How Venture Capital (VC) & a CommunityVC Fund Works
There’s traditional VC and now there’s an emergence of what I’m calling a #CommunityVCFund.
A VC is an individual or group who invests other people’s money
…typically into startups e.g. ‘paper napkin’ idea, ‘garage-stage’, …or a little later future potential Google’s and Apple’s of the world. Yes, there’s a ton of potential money in this, but also a ton of risk. (See the VC calculator at the end)
A VC has 2 primary parts.
- The VC Private Fund where the LP’s money goes
- A General Partner (GP)which acts as what’s called an “Investment Advisor” whose job is to direct the $ invested by LPs into the VC Private Fund into the multiple investments into separate startups (companies).
A GP also has to:
- Recruit Investors (LPs)
- Source and find startups with tons of potential for returns (50X, 100X, 1,000X after 5 to 8 years)
- Help those companies succeed
How does a VC get paid?
Let’s assume a VC actually has startups who are successful and return more than the VC’s private fund investors invested (see a calculator at the bottom of this article). Carried Interest or ‘Carry’ is a percentage of the returns (paid by the private fund investors) to the GP.
e.g. If the Private Fund is valued at $110M on $10M invested, and Carry is 20%, then the GP makes 20% of $100M ($20M) and the LPs take home $80M (8X) on their $10M invested.
The GP also typically charges a Management Fee for all the work they do. This Management Fee is typically 2%/yr on the money invested into the VC Private Fund.
e.g. 2% on $10M invested is $200K/yr (not a ton to do all the work a GP does — remember they have to find investors, source and find startups, help those startups — and that’s a very simplified list). This is why starting a VC is hard.
What does a CommunityVCFund Do?
It basically operates the same way as a traditional VC, but shares in the rewards (or failures) of a successful VC with a crowd of both non-accredited and accredited* investors by allowing investment into the GP entity. A larger investor base helps increase the chances of startup success.
*An accredited investor is one with more than $1M in net assets (not including their primary residence) or makes $200K a year or more if single; $300K if married. The definition of an accredited investor changed in Dec 2020 to include some more people based on knowledge or Series licenses rather than wealth.
…but a non-accredited investor can’t legally invest into the VC Private Fund.
…but what about the GP’s entity? aka. The Investment Advisor
The Investment Advisor entity (broadly speaking) is not the Private Fund. It is simply an entity that is legally allowed to direct investments into private funds.
This is the beauty of what I’m calling a CommunityVCFund. Now instead of a $10M fund having to scrape by with almost NO staff off $200K/yr to pay them, the GP is sharing in a portion of the Carried Interest and sometimes the Management Fee (if the GP has one). The Result:
- Even the $100 (or $5K) investor has an opportunity to share in a piece of VC action through a cut of the Carry (a portion of the $20M at exit in our above example) and Management Fee.
- The crowd can help make the startups successful that the VC Private Fund $, funds! Reminder, the VC Private Fund can legally only take ‘wealthy’ (aka ‘accredited’) investors.
Sidenote: The accredited investor definition did change…a little bit in 2020 to accept money from non-wealthy people who are knowledgeable , but it’s still very limiting.
Fun Fact: VC was originally formed by Georges Doriot to encourage private sector investments in businesses run by soldiers who were returning from World War II. Our group has met some like Gerry Hayes and some others are also on a mission to fix VC and make it more inclusive through Doriot.com starting on the education front.
Why is this Controversial?
What about ‘blank check’ Reg CF rule (the rule that says one can’t invest money in unidentified startups or private businesses). e.g. Who are the startups the VC Private Fund is investing in who provide the potential returns that provide $ for the Carry which is returned to the GP and then to the crowd?
I’m no attorney, but personally I think this is the wrong question. While a VC may have unidentified startups (or at least ones they’ve listed with very little information on compared to an individual company raising a Reg CF round), they are vetting these startups. Now they have a lever to bring in a large crowd that can be ‘partners’ to help drive sales, marketing, connections, etc for those startups the VC Private Fund invested in. aka. One of the primary principles of why Reg CF / investment crowdfunding is strategic to companies.
The bigger question IMHO is does this abide by the ultimate mandate of the Securities and Exchange Commission (SEC), “For more than 85 years since our founding at the height of the Great Depression, we have stayed true to our mission of protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation.”
