Fund Management in Venture Capital: A Beginner’s Guide

Table of Contents

• Introduction
• First Investment vs. Follow-Up Investments
• The J-Curve: The Cash Flow Rollercoaster
• Capital Calls: “Pay as You Go” in VC
• Managing a €100 Million Venture Fund
• Conclusion
• Read More about Venture Capital

Introduction

Venture capital (VC) fund management can feel like navigating uncharted waters, but understanding the basic structure is key to demystifying the process. Unlike other investment types, venture capital doesn’t follow a one-size-fits-all approach. Instead, it takes time and careful planning to ensure that funds are deployed efficiently while balancing risk and reward. Here’s a breakdown of how venture capital fund management works and why each stage matters.

First Investment vs. Follow-Up Investments

Venture capital funds typically begin with an initial wave of investments during the early years, often referred to as “first investments.” These are spread over the first three years of the fund’s life, during which time VCs scout out promising startups.

From Year 4 onward, the focus shifts from new startups to “follow-up” or “harvest” investments. These are critical moments where VCs double down on the portfolio’s top-performing startups while avoiding further investments in new ventures. By Year 5, no new investments are made in startups; instead, the fund hones in on pushing its existing portfolio to mature and eventually exit.

As one VC note wisely advises: “Your portfolio in years 1-5 will define years 10.” Essentially, the decisions you make early on will heavily shape your long-term returns. So, it’s all about playing the long game.

The J-Curve: The Cash Flow Rollercoaster

One of the most important concepts in venture capital is the J-curve, a visual representation of how the cash flow of a fund typically behaves. In the early years, investors can expect negative returns as they pour money into startups that haven’t had time to grow. This is the low point of the J-curve, typically around Year 3.

However, things start looking up in the later stages. The curve starts its upward climb between Year 6 and Year 10 as startups in the portfolio mature and, in some cases, achieve successful exits. Cash flow turns positive, and investors finally see their capital commitments turn into profits.

But the catch is: “The time to exit increases, pushing the inflection point further out.” Simply put, you need patience.

Capital Calls: “Pay as You Go” in VC

Unlike other types of funds, venture capital operates on a drawdown schedule known as capital calls. Investors (Limited Partners or LPs) don’t hand over all their money upfront. Instead, the VC fund will call on capital as needed, generally between Year 1 and Year 5, to make new investments.

Penalties for late transfers can apply, so LPs need to be ready when the VC makes a call. Repayments to LPs only start later, typically around Year 5, after some startups have exited (if at all…) or generated returns. But in reality LPs’ commitments are rarely fully realized. On average, only 70-80% of commitments are called, leaving some capital sitting idle.

Managing a €100 Million Venture Fund

Let’s take a typical €100 million venture capital fund. The first five years are all about deploying capital into 20-25 startups, typically investing in 3-5 companies per year. This is where you’re planting the seeds, waiting to see which ones will flourish.

After Year 5, things get more selective. The VC sets aside two-thirds of the remaining capital for “follow-up” investments in the most promising startups. During this phase, the focus is on “living dead” (startups that haven’t failed but also haven’t taken off) and potential big hits. You’re no longer betting on every horse in the race, but doubling down on the strongest contenders.

The goal? Push the best-performing startups toward exits while writing off or exiting from those that aren’t scaling. At this stage, roughly 10-12 startups are likely to survive and return capital.

Conclusion

Fund management in venture capital is a balancing act of managing risk and reward. From carefully selecting startups during the first phase of investment to knowing when to scale back or double down in the follow-up phase, the timeline and structure of a fund dictate its overall success. Patience is key, as returns don’t materialize overnight, but understanding the process can help you make smarter decisions. So, whether you’re an LP or a founder looking for investment, knowing how a venture capital fund operates is essential.

Read More about Venture Capital

• Understanding fund management is key, but it’s also important to know how venture capitalists raise the funds in the first place—learn more in How Do Venture Capitalists Raise Funds? A Simple Guide.
• For a better understanding of the entire VC ecosystem, dive into the various ways these firms make money in How Do Venture Capital Firms Make Money?