I'll go through the basics of how VC firms typically work below.
Partners & the fund
VCs are people who invest other people’s money, called the limited partners or LPs, into high-risk startups. This is where the name “venture” comes from. The LPs can be all kinds of entities such as pension funds, insurance companies, family offices, or even governments. They want a return on their investment. This creates motivation for general partners to close good deals (who also benefit from this in other ways). The people doing the investing in the VC firm are the general partners or GPs. That said, you often see other titles like analysts and associates in a firm. Only partners have the ability to make deals.
The money GPs raise from their LPs becomes a fund. Why do you need a fund? Raising money is relatively hard/time-consuming even for the VCs so it makes sense for them to do it in batches (funds) and then invest from them for years. Typically the LPs commit 99% of capital while the GPs do 1%. A fund typically has a 10 year lifetime. However, VCs only invest in companies in the first 5 years (called the commitment period), the period after that is less active. If a VC is doing well after the first few years, they typically have the ability to raise a new fund. Raising new funds every 3-5 years is fairly common.
If a VC is doing poorly though, they will have a hard time raising a new fund. Not having raised a new fund in a long time is generally a bad sign. It can also be problematic if a fund is very late in its lifecycle because there can be increasing pressure for liquidity in the portfolio (need to return money to LPs). In this case, the founder and VC’s interests might not be aligned, eg. if the VC pressures the founders to sell even though it’d be bad for the business.
Compensation
VCs are compensated in two ways: management fees and carry. Management fees are roughly 2% per year of the fund’s total capital; this is paid regardless of performance. Carry is a percentage of returns exceeding the initial investment, typically 20% goes to GPs and 80% to LPs. As an example, a $100m fund would have $2m per year go to VCs as management fees. If the fund does well and returns $300m (3x), the VCs would also get 20% of the additional $200m ie. $40m. Typically the management fees add up to 15% of the fund’s value over the 10 years, so in this example, the VCs receive $15m + $40m = $55m in total. (You might be asking why 15%, wouldn’t 2% for 10 years be 20%? It’s because the 2% management fee decreases beyond the commitment period when the active investing stops).
If the management fees take up $15m from the fund, doesn’t that only leave $85m to be invested? Yes, however, VCs often reinvest the proceeds from the early investments so they can go up to $100m invested – this is called recycling.
Term sheets
There are two types of stock in startups: preferred and common stock. Investors, including VCs, almost always buy preferred stock while the founders get common stock. They both give you percentage ownership in the business, but preferred stock is better because it has stronger rights and you can do more with it. You can always convert preferred stock to common stock, but you can’t do it the other way.
The term sheet is a document outlining the terms of the deal. This is what the VC gives founders to indicate the deal he or she would like to make. It’s typically a non-binding document, barring a few provisions. However, not following through on a signed term sheet is still rare, because the VC’s reputation is on the line.
After the term sheet is signed, the due diligence process begins. This is essentially the VC firm doing work to determine whether what the founders said about the company is actually true. This typically takes 30-60 days and covers tech, legal, traction, finance, etc. Remember that a deal is over when the money is wired and can fall apart anytime before that.
Exit terms
Fast forward to a future exit. What determines how much the VC and founders make? Two key terms affect this: liquidation preference and participation rights. In the examples below I’ll use an example of selling a startup, but it could be any liquidation event.
Liquidation preference is a number (eg. 1x) that will indicate how much the VC gets paid before anyone else. If a VC invested $10m at a 1x liquidation preference and the company gets sold, the first $10m of that will go to the VC, and only then to the other shareholders. If the company is doing very badly and is sold at less than the investment amount, then the VC gets that amount back and the founders get nothing. The value is typically 1x, while a high multiplier such as 2x, 3x, or more is generally considered greedy and a red flag.
Participation rights are something that the investor’s stock either has or doesn’t have. When preferred stock is participating, what that means is on top of what is paid out to the VC as the liquidation preference, they will also get a portion of the remaining money proportionally to their ownership in the company. If a VC invested $10m for 10% preferred participating stock with a 1x liquidation preference and the company gets acquired at $50m, the VC not only gets the $10m back but also 10% of the remaining $40m ($4m), totaling $14m. The founders get 90% of the $40m, ie. $36m.
Take a look at this diagram. Remember that since you can always convert preferred stock to common stock, there’s a small triangle on the right where it makes more sense for the VC to convert her preferred stock to common. This is worth it when the percentage ownership of the exit exceeds the liquidation preference you’d otherwise have. If you think about it, converting is sometimes worth it for non-participating stock, and never worth it for participating stock because there you get the best of both worlds.
These notes are largely based on the book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist by Brad Feld & Jason Mendelson (Amazon, Goodreads). It's a very informative book on the subject, highly recommended read.