1. VC Limited Partners (LPs) contractually obligate the VC General Partners (GPs) to avoid any pass through tax liabilities that may result in an investment into a portfolio company that wasn’t a C-Corp.
2. Even if the company was a non pass-through tax entity (like an LLC with an election to be treated as a non pass-through entity), the governance of the company would be non-standard as compared to a C-Corporation. VCs focus on C-Corps, and even though it is possible to invest in an entity like an LLC, they don’t to avoid complexity.
3. Lastly, if the company was an S-Corp, the company would immediately be converted to a C-Corp when a VC invests, as the fund is a non-person. See this post for more information.

For me, an understanding of how the money flows helped immensely:

1. Venture Capitalists raise a fund from Limited Partners
2. The VCs invest that money into startups, their Portfolio companies
3. In return, the VC receives equity (a % ownership of the company)
4. The company “exits” (is sold, or has an IPO) at some point
5. Proceeds are returned to the fund, sometimes cash and sometimes stock

External Links

Fred Wilson describes Venture Fund distributions in a related post.

Understanding how VC firms are measured is the basis for understanding a venture capitalist’s motivations. Fred’s three part series on Venture Fund Economics is great for more detail if you’re interest. (Part 1, Part 2, Part 3). Part 3 is especially helpful for understanding multiples and IRRs.

One last post on the same subject from David Hornik at VentureBlog.

Definitions

Venture Capital: Investment into early stage companies by full-time professionals.  The majority of the money invested is not their own (99% typically comes from Limited Partners).

Limited Partners:  LPs are the money.  Limited Partners are typically corporations (private pension plans), endowments, foundations, or state pension plans.  Wealthy families also invest as LPs into, typically, smaller venture capital funds.

General Partners:  These are the actual Venture Capitalists.  In VC firms (management companies), you hear about the “partner track”.  General Partners often put in 1% of the overall VC fund, with LPs accounting for 99% of the fund.

Venture Capital Fund:  This is the separate legal entity where the money is placed (either from the beginning, or is available through capital calls as needed during the lifetime of the fund which is typically 10 years).  These are typically Private Partnerships, which is the why you have “Partners” as they are the basis of the entity.

Details

Venture capitalists raise money from Limited Partners and invest that money into early stage companies.  LPs are only passive investors and agree to pay a management fee (typically 2-2.5% per year for the duration of the fund) to the GPs to manage their investments.  As Limited Partners include state pension plans and private pension plans, you may actually be a limited partner in a VC fund without even knowing it.

A VC firm may have multiple funds that have been raised and invested over a long period of time.  When money is invested into early stage companies, they become portfolio companies.

External Links

National Venture Capital Association – NVCA – describes the basics very well if you want a more detailed description.

Hurdle rate chart

If you click on the chart, you can download an Excel file with both the image and the formulas used to create it.  For a startup, the most important aspect to the Hurdle Rate is not the 40% IRR number, but the fact that most VCs use the multiple (shown on the verticle axis) when discussing an investment’s potential.  A venture capitalist might say a deal is a “10 bagger”, which means the deal could return 10 times their money.  Rarely, if ever, will a VC say that a deal shows the potential for an IRR of 63.3%.  However, as VCs report to their limited partners using IRRs the hurdle rate is still something on their mind when evaluating investments.

Illustrated on the right is the difference for methods used to create an option pool. In both pie charts, you’ll notice that the option pool size is 10%, as this is computed on a post-money basis (after the investment). On the top is the option pool created from the pre-money side. As the Investor bought 40% the company ($2M investment on a $3M pre-money valuation), that leaves 60% for the founder and option pool. Since the option pool accounts for 10%, logically the founder own’s 50% of the company. In the bottom the option pool is created from the post-money side, which dilutes both the founder and investor. Before the option pool, the founder owned 60% while the investor owned 40%. Dilution to both sides is based on the 60/40 ratio. Therefore, the founder goes from 60% ownership to 54%. The investor goes from 40% to 36%.

The equations are shown for these two situations. Please note that you can update the values and watch the equations solve for other values as you desire.