The VC Fund Life Cycle: Understanding the Stages of Venture Capital Investments
- 1 day ago
- 8 min read
Many physicians wonder how they can invest in exciting new companies at the ground floor level. While there’s several ways to do this, including angel investing and venture capital, it’s important to understand the life cycle of these deals, as it’s quite different from other popular investments in our online communities for doctors, such as real estate investing or investing in the stock market, which can be more of a predictable pathway to building wealth. In this article, we’ll cover what happens with a venture capital investment from start to finish, including at what stages you may be able to get your money back or take some chips off the table.
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What is a VC fund?
A venture capital (VC) fund is a type of pooled investment opportunity that invests in early- or growth-stage startups. The fund is typically managed by the General Partner (GP) or General Partners (GPs), who raise the capital and ultimately make all the investment decisions. They raise this capital from investors that may include institutional investors, high net worth individuals, or family offices. Investors who are passive and don’t have decision making power are referred to as Limited Partners (LPs).
Venture capital is typically thought of as a high risk, high potential reward investment. Typically, companies such as startups or early stage companies need capital to grow, and the VC funds provide this financing in exchange for ownership, also known as equity. The goal of the VC firm is to get this equity early in the process, and then as the company (hopefully) grows and increases in value, the value of that equity increases. Then, at a potential exit point, usually acquisition or IPO, investors are able to sell their equity at the current market price.
You can see how, if a company is successful, you can make back your investment many times over. On the flip side, if a company fails, which many startups do, you may never recoup that investment. The VC funds know this, and anticipate that many of the companies may not return capital, which is why they invest in a breadth of companies that they believe in. Their hope is if even a few make it big - or even if one makes it really big - the investment will be well worth it for investors.
The typical life cycle of a venture capital (VC) fund
VC funds typically have a fixed life of an average of about 10 years, but it can vary a lot depending on the stage of investment and the type of investment. For example, if it's a fund investing in the early stage development of devices or drugs, the pathway to exit for these companies can be long between development, testing, approval, and go to market. Conversely, investing in later stage companies that are closer to exit or acquisition may shorten the life cycle. VCs will accordingly pick a length of time for their fund that meets the time they think companies that meet their investment thesis and goals will meet. This fixed life cycle helps provide the GP time to identify, invest in, and help grow the companies within the fund for an eventual exit. When investing in a VC fund, you usually cannot withdraw your investment early during the fund’s life. We cover this in more detail below.
Phases of a VC fund life cycle
There are five general phases in the life cycle of a VC fund.
Phase 1: Fund formation & fundraising period
Before investments are made, the GP has to raise funding for the investments they’ll make. In this stage, which generally lasts up to a year, the legal documents of the fund such as the Limited Partnership Agreement (LPA) and the Private Placement Memorandum (PPM) are drafted.
Once the fund’s size and investment thesis are established, the GP pitches the fund to potential investors, which can include:
Institutional investors
Family offices
High net worth individuals (often accredited investors)
The fund may hold a “first close” for funding once a minimum threshold is reached, which allows the fund manager to begin deploying capital while they continue to raise more funding.
A “final close” ends the fundraising phase of the VC fund. At this point, no new LPs are admitted.
While LPs are asked to commit a specific amount of capital for the VC fund investment, it’s important to note that you typically don’t contribute this full commitment upfront all at once. For example, if you sign a commitment for $250,000, this is often spread out over multiple years versus a lump sum of $250,000 up front.
Phase 2: The investment period
Once the capital has been raised, the fund manager can begin making investments into companies. In this stage, the GP may evaluate hundreds of companies as they work to build an initial investment portfolio, which typically includes 15-30 companies, depending on the fund’s strategy and size. Some funds concentrate on a few, larger investments where they may take board seats and actively participate in the operations of the companies. Others make smaller investments into more companies for larger diversification.
During this phase, the GP issues “capital calls” as they identify the investments they wish to include.
The investment period typically spans the first three to five years of the fund’s life.
Phase 3: The portfolio management period
This phase can overlap significantly with the investment and harvesting/exit periods.
Here, GPs support the startup companies within the VC fund’s portfolio through stages of their growth with strategies such as:
Providing additional capital
Helping with recruiting
Giving operational guidance
Leveraging networks for strategic introductions
Funds often hold a portion of their raised capital to deploy in this phase as they make additional investments into the best performing companies.
