VC Fund Mechanics 101: Understanding the Fund Lifecycle 

Imagine a world where game-changing startups like Uber, Airbnb, and Stripe never existed. What if the capital to fuel their growth wasn’t there? This is the reality we’d face without venture capital (VC) funds.

VC funds are the lifeblood of the startup ecosystem, injecting the financial fuel that turns bold ideas into transformative companies. They don’t just cut checks—they build bridges between investors and innovation, taking calculated risks on founders who dare to challenge the status quo.

But how do these funds work? How do they decide which startups to back, and what happens behind the scenes after an investment is made? Whether it’s a €100,000 seed round or a €10 million growth investment, the machinery of VC funds operates in a way that shapes not only individual businesses but entire industries.

In this article, we’ll peel back the curtain on the VC fund cycle and provide insights into how VCs generate revenue and key considerations to make along the way.

What is a VC and How Do They Generate Revenue?

VC funds are specialised legal entities designed to pool capital from multiple investors and deploy it into startups with high growth potential. Understanding how these funds operate goes beyond their structure—it requires insight into what drives venture capitalists and shapes their decision-making at every stage of the fund cycle.

At the core of VC operations are two primary revenue streams: management fees and carried interest (carry). These not only sustain the fund but also shape its incentives and priorities during each phase of its lifecycle.

Management Fees: Keeping the Fund Operational

Management fees provide the steady income VCs need to cover their operational costs, such as salaries, office expenses, and due diligence efforts. These fees typically range from 1% to 2% of the fund’s committed capital and are charged annually throughout the fund’s 10-year lifespan.

For example, if a fund raises €50 million and charges a 2% management fee, it collects €1 million per year. Over a 10-year fund lifecycle, this adds up to €10 million, ensuring the team has the resources it needs to operate smoothly. However, management fees are just the tip of the iceberg—most of the fund’s resources remain focused on investing.

Carried Interest: The Real Payoff

While management fees keep the wheels turning, carried interest—known as carry—is where VCs see the real rewards. Carry is essentially a performance bonus, typically around 20% of the fund’s profits, earned when their investments succeed.

For instance, if a €50 million fund grows to €300 million over a decade, generating €250 million in profits, the VC takes €50 million as carry (20% of the profits). This lucrative incentive is mostly distributed to the fund’s general partners (GPs), with smaller portions going to employees and stakeholders.

Carry aligns the VC’s success with the success of their startups. The better their portfolio companies perform, the more significant the payoff, making carry a powerful motivator for helping founders achieve strong exits.

How Revenue Impacts VC Behaviour

A VC’s revenue model influences how they operate and interact with startups. Whether a fund relies more on management fees or carry can shape their priorities, the resources they offer, and their level of involvement.

Smaller Funds: High Alignment with Startups

Smaller funds often depend heavily on carry for their financial rewards. With limited management fees, these funds are run by managers whose personal success is tied closely to the success of their startups.

Key characteristics of smaller funds include:

• Low management fees: Modest fees mean that fund managers depend on profits from successful exits to earn significant returns.
• GP investment: Managers often contribute personal capital, tying their success directly to the fund’s performance.
• Hands-on involvement: Smaller fund managers typically offer tailored guidance, mentorship, and active participation in strategy and growth.
• Strong alignment with founders: Since their rewards hinge on startup exits, smaller fund managers are highly motivated to support the growth and success of their portfolio companies.

Larger Funds: Resource-Rich but Less Personal

Larger funds, especially those managed by well-established firms, have a different structure. They bring in substantial management fees, which provide financial stability regardless of how their portfolio performs.

Key characteristics of larger funds include:

• High management fees: These provide a steady income stream, allowing managers to focus on the broader portfolio without depending heavily on carry.
• Extensive resources: Larger funds offer startups access to vast networks, significant capital, and industry expertise, making them well-suited for scaling businesses.
• Broader focus: With larger portfolios, fund managers may have less time to dedicate to individual startups, often focusing on big-picture strategy rather than day-to-day operations.
• Prestige and credibility: Backing from a well-known fund can enhance a startup’s reputation, attract follow-on investors, and create strategic opportunities.

The Journey of a VC Fund

Like startups, VC funds have their own journey, marked by distinct phases that dictate how they operate and interact with the companies they back. From preparation to exit, the journey of a VC fund is a structured process designed to maximise returns for its investors while fuelling the growth of innovative startups. But, what does each phase look like?

The Preparation Phase 

Every VC fund begins with the preparation phase, a critical period focused on setting up the foundations for the fund’s operations. This stage typically lasts one to two years and involves:

• Drafting legal documents: This includes structuring the fund and setting the terms for both general and limited partners.
• Assembling the team: Fund managers build a team with the expertise and connections necessary to identify and support high-potential startups.
• Defining the strategy: The fund clarifies its focus, such as targeting early-stage startups with smaller investments or later-stage ventures requiring significant capital.

By the end of this phase, the fund has a clear roadmap and is ready to attract investors in the next stage.

The Marketing Phase

Once the strategy is in place, the fund enters the marketing phase, where it seeks investments from limited partners (LPs). This phase can take anywhere from one to five years, depending on the fund’s size and complexity.

During this period, fund managers pitch the potential of their fund to LPs, focusing on metrics like the Internal Rate of Return (IRR). A typical target IRR of 20% annually suggests that an initial investment of €100,000 could grow to €600,000 over 10 years.

However, while the numbers are compelling, this phase isn’t just about selling returns—it’s about building trust and credibility. Not all funds succeed in generating the expected outcomes, so convincing LPs requires demonstrating both a solid strategy and a proven team.

The Capital Commitment and Deployment Phase

With committed capital in hand, the fund begins its investment phase. Funds usually raise capital in stages through multiple closings, such as starting with €10 million for a €100 million fund and securing the remaining amount over time.

Once the capital starts flowing, the fund’s 10-year lifecycle officially begins:

• Initial investments: The first four to six years are spent identifying and funding a diversified portfolio of startups. This period is crucial for balancing risk and maximising the potential for returns.
• Portfolio management: After making these initial investments, the focