means they get a % of profits after the LPs get their money back. However, carry only applies if the fund actually provides profit for LPs, so choosing the right investments is key.

How A VC Funding Cycle Works

So we now know how VCs get their money, but when it comes to investing, how does that work? Normally, the cycle looks something like this:

Raise the fund: Start by speaking to LPs to commit capital for the VC to invest.

Invest the capital: Find startups to back at multiple stages in exchange for equity.

Support and mentor: Work with the startups to mentor growth and raise further rounds, driving up the value of the equity.

Exit: Either IPO or sell the company to a larger business, releasing the capital and returning the investment to the LPs. At this point, the VC also cashes in on the carry.

The World Of Venture Capital

Whilst it might sound like an elusive world, venture capitalists have been behind some of the world’s biggest tech companies.

Think Apple, Amazon, Uber, Airbnb. Without VCs, they wouldn’t be the companies they are today.

However, as a startup, it’s important to understand what different types of VCs exist, how they raise their funds and what type of returns they like to see. Because with the right VC partner, your business can go from startup to scaleup very quickly.