Point: If a VC is going to provide access to potential returns of their vetted diversified portfolio of 10, 20, or even 50 startups for a single investment (e.g. $100 at risk) WITH A CROWD also helping to make those startups successful isn’t that less risky on a new startup investor …or even an experienced investor than making them pick and choose 10, 20, 50 startups on their own where they have to place $100 in each ($1K, $2K, $5K at risk)?
Is this just another move by VC to survive and evolve or are they really looking to make a systemic change that benefits all?
I’ll let you decide based on the facts and information at hand. I personally think it’s Good Intent by some of these early trailblazer VCs like Arlan because the persistence of her actions to provide access to those historically overlooked in VC is way too consistent.
At the end of the day, I hope a moral society who doesn’t exist purely for the sake of financial gains and at the detriment of their community will win out! That drives innovation, inclusion, and a leveler playing field so we help reduce the wealth gap while creating the future world we want for our children.
Are VCs focused on ‘calm’ startups also CommunityVC Funds?
Not always, but I’m seeing some VCs focused on ‘calm’ companies start to deploy the #CommunityVCFund approach.
What is a ‘calm’ startup? Essentially it’s a startup that either
- was originally thought to have unicorn ($1B or more) valuation potential and it’s found it won’t achieve that status, or
- originally was planned to be <$1B in potential valuation (~99% of companies)
Collab Capital, a fund focused on investing in the best Black led early stage startups describes this very well in Scenario B in the article linked.
Where does this end up 5 years from now?
Within 5 years (by 2026), my prediction is that most VC funds will have either an ‘arm’ of the VC focused on operationalizing a #CommunityVCFund approach or helping ‘calm’ startups (if not both).
There’s too much competition emerging in the private markets with massive amounts of wealth either:
- shifting from the stock market to the private markets, or
- being untapped from people’s bank accounts for the private markets even if they’ve never invested before
This is a MAJOR cultural shift brought on by the convergence of the JOBS Act (Reg CF/A+ that allows anyone to be an investor) and the gig economy. The word ‘investing’ will shift from being this scary word and become a mainstream practice for how we help tap into the ‘calling’ of each individual. Investing culture will be one more about how to maximize human capital and the value one has to provide to society vs. this linear box of investing purely for the sake of $$$returns which has destroyed entire communities.
I hope CommunityVC Funds and a focus on how to invest in and help build ‘calm’ companies continues to expand. It provides a more level playing field for anyone who wants to choose to put money into these highly risky startup investments. Seriously, no one should be involved in this world, unless they are comfortable loosing everything they invest, because that is the risk.
However, the education an individual gains for why a business fails or succeeds, how industries are built, etc. is unparalleled. It’s a world I’m comfortable getting my kids involved in early and are seeking what they are called to do in life, because it surrounds them with founders and entrepreneurs who are building the future. This helps my children and others explore earlier on, take risks, and find what they are called to do vs. having the system we have today which seems to be very linear from an educational path. e.g. go get an education, to get more education, to get a (comfortable) job, to train your kids to do the same.
How about go get an education in how the spaces we meet are created, the future tech that connects us is built, the companies creating life saving cures do it, and more …and then if you’re called to create something new, go do it with your peers and a community that you recruit that will back you.
That’s a hell of an education, but it’s also my vision of the future.
VC Simple calculator
VCs typically invest in startups which can generate no less than $100M in valuation at exit, but preferably $1B+ in 5 to 10 years. e.g. invest in a company at $3M to $5M valuation to start.
[Exit Valuation] / [Initial Investment Valuation] / [Dilution]. Dilution is what happens when other investors keep coming in later. It’s like if you add more water to coffee, the ratio of coffee to water is less.
So $1,000,000,000 / $3,000,000 / 2 = 166X or use 4 for dilution and it’s 83X on their money …meaning that even if 50 startups fail, they’ve still made money. This is a very top level calculator without a ton of nuances, but I think you get the point.
…but what if they have no $1B potential companies? Perhaps we should spend more time on increasing the likelihood that the companies invested in are successful.
Disclaimer: This article is for educational purposes ONLY and NOT a solicitation to invest. Investing in small and mid-sized businesses is risky. Returns aren’t guaranteed, and you could lose your entire investment. Never invest more than you are willing to lose. This article is not meant to provide investment, legal, or tax advice and no party listed is an investment advisor, attorney or tax advisor.