Venture capital is a system where professional investors pool money from wealthy backers, invest it into early-stage companies, and aim to sell those investments years later for a large profit. The entire process runs on a specific structure with defined roles, timelines, and financial incentives that determine who puts in the money, who picks the companies, and who gets paid when things go well.
The Fund Structure: GPs and LPs
Every venture capital fund has two types of participants. The general partner (GP) is the entity that actually runs the fund. GPs manage deal flow, perform due diligence, and decide which companies to invest in. They set the fund’s overall strategy and handle operations from start to finish. Despite the name, the GP is typically structured as a limited liability company, which protects the individual fund managers from being personally liable for the fund’s debts.
The limited partners (LPs) are the investors who supply the money. They provide more than 98% of the total capital in a typical fund. LPs are passive: they write checks but do not participate in choosing investments or managing the fund. Their liability is capped at the amount they committed, so if every investment goes to zero, an LP cannot lose more than what they put in. LPs are often pension funds, university endowments, insurance companies, family offices, and high-net-worth individuals.
The relationship between GPs and LPs is governed by a limited partnership agreement that spells out each party’s rights, the scope of the GP’s activities, how profits get divided, and the rules for the fund’s entire lifespan.
How VCs Get Paid: The 2 and 20 Model
VC compensation follows a structure known as “2 and 20.” The GP charges an annual management fee of about 2% of the fund’s total committed capital. On a $100 million fund, that’s roughly $2 million per year, used to cover salaries, office space, travel, and operational costs. This fee gets charged regardless of whether the fund makes money.
The real upside comes from carried interest, which is the GP’s share of investment profits. The standard rate is 20%. Carried interest only kicks in after LPs have received their original investment back. Here’s a simple example: if an LP invests $5,000 and their share of a successful exit is worth $100,000, the profit is $95,000. The GP takes 20% of that profit ($19,000), and the LP keeps the remaining $76,000 plus their original $5,000.
Many funds also require the GP to hit a preferred return, sometimes called a hurdle rate (often around 8% annually), before any carried interest is distributed. This ensures the GP only profits after LPs have earned a minimum return on their money.
How Capital Actually Moves
When LPs commit to a fund, they don’t wire all their money on day one. Instead, the GP issues capital calls as investment opportunities arise. A capital call is a formal notice asking LPs to transfer a portion of their committed funds to the fund’s bank account. These are typically pro rata, meaning every LP sends the same percentage of their commitment regardless of total pledge size. Once the notice goes out, LPs usually have 10 to 14 days to wire the funds. The GP then deploys the capital into the target company.
This structure means the fund doesn’t sit on a mountain of idle cash. Money flows in as it’s needed, whether to fund a new investment, make a follow-on investment in an existing portfolio company, or cover fund expenses.
How VCs Find and Evaluate Companies
The investment process follows five stages: sourcing, screening, due diligence, negotiation, and closing.
Sourcing is about generating a steady stream of potential investments. Leads come from accelerators, incubators, networking events, conferences, and referrals from other investors or founders. Top-tier VCs often receive thousands of pitches per year and invest in fewer than 1% of them.
During screening, the GP evaluates each opportunity against set criteria to decide which startups deserve a deeper look. They consider the company’s stage, industry, geography, market size, financial profile, and whether there’s meaningful customer traction.
Due diligence is where things get serious. The deal team digs into financials, market potential, competitive landscape, legal structure, and the people running the company. Specific metrics matter here: customer acquisition cost, lifetime customer value, and revenue growth broken down by marketing channel. The team is looking for problems around product-market fit, business model viability, and management capability. They’re also assessing the probability of being able to sell the investment within three to five years.
Founder evaluation is a major component. VCs assess professional background, domain expertise, passion for the problem, and what the founders say they want from their investors. The exit strategy also gets scrutinized: how does this company eventually become a liquid investment?
Negotiation covers the deal terms: valuation, how much of the company the VC will own, board involvement, and protective provisions. Closing involves completing legal documents and transferring funds.
How Valuation and Equity Work
When a VC invests, two numbers define the deal: the pre-money valuation (what the company is worth before the investment) and the post-money valuation (what it’s worth after). The formula is straightforward:
Post-money valuation = pre-money valuation + amount invested.
If a company has a pre-money valuation of $20 million and a VC invests $5 million, the post-money valuation is $25 million. The VC now owns $5 million out of $25 million, or 20% of the company. The founders and any earlier investors hold the remaining 80%. Every subsequent round of funding repeats this process, and each new investment dilutes the ownership percentage of everyone who came before.
What VCs Do After Investing
The investment itself is only the beginning. VCs typically take a board seat, giving them direct involvement in the company’s strategic direction. For inexperienced founders especially, this hands-on guidance can be as valuable as the capital. VCs advise on everything from recruitment strategies and international expansion to setting up partnerships and navigating acquisitions.
A well-connected VC also acts as a connector and advocate. At every networking event and industry gathering, they’re telling the company’s story to potential customers, partners, and future investors. When the startup needs to raise its next round, the VC’s reputation and introductions can make that process dramatically easier. They bring a wealth of relationships across industries, and for an early-stage company trying to hire its first VP of Engineering or land its first enterprise customer, those connections often matter more than the check.
The 10-Year Fund Lifecycle
A typical VC fund operates on a roughly 10-year timeline, split into two phases. During the investment period (years one through five), the GP deploys capital into startups that fit the fund’s strategy. This is when most of the capital calls happen and most new investments are made.
The harvest period (roughly years six through ten, sometimes longer) is when the GP focuses on exits. The goal is to turn equity stakes in private companies into cash through liquidity events: an IPO where the company goes public, an acquisition by a larger company, or a secondary sale where shares are sold to another investor.
How Profits Flow Back to Investors
When exits happen, the proceeds flow through a distribution waterfall, a set of rules in the partnership agreement that determines who gets paid and in what order. The general priority is consistent: LPs get their invested capital back first, including any fees they’ve paid into the fund. Only after LPs are made whole does the GP start receiving carried interest.
There are two common waterfall structures. In a whole-fund waterfall (sometimes called the European model), 100% of called capital plus the preferred return must be returned to LPs before any profits are split. This is LP-friendly because the GP can’t collect carry on one good deal while other investments are still underwater. In a deal-by-deal waterfall (the American model), the GP can take carry on individual successful exits, though LPs still receive their capital contributions and preferred return for that specific investment first.
Using a real-world example from a large pension fund’s portfolio: on a $100 million investment with $20 million in management fees, the LP receives $100 million back (return of capital), then $20 million in management fee recapture, then 80% of profits. If the total gain is $80 million, the LP gets $64 million of that, and the GP takes $16 million as carried interest. The GP also collected $20 million in management fees over the fund’s life, bringing their total compensation to $36 million. The LP walks away with $184 million on their original $100 million commitment.