How much capital a fund holds in reserves can play into how capital is called from LPs throughout the fund’s life. Some funds may call capital quickly upfront, while others may extend capital calls for 6+ years depending on the needs of the companies within the fund.
The ability to call on capital throughout the different stages of a VC fund’s lifecycle requires investors to maintain liquidity of their commitment to honor calls when they arise.
Phase 4: Harvesting & exits period
This phase is likely the most interesting part of a VC fund’s life for the investor, as this is where funds generate cash returns.
The GP focuses on exiting the investments within the fund in three common ways:
Initial public offerings (IPOs): A portfolio company goes public on the stock market and the fund’s shares become publicly traded. The GP typically distributes shares or sells them and distributes the proceeds from the sale to the LPs. While IPO exits are often the more high-profile cases, they aren’t the majority of exits seen.
Mergers and acquisitions (M&As): Here, a larger third-party company acquires a company from within the VC fund’s portfolio. This is much more common than an IPO. The acquiring company pays cash or stock for the acquisition, and the fund distributes the proceeds to LPs.
Secondary sales: The VC fund sells its stake in the portfolio company to another third-party investor. These types of exits are becoming more common as companies choose to stay private longer. These transactions often happen at a discounted value compared to the valuation of the company, but they do provide earlier liquidity to the LPs.
Phase 5: Final distributions
As the fund reaches the end of its term, the GP must wind down any remaining positions in portfolio companies. Companies they are not able to successfully exit from are written off as failures. (This is a risk of any VC fund investment).
If the fund holds investments that still carry potential but don’t have a clear exit, the GP may seek approval from the investors to extend the fund’s life (typically by a year or two) to allow these holdings to mature for a better potential exit strategy.
Final distributions to investors typically come in two forms:
Cash
In-kind shares of publicly traded companies
In-kind shares require investors to decide when and how to sell their investments.
It’s important to understand the tax implications when funds are distributed. We highly recommend working with a tax professional to understand–and plan for–related taxes, especially when strategizing when to sell shares.
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What the VC fund life cycle means for investors
A few quick points to emphasize for doctors considering investing in venture capital funds.
When do you actually make money with venture capital?
Unlike real estate, where rental income can generate cash flow from day one, venture capital is a highly illiquid investment that is heavily back-loaded for returns. During the first several years, LPs typically aren’t receiving distributions. Instead, they are making contributions via capital calls.
Meaningful distributions typically don’t begin until the harvesting and exit period, which can often be 5-8 years into the fund’s life. Even then, distributions can be unpredictable based on specific exits of companies within the fund’s portfolio.
Given the extended life cycle until investors see returns and the illiquid nature of VC fund investments, physicians shouldn’t invest any capital into a VC fund that they need access to within the next decade. Venture capital investing isn’t thought of as a go-to for your retirement planning, but rather an interesting way to deploy additional capital once retirement is taken care of, and you have money that you can take more chances with. Remember, you may never make any money from these investments, and could lose all of your capital.
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What exit strategy options exist for investors in VC funds?
When you commit capital to a VC fund, you sign a Limited Partnership Agreement that binds you to the fund for its full term. Your capital must be presented when the capital calls come, and your liquidity is dependent on the fund returning capital through portfolio company exits.
An early exit may be possible, but it’s usually difficult and can be costly. The most common option LPs explore is selling their interest to someone else on a secondary market. This often requires approval from the GP, and it is almost always at a discounted rate.
When dealing with VC funds, it’s best to treat your investment as fully illiquid from the start until the end of the fund’s life cycle. Know that there is always a risk of not getting your money back at all - but hopefully you’ll eventually make your investment back in multiples. That’s definitely the goal.
Conclusion
Before considering a venture capital investment, it’s important for physicians to understand the life cycle of a VC deal, as it’s so different than many things that physicians typically invest in, like the stock market or real estate. These are high risk, high potential rewards investments, and should be treated as long term holds. They rarely offer short term liquidity, and returns depend on the investments doing well. For a company to have the time to mature and have a successful exit or be able to offer liquidity, it’s got to perform, so it’s very important to vet the team making the investments. We’ll be doing future articles and events soon to dig into all of these things deeper, but hope you got an understanding of the 30,000 foot view!
Additional venture capital investing resources for physicians
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