Behind the Curtain of Startup Investing

TL;DR: The money that is invested in startups is provided by Limited Partners (LPs), which are large institutional investors. This money is managed by General Partners (GPs), which are professional fund managers that take a more active role in the startups in their portfolio. GPs are rewarded for successful investments through 'carry', and earn management fees on money that they manage.

The spotlight of startup finance shines brightest on the capital that startups raise. The progression of a company from pre-seed to initial public offering (IPO) is generally well understood because of the daily fury of press releases advertising a successful capital raise. Here's what I mean.

There is, however, less understanding of what happens ‘behind the scenes’ of startup fundraising. Where does the capital that ends up in a startup’s bank account come from? And who are the key players in this ecosystem? 

This post delves into these questions. 

Venture Capital as an Asset Class

Wikipedia defines ‘venture capital’ as:

a form of private equity financing that is provided by firms or funds to startup, early-stage, and emerging companies that have been deemed to have high growth potential.

For this discussion, we will zoom into the component of that definition that is most confusing: what is private equity financing?

To understand the answer, we look at the broader world of public and private markets. 

We are all familiar with the world of public markets, which includes all of the shares traded on the New York Stock Exchange, the Toronto Stock Exchange, etc, and all of the bonds traded on exchanges or over-the-counter (OTC). 

Private markets, on the other hand, are investments that are not traded on public exchanges. As a result, these markets lack many of the benefits that make public markets so accessible. 

Benefit	Public Markets	Private Markets
Transparency	Companies trading on public exchanges have strict reporting requirements, and their financials are accessible by the public.	Private companies are not required to disclose their financials.
Liquidity	Investors in public markets are able to easily buy and sell securities.	Private market securities are difficult to buy and sell. The cap table software Carta learned this the hard way.
Regulatory Oversight	Government agencies heavily regulate public markets.	Subject to less regulatory oversight, which can increase risks but also reduce bureaucratic hurdles for companies and investors.
Valuation	The valuations of public companies are driven by the demand and supply dynamics of the market.	Valuations are determined less frequently, often through negotiations during funding rounds or based on financial performance metrics, and may not always reflect current market conditions.

In terms of size, public markets are much larger than private markets: whereas the total amount invested in private markets is $12 trillion (source), the market capitalization of public markets is $230 trillion (source), around 20 times the size of private markets.

We now go back to the question that opened this section: what is private equity financing?

This term refers to a subset of the $12 trillion in private markets: the buying and selling of shares in private companies (i.e., startups). 

Stated more simply, venture capital (VC) is one of several asset classes in the broader world of private markets. 

The reason that I went into all of this hoopla is because once we look at the world of VC as ‘just another asset class’ we can begin to think of venture capitalists as investors. And, like all other investors, venture capitalists invest money because they seek a favourable return.

The Limited Partner (LP): the Financial Backbone of VC

Who are the investors investing in VC? 

The first group are ‘angel investors’ (the term ‘angel’ originated in Broadway to describe wealthy individuals who funded theatrical productions). Angel investors are individuals that provide funds directly to founders at the startup’s infancy, most commonly during what are called the ‘pre-seed’ and ‘seed’ stages of fundraising. In exchange, they get an ownership stake in the startup. In the world of VC investing, angel investing is the most risky: only 11% of angel investments end with a positive result. 

The second group of investors are called limited partners (LPs). LPs fund all but the early stages of a startup’s growth, and thus provide the financial backbone of the asset class. LPs are institutions - pension funds, endowments, sovereign wealth funds, or foundations. The reason why venture capital investing is most commonly done by these large institutions is because, with billions of dollars under management, they have both the scale and the appetite to take the startup gamble: to invest significant sums of money in hundreds or thousands of companies with the expectation that only a handful will provide the vast majority of returns. 

To understand why LPs are called LPs, we have to dig into corporate law (only briefly, I promise). From a legal perspective, LPs are ‘partners’ to a special type of business: a ‘limited partnership’. This business is created for the specific purpose of ‘pooling’ money from LPs and investing those funds in startups. The investment decisions of a fund are made by the other type of partners to a fund: general partners (GPs).

Examples of prominent LPs

Understanding the Role of a General Partner (GP)

To recap: LPs inject money into a fund, a business created specifically for the purpose of investing in startups. LPs are investors primarily concerned about generating a good return on the money that they invest. They are not involved in the day-to-day management of the businesses that end up receiving this money. 

This task is the responsibility of General Partners (GPs): professional investment managers who choose which startups to invest in (called their ‘portfolio companies’). GPs nurture their portfolio companies towards growth and success. GPs fulfill this obligation by, for instance, assuming board positions on the boards of their portfolio companies, and by providing guidance and coaching to entrepreneurs. 

GPs do not do this for free. Instead, they are compensated through an annual management fee - ranging from 1% to 3% - on the amount of assets that they manage plus earn a share of the profits of the fund in the form of ‘carried interest’ (or ‘carry’) - typically around 20%. Both the management fee and the carry are outlined in the agreement between LPs and GPs at the inception of a fund.

One last complication worth mentioning is that GPs are individuals that are employed by VC firms. This is noteworthy because we frequently talk about the VC firms with the most successful GPs but less frequently talk about the GPs themselves.

Examples of prominent and successful VC firms