Venture capitalists are compensated through a combination of management fees and carried interest (often referred to as a "two and 20" arrangement):
- Management fees – an annual payment made by the investors in the fund to the fund’s manager to pay for the private equity firm’s investment operations.[25] In a typical venture capital fund, the general partners receive an annual management fee equal to up to 2% of the committed capital.
- Carried interest – a share of the profits of the fund (typically 20%), paid to the private equity fund’s management company as a performance incentive. The remaining 80% of the profits are paid to the fund’s investors[25] Strong Limited Partner interest in top-tier venture firms has led to a general trend toward terms more favorable to the venture partnership, and certain groups are able to command carried interest of 25-30% on their funds.
Because a fund may run out of capital prior to the end of its life, larger venture capital firms usually have several overlapping funds at the same time; this lets the larger firm keep specialists in all stages of the development of firms almost constantly engaged. Smaller firms tend to thrive or fail with their initial industry contacts; by the time the fund cashes out, an entirely-new generation of technologies and people is ascending, whom the general partners may not know well, and so it is prudent to reassess and shift industries or personnel rather than attempt to simply invest more in the industry or people the partners already know.
Main alternatives to venture capital
Because of the strict requirements venture capitalists have for potential investments, many entrepreneurs seek seed funding from angel investors, who may be more willing to invest in highly speculative opportunities, or may have a prior relationship with the entrepreneur.
Furthermore, many venture capital firms will only seriously evaluate an investment in a start-up company otherwise unknown to them if the company can prove at least some of its claims about the technology and/or market potential for its product or services. To achieve this, or even just to avoid the dilutive effects of receiving funding before such claims are proven, many start-ups seek to self-finance sweat equity until they reach a point where they can credibly approach outside capital providers such as venture capitalists or angel investors. This practice is called "bootstrapping".
There has been some debate since the dot com boom that a "funding gap" has developed between the friends and family investments typically in the $0 to $250,000 range and the amounts that most Venture Capital Funds prefer to invest between $1 to $2M. This funding gap may be accentuated by the fact that some successful Venture Capital funds have been drawn to raise ever-larger funds, requiring them to search for correspondingly larger investment opportunities. This ‘gap’ is often filled by sweat equity and seed funding via angel investors as well as equity investment companies who specialize in investments in startup companies from the range of $250,000 to $1M. The National Venture Capital Association estimates that the latter now invest more than $30 billion a year in the USA in contrast to the $20 billion a year invested by organized Venture Capital funds.
Crowd funding is emerging as an alternative to traditional venture capital. Crowd funding is an approach to raising the capital required for a new project or enterprise by appealing to large numbers of ordinary people for small donations. While such an approach has long precedents in the sphere of charity, it is receiving renewed attention from entrepreneurs such as independent film makers, now that social media and online communities make it possible to reach out to a group of potentially interested supporters at very low cost. Some crowd funding models are also being applied for startup funding.
In industries where assets can be securitized effectively because they reliably generate future revenue streams or have a good potential for resale in case of foreclosure, businesses may more cheaply be able to raise debt to finance their growth. Good examples would include asset-intensive extractive industries such as mining, or manufacturing industries. Offshore funding is provided via specialist venture capital trusts which seek to utilize securitization in structuring hybrid multi market transactions via an SPV (special purpose vehicle): a corporate entity that is designed solely for the purpose of the financing.
In addition to traditional venture capital and angel networks, groups have emerged which allow groups of small investors or entrepreneurs themselves to compete in a privatized business plan competition where the group itself serves as the investor through a democratic process.
Law firms are also increasingly acting as an intermediary between clients that seek venture capital and the firms that provide it.