The traditional venture capital fund

Most venture capital funds are set up as independent Limited Partnerships. This includes well-known coastal names like Kleiner Perkins Caufield & Byers, Draper Fisher Jurvetson, and Highland Capital Partners, as well as regional up-and-comers Akers Capital, DLJ Frontier and William Blair New World Ventures. The venture capital firm acts as the General Partner (GP) with third-party institutions investing the bulk of the capital to the fund, filling the role of Limited Partner (LP). During the fundraising phase that every venture firm goes through in building a new fund, the GP seeks out investment commitments from accredited investors. The VC distributes a private placement memorandum (PPM) or prospectus to potential LPs, and might expect to raise the necessary capital over the course of the ensuing 6 to 12 months. To place this within context of the Internet boom, some new funds closed within 60 to 90 days during the height of 1999-2000.

Funds generally raise anywhere from $10 million to several billion dollars from their Limited Partners. According to the National Venture Capital Association (NVCA), over 50% of investments in venture capital comes from institutional pension funds, with the balance coming from endowments, foundations, insurance companies, banks, affluent individuals and other entities who seek to diversify their portfolio with an investment in risk capital. A strong fundraising climate in 2004 helped to make that year the most active year for venture capital commitments since 2001. In the first quarter of 2005, venture capital funds raised (on average) approximately $110 million in committed capital. It is the GP's job to invest this capital in privately held, high-growth companies. In order to make these investments, the venture firm has to "call in" its LPs' commitments through tranches or "capital calls." Venture firms have synchronized these calls (sometimes also called "takedowns" or "paid-in capital,") to their funding cycles, allowing funds to be available on an as-needed basis.

A partnership agreement sets forth the relationship between the GP (the VC firm) and their LPs (investors). The returns of the venture capital fund are distributed back to the LPs as dictated by the partnership agreement, but naturally lean toward the later years of the fund. The reason for the preponderance of partnerships, as opposed to corporations, is the security it gives the VC firm to make long-term decisions. Once an agreement is signed and the capital commitments are made, the LPs are generally stuck with this group of venture professionals for the duration of the partnership (VC funds are generally organized as 10-year partnerships). For the duration of the partnership, the institutional investors cannot remove their capital from the fund at will. Liquidity is realized when a viable exit option becomes available. While both Initial Public Offerings (IPOs) and Merger & Acquisition (M&A) transactions are credible exit strategies, current market conditions have temporarily placed an undue burden on M&A to exit a portfolio investment. A liquidity event can take several forms, including a cash deal, stock, or both. Capital or shares of stock are then distributed back to investors according to the partnership agreement, unlike a mutual fund where invested cash can be withdrawn at any time. As a result however, the arrangement allows VC firms to act as a relatively reliable pool of risk capital. Plus, VC firms will rarely "go bankrupt." If unsuccessful, they are more likely to be wound down over time without the ability to raise an additional fund.

A typical 10-year venture capital fund may cash flow something like this: