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It is helpful to understand the economics of venture capital firms because that determines what kinds of ventures they select and what kinds of valuation and deal terms they negotiate. Suppose, for example that three venture capitalists raise a $100 million fund. They charge $2 million per year to manage it, and take 20% of the profits, after paying back the $100 million and covering expenses. Typically, the fund managers invest the capital over the first five years, and distribute the proceeds from returns over a period of up to ten years.

If the fund does well, and generates a total profit of $100 million (i.e., they double the money after expenses of $20 million), then the limited partners who invested $100 million get the $100 million back, plus 80% of the profit of $100 million, or $80 million. The venture capitalists (the general partners) get 20% of the total profit, or $20 million, plus whatever surplus was generated on an annual basis from the management fees, after operating expenses.

The limited partners would likely be quite satisfied with this outcome. If the average time commitment of the money is 5 years, and they get $1.80 back for every $1.00 invested, then they earn a 12.4% annual rate of return. They would compare that return with other investments, from buying common stocks or bonds, to investing in any asset class.

Because investing in venture capital firms is a long-term commitment, and because the investment is illiquid, investors want to make higher rates of return than they could by just buying common stocks. Also, the costs (fees and profit share) are high, so the fund has to make even higher returns on its investments to leave the limited partners with enough profit to justify their investment.

You learned earlier that investing in entrepreneurial ventures is risky business over 50% of ventures fail, even with the most successful venture capital firms. Suppose you had your own venture capital firm and tried to pick a portfolio of twenty firms to back. Your limited partners have informed you that they want to earn 15% per year, after all fees and profit sharing. That means you have to earn almost 20% on the investments you make in order to generate a net 15% return for limited partners.

If you invest in twenty ventures, and ten fail (return $0), what rate of return do you have to earn (or multiple on cost) on the other ten companies in order to earn 20% per year for the firm?

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