Many founders raise from venture capitalists without understanding how VC funds actually work — a knowledge gap that can lead to suboptimal decisions about which investors to take money from, how to structure rounds, and how to manage investor relationships over the long term. This guide covers the fundamentals.
The LP/GP Structure
A venture capital fund is a legal partnership between Limited Partners (LPs) — who provide the capital — and General Partners (GPs) — who manage it. LPs typically include institutional investors like university endowments, pension funds, and family offices, along with high-net-worth individuals. GPs are the investment professionals who source, evaluate, and manage investments.
The standard compensation structure is "2 and 20": GPs receive a 2% annual management fee on committed capital (to cover salaries and operations) and 20% carried interest on profits. Carried interest — "carry" — is the primary incentive for GPs and accrues only after LPs have received their initial capital back plus a preferred return (often 8%).
Fund Lifecycle and Investment Pace
Most VC funds have a 10-year lifespan, typically structured as 3-4 years of "investment period" (deploying capital) followed by 6-7 years of "harvesting" (managing and exiting existing investments). This lifecycle has important implications for founders: an investor in year 7 of a 10-year fund is under pressure to exit, which may not align with a founder's long-term vision for their company.
Understanding where a fund is in its lifecycle — and how much "dry powder" the GP has remaining — helps founders anticipate how engaged and patient their investors will be at different stages.
What VCs Actually Need: Power Law Returns
VC economics are driven by the power law: most investments return little or nothing, but a small number generate enormous returns that carry the entire fund. A typical fund expects 40-50% of investments to lose money, 30-40% to return capital or modest multiples, and 10-20% to generate 10x+ returns. The top 1-2 investments must return the entire fund to deliver good LP performance.
This math explains why VCs push for large markets, aggressive growth, and ambitious outcomes. A company that grows steadily to $20M ARR and sells for 3x revenue is a fine outcome for the founder — but a disaster for a VC who invested at a $10M valuation and needed a $100M+ return. Alignment of return expectations between founders and investors is crucial before signing term sheets.
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