Are Venture Capitalists Rich?

Facebook might be worth more than $470 billion today, but it was a relatively humble half-a-million dollar investment from Peter Thiel that got things moving for Mark Zuckerberg in 2004.

In fact, having had the story immortalized in a big-name Hollywood production, the tale of how Facebook came into existence is now the stuff of Silicon Valley legend.

Although that small vignette of history suggests you should never bet against the success of a new social media network, it also highlights the critical importance of venture capitalists in incubating the latest and greatest of the start-up scene.

And Facebook isn’t the only high-profile enterprise to benefit from venture capital over the years. Airbnb – one of the most disruptive and industry-defining businesses to ever exist – got its first break via Sequoia Capital, another prominent VC fund operating out of Menlo Park.

Indeed, the popular image of venture capitalists has them as rich and powerful modern-day captains of industry, able to catapult any company with an excellent idea to stardom.

But is this correct? Are they really as wealthy as some would perceive? And what exactly is it that these risk-takers actually do?

Source: Unsplash

Why Is There A Need For Venture Capital?

When a company’s at the earliest stage of its life cycle, it can take a lot of work to raise money and grow and expand its business. This is often because they need a proven track record of success, with likely investors wary of committing cash to such projects.

However, venture capitalists see things differently. VCs are on the hunt for fledgling enterprises that have the potential for massive growth and are more than willing to invest in these higher-risk propositions.

Moreover, venture capitalists are usually privately-run operations that exchange equity in the start-up for an injection of funds into the budding company.

The source of such funds normally comes from financial institutions, well-off individuals, and other kinds of investment banks and are collectively known as limited partners (LPs).

Being involved with a venture capital firm brings many benefits for a young company. Not only do they receive the necessary money needed for growth, but they also have access to industry expertise, a network and community of like-minded people, and career development from those who have nurtured similar outfits before.

What Type Of Companies Do Venture Capitalists Invest In?

In general, VCs will be attracted to any business that has the ability to return their investment at least 10-fold over the course of the association with the company.

That said, some prefer to focus on start-ups within a particular sector, such as the IT and computing industry or the pharmaceutical and medicines space.

There are, however, some broader characteristics that all venture capitalists will seek in a potential investment.

For instance, VCs will want to work with founders that have passion for their projects and are talented and driven to succeed.

On top of that, having a competitive edge in a large or otherwise untapped market is also helpful. And if a product or service solves a real-world problem that promises global application, then all the better for it.

How Do Venture Capitalists Make Money?

Venture capitalists are recompensed in two main ways.

The first is via a basic management fee distributed annually and intended to cover the costs of managing the fund’s portfolio of companies.

This charge – which is typically 2% of the capital under investment -is paid for by the firm’s limited partners. Obviously, the larger the fund, the more money is generated. So, if a $10 million investment earns $200 thousand, a $10 billion one will reach $200 million instead.

The second method, which pays out less regularly but is often more lucrative, is known as “the carry” – or carried interest.

More precisely, the carry is the cut of the profits a venture capitalist firm receives when it exits from an investment.

For most projects, the carry is generally set at 20%. This means that if a profit of $200 million is realized, the VC takes $40 million. This $40 million is then shared between the venture capitalists and limited partners that funded the investment in the first place.

Are Venture Capitalists Rich?

As has been attested to in many news articles, venture capitalists can produce large sums of money from the investments that they make – notwithstanding whether they’re as successful as Facebook or not.

An ongoing 2% charge off of a well-capitalized portfolio provides a consistent and predictable source of income, while the substantial carried interest at the termination of an investment serves as a jackpot of sorts.

It should be noted, though, that it can be many long years before a venture capitalist gets to benefit from the money that the carry brings.

In fact, it’s not unusual for a VC firm to wait a decade or so until it has the opportunity to exit from an investment, and thus take its 20%. Even shorter-lived projects are measured in time spans that would have equity traders in a sweat, showing the level of conviction a venture capitalist must have.

However, this standard payment package, sometimes called the “2 and 20,” has been increasingly scrutinized in recent years, with some investors arguing the fees are too high – not least when you consider that many VC funds aren’t even able to deliver returns that beat a regular index-tracking ETF.

As a result, some venture capital firms have decided it would be more prudent to move toward a “1.5 and 15” model, which would involve a management fee of 1.5% and a carry of 15%. This would improve the financial outcomes for limited partners while still providing a strong incentive for managers to generate high returns from their efforts.

Paradoxically, several hedge firms have gone in the other direction and are more intent on rewarding themselves and their backers rather than cutting costs. For instance, after delivering record profits in 2022 from its winning inflation and interest rate bets, Caxton Associates decided to raise its fees from 2% to 2.25%.

Conclusion: Are Venture Capitalists Rich?

Most investment funds would balk at the kind of high-risk, high-reward projects with which venture capital firms are associated.

However, because of the higher risks that VCs are exposed to, they consider themselves entitled to a greater fraction of the profits when a business does hit the high notes.

So yes, while many venture capitalists are rich, it comes with a hefty price tag – one paid for with uncertainty and the ever-present possibility of failure.

#1 Stock For The Next 7 Days

When Financhill publishes its #1 stock, listen up. After all, the #1 stock is the cream of the crop, even when markets crash.

Financhill just revealed its top stock for investors right now... so there's no better time to claim your slice of the pie.

See The #1 Stock Now >>

The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.