BUS 552 Module 1 How Venture Capital Works Example

Twenty Bets to Find Two Winners: How an $80 Million Venture Fund Raises, Invests and Returns Money

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MBA Program, Aspen University

BUS 552: Innovative Finance and Venture Capital

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Twenty Bets to Find Two Winners: How an $80 Million Venture Fund Raises, Invests and Returns Money

Three Rivers Ventures, a composite venture capital firm in Pittsburgh, Pennsylvania, manages an $80 million fund that invests in early-stage companies in robotics, industrial software and advanced manufacturing, drawing on the region's universities and industrial base. Its three general partners include a former robotics engineer, a software executive and a former investment banker. This paper explains how the fund raises, invests and returns money, and why its structure shapes every decision it makes.

The Fund's Structure

Venture capital funds are usually organized as limited partnerships. The limited partners, institutions such as university endowments, pension funds, foundations and wealthy families, commit most of the money; Three Rivers' limited partners include a university endowment, a state pension fund and several family offices. The general partners manage the fund, choose investments and sit on portfolio companies' boards. Limited partners commit capital for about ten years, and the general partners call it as investments are made.

The general partners are paid in two ways. They receive an annual management fee, here 2% of committed capital, or $1.6 million a year, to pay salaries and costs. And they receive carried interest, 20% of the fund's profits after the limited partners have received their capital back. If the fund returns $240 million on $80 million, the profit is $160 million, of which the general partners receive $32 million and the limited partners $128 million plus their original capital.

Why Venture Capital Exists

Gompers and Lerner (2001) explained that young, innovative companies are hard to finance with bank loans because they have few tangible assets, uncertain prospects and founders who know much more than outsiders. Venture capitalists address these problems through intensive screening before investing, staged financing that releases money as milestones are met, contracts that give investors control rights, and active involvement on boards. They also noted the industry's sensitivity to public market conditions, which determine how easily companies can be sold or taken public.

Raising the Fund

Before investing a dollar, the general partners spent eighteen months raising the fund. They met with more than 60 potential limited partners, presenting their strategy, their experience and the deals they had sourced while raising money. Institutions committing to a first-time fund look closely at the partners' backgrounds, the region's flow of companies and whether the strategy fills a gap in their own portfolios. The university endowment committed $15 million partly because the fund would invest in companies spun out of local research. The general partners themselves committed about 2% of the fund, a common practice that aligns their interests with the limited partners'.

How the Fund Exits

Venture capitalists earn returns only when portfolio companies are sold or go public. In robotics and industrial software, most successful exits are acquisitions by larger industrial or technology companies. An initial public offering is rarer and depends on market conditions. Because the fund has a ten-year life, the general partners must plan exits within that window, which can lead to pressure to sell a company before its full value is reached. Limited partners can extend the fund's life, usually by one or two years, if a valuable company needs more time.

Selecting and Staging Investments

Three Rivers reviews about 600 companies a year, meets with about 150 and invests in about five. Gompers et al. (2020) surveyed 885 venture capitalists about how they make decisions. The founding team was the most frequently cited factor in selecting investments, ranked above business model, product and market, and was also seen as the most important driver of success or failure. Three Rivers' partners spend much of their diligence on the founders: their technical depth, their ability to recruit and their response to setbacks.

The fund invests in stages. A first investment of $1.5 million might fund a prototype and early customer pilots. If the company meets its milestones, the fund invests more in later rounds, often with other investors. The fund reserves about half its capital for follow-on investments in its best companies.

Why Returns Are Skewed

After fees of about $16 million over the fund's life, the fund invests $64 million. In this illustrative model, the two large exits return about 79% of the fund's proceeds, and half the companies return almost nothing. The fund's success depends on a few winners, which is why venture capitalists pursue companies that could become very large, even if most will not.

Does Skill Persist

If outcomes are so skewed, is venture performance mostly luck? Kaplan and Schoar (2005) studied private equity and venture capital fund returns and found strong persistence: general partners whose funds outperformed tended to do so again in their next funds, a pattern unlike mutual funds. Limited partners therefore pay close attention to a firm's record when deciding whether to commit to its next fund, and new firms like Three Rivers must prove themselves with their first fund.

The Limited Partners' View

For limited partners, venture capital is a small, risky slice of a larger portfolio. They accept that money is locked up for a decade and that early years show losses, the pattern investors call the J-curve, as fees are paid and failed companies are written off before winners mature. They commit in exchange for the chance of returns well above public markets, though research shows such returns are concentrated in the top-performing funds. A pension fund choosing among venture managers therefore weighs track record heavily, consistent with Kaplan and Schoar's finding on persistence.

What This Means for Founders

Understanding fund economics helps entrepreneurs. A fund that needs large exits to succeed will push for rapid growth and may prefer a riskier path to a large outcome over a safe path to a modest one. Founders who want to build a steady, profitable company of moderate size may be better served by other financing. Founders who take venture money should expect board involvement, staged funding tied to milestones and pressure to reach a large exit within the fund's life.

Conclusion

A venture fund is a ten-year partnership in which limited partners supply capital, general partners earn fees and a share of profits, and returns depend on a few large successes. Research explains why the industry stages investments and takes control rights, shows that skill appears to persist across funds, and confirms that teams matter most in selection. These features shape the tools and decisions examined in the rest of the course.

References

Gompers, P., & Lerner, J. (2001). The venture capital revolution. Journal of Economic Perspectives, 15(2), 145-168. https://doi.org/10.1257/jep.15.2.145

Gompers, P. A., Gornall, W., Kaplan, S. N., & Strebulaev, I. A. (2020). How do venture capitalists make decisions? Journal of Financial Economics, 135(1), 169-190. https://doi.org/10.1016/j.jfineco.2019.06.011

Kaplan, S. N., & Schoar, A. (2005). Private equity performance: Returns, persistence, and capital flows. Journal of Finance, 60(4), 1791-1823. https://doi.org/10.1111/j.1540-6261.2005.00780.x