Venture capital investing | Equity 101 Course

How venture capital investment works

Now that you’ve learned how personal equity works, we’ll walk through how the larger ecosystem works and how companies raise money from investors.

Knowledge check

Video transcript

So by now, you should have a good grasp on how your personal equity works. You understand your grant, you know the type of equity you were given and you know what to expect when it comes to things like vesting, exercising, taxes, all that stuff.

And that’s great, but there’s one big piece of the puzzle that’s still missing. And that missing piece is how the larger venture capital industry works. So whether you know it or not, we are all operating in the venture capital ecosystem.

What is the venture capital ecosystem? It’s any startup, any funder, or any consumer of any product that was funded by venture capital. If you downloaded an app, if you bought something from a new company, you probably interacted with the venture capital ecosystem. So in this final lesson, we are going to step back and zoom out and look at this venture capital ecosystem as a whole. What happens when a company raises money and what does that mean for you?

So, there are a bunch of different ways that a private company can raise money. And in this universe, we say “raise capital” instead of “money.”

In the startup universe, there are two types of ways to raise capital: equity financing and debt financing. We are going to focus on equity financing. And within this system, there are several different types of entities that can give a company capital or money. The main types of investment entities that we are going to talk about here are angel investors, venture capital funds, and a unique type of fund entity called a special purpose vehicle.

So depending on the fund type involved in the fundraise, there will be different terms and conditions associated with that capital (money). These terms and conditions ultimately trickle down to the shareholders, which could be the employees or the investors.

So the big question is: What are the terms and conditions associated with raising capital from an investor? This all depends on the type of fundraise your company is doing. And there are traditionally two main instruments. The first is called a convertible instrument and the second is a priced round.

So our traditional understanding of how startup investments work is a lot like the show “Shark Tank.” The people on stage will give startups a million dollars in exchange for 20% of the company. Simple transaction: Money goes in, in exchange for shares. It’s easy to follow. And that is exactly how a priced round works. It’s called a “priced round” because the investor is paying a clear, defined price for a certain percentage or number of shares in the company.

But in the early stages of company development, it’s actually very common for companies to fundraise using a different kind of instrument. And this is called a convertible instrument. You can think of a convertible instrument like an IOU: An investor gives money to Startup A today, but Startup A does not give the investor any shares yet. Instead, Startup A promises the investor two options. The startup will pay the investor back with interest at a future point in time, or the company grows, and at a certain point in the future, they want to raise a priced round. When they actually have a price on their company, they promise to convert that note into shares of the company.

So the investor who invested via a convertible instrument now owns equity in the company.

So you might be wondering: Why would a company do this—right? If you give me money today, then what difference does it make if I give you shares a year from now? It’s a good question. And there are actually a bunch of reasons for this kind of transaction, but the main one you need to know is control.

All investments are about control. And when an investor takes a percentage of a company, the investor typically gets a certain level of decision-making power and influence over the direction of that company. But in that very beginning stage, it’s typically too early to make all of these decisions about control. Why? Because the founders are still figuring out their product-market fit.

So a convertible instrument allows the founder to hold on to their shares for now and promises the investor that in the future, those shares will convert the instrument into an even friendlier amount of shares and equity.

The point of all this is to give you an understanding of who is investing at a company at each new stage of company growth. So if you look back at the two types of investments—convertible instrument and priced round—the convertible instruments tend to be used for very early funding rounds like the pre-seed and seed stage rounds.

On the other hand, priced rounds tend to be used when a company gets some traction and really starts growing. Priced rounds are when the value is set by the investors. And those rounds tend to be lettered like Series A, Series B, and C, and so forth.

Depending on the round, the type of investor that’s putting money in will be different. So investors are specialized by stage. You’ll have investors that only focus on the pre-seed stage, seed stage, Series A.

So now, let’s take a deeper look at each investor type. If you remember the last lesson, we talked about accredited investors. These are typically high-net-worth individuals who are considered sophisticated and financially educated—at least enough to be able to invest in non-public companies aka startups.

These individuals, who are investing in startups on their own, are referred to as angel investors. And in the earliest stages of a company, like the pre-seed or the seed rounds, it’s pretty standard for founders to seek funding from their friends, their family, or other people in their network.

So if an angel investor is a single person investing their own money, then you can think of a venture capital firm as an entity that pools together capital from other people and invests it on their behalf.

Let’s take a look at an example. Iris played the startup game well, and now she wants to start her own venture capital firm.

She starts a venture capital firm and she names it Iris Ventures. She decides to raise that capital from a whole bunch of other people.

The first thing she’s actually going to want to do is work with a bunch of advisors to make sure she understands the legal and compliance requirements of all of this stuff. Then, she’s going to want to start an LLC.

This entity, the LLC, is called the general partner. And since she’s the leader of the firm, she is what we call a member of the general partner.

The second entity that Iris is going to create is called the management company. Think of the management company as the brand, or the headquarters, of the firm.

The third entity that Iris is going to create is the fund. This fund is not like the other companies. It is not an LLC. Instead, the fund is a limited partnership.

Let’s go back to that concept of liability. In this partnership, we have two kinds of partners:

Iris has raised a $200 million fund from a bunch of investors who become limited partners.

Now we have this big pool of cash with $200 million in it. This pool of $200 million is the fund.

A typical fund will invest in anywhere from eight to 25 companies.

Iris’ firm might raise several funds. This very first one is Iris Ventures Fund 1.

But there’s still one last question we haven’t answered: How does Iris make money from all of this? Right here, this is where the two final ingredients come in: management fees and carried interest.

The management fee is around 2%. For this fund, since it’s $200 million, the management fee will be 2% of that or $4 million per year.

The other way Iris and the general partner make money is through a thing called carried interest. This is essentially Iris’ cut of the overall profits of the fund.

There’s one last type of investment fund I want to tell you about, and it’s called a special purpose vehicle (SPV). SPV is designed to invest in one company, one opportunity.

You did it. You started from zero and you made it all the way to the end. So pat yourself on the back, you have officially finished Equity 101 by Carta. The learning doesn’t stop here. It’s just the beginning. And with the tools you now have, we hope you can set off on your own equity journey, feeling confident and ready to take control of your financial future. Know your worth.