What is VC Math & How Does It Impact Your Company?

If you’re planning to explore venture capital (VC) funding, it’s helpful to understand how VC firms make their money. A lot of founders operate under the assumption that every project a venture capital group funds needs to turn a profit. Actually, though, most firms can function successfully even if only 10–15% of their portfolio thrives. 

Ultimately, each company a VC fund backs is just one spoke in a large wheel. Getting clear on how that wheel works — and the role your spoke can play —  is essential. If you’re a founder who needs to determine whether this is the right source of investment for your company’s growth, this quick-start guide can help.   

The basics of VC funds

You have two main players in any VC fund: general partners (GPs) and limited partners (LPs). The LPs invest their money, while the GPs — also called managing partners — actually manage the fund. 

Both parties get paid out when one of the individual companies in a VC fund’s portfolio have a successful exit. That means the company either goes public or gets acquired. 

LPs and GPs also both get what’s called carried interest. This is a slice of the fund’s profits allocated to GPs and LPs based on a predefined percentage (e.g., 20% to the GP). Because GPs get a chunk of the fund’s profits, they’re quite literally invested in seeing the companies in their portfolio succeed. 

Beyond that, GPs get paid for the work they do to manage the fund in the form of an annual management fee. This is usually a percentage of the overall committed capital in the fund (e.g., 2%). This fee essentially covers the operational costs of the fund. 

Clearly, then, GPs and LPs can expect some level of regular payouts from their VC fund. But the biggest return on their investment comes when a company successfully exits. So let’s take a look at how startups move from their seed stage to that point. 

The venture capital investment lifecycle

Here’s the ideal pathway for any company backed by a VC firm (in the eyes of the VC fund, at least):

#1: Fundraising

During this phase, GPs raise capital from LPs by showcasing the fund’s strategy and unique value proposition. If an LP decides to get on board with that particular fund, they commit a set amount of money. Once that commitment is in place, the LP is legally required to transfer that amount to the VC fund when the GP initiates a request. 

That said, GPs don’t usually request the full amount right away. Instead, LPs generally transfer a small percentage of their total committed capital initially. This money helps the VC fund cover its operating expenses (like the GP’s management fee) while the fund moves into its second phase. 

#2: Investment

Once the VC fund is sufficiently backed by committed capital from LPs, GPs make decisions about how to allocate that money. They vet budding entrepreneurs and their companies. 

When the GP decides on a company to invest in, it submits a capital call to the LP. Basically, that request tells the LP to transfer a portion of their committed capital into the VC fund. After initiating capital calls for the relevant LPs, the GPs prepare the money to invest in the startup. 

#3: Management and growth

The money doesn’t get handed over to the startup with no strings attached. Instead, taking money from a VC fund means getting a GP involved in your company. Usually, they take a seat on your board. 

Additionally, the GP should provide mentorship and guidance, which can be a huge help as you scale up. They might advise on key hires and even connect you to potential customers. In some cases, GPs are able to help companies move forward in their growth plan by introducing them to interested investors or teeing up merger and acquisition (M&A) opportunities. 

All of that said, the level of involvement from the GP depends on both the VC fund and the founder’s relationship with their board members. Before you accept VC funds, you should get clear on the expectations from the GP. 

#4: Exit

Most founders don’t dream of the day they’ll turn over the reins to their company (although they might dream of the associated payout). But if you work with a VC fund, making it to the exit phase will be the GPs primary goal — and, consequently, you need to align with that ambition.

An exit means your company either gets acquired by another entity or you have an initial public offering (IPO). Either of these outcomes generate a significant return for the LPs and GPs behind the VC fund that backed the company. 

Obviously, many companies never make it to a successful exit. This is why VC funds invest in so many different companies. By diversifying their portfolio, they increase the odds that at least a few of their startups will make it to an exit. Realistically, if even one company in the portfolio is a big winner (e.g., IPOs as a unicorn), the fund sees sufficient yield to satisfy LPs.

Crunching the VC math for your startup

Getting backed by a VC fund can give your company a lengthy runway while looping in a GP who can provide critical guidance. But it’s not without its drawbacks. That money usually comes with specifications like liquidation preferences. In many cases, the VC fund will demand an outsize return if you make it to the exit phase. 

On top of that, getting investment from a VC fund means turning over a portion of your company’s ownership to the fund. This dilutes other people on your cap table (including you). And because of that dilution, the investment you take now could affect your ability to get more investment in the future. 

Ultimately, before accepting VC funding, you need to carefully analyze your cap table. Make sure you understand what you’re giving up — both now and in the future — before you take that check. 

You should also know that not all VC funds will back all startups. A lot of GPs only work with companies that they expect to be able to scale up to a $1 billion company in 10 years or less. If you’re not planning for that kind of rapid growth, you might need to look to other investment sources, like angel investors. 

If you’re considering VC backing, talk with an accountant first to understand the ramifications for your company and your ownership stake in it. Our team specializes in working with startups, so we’re here to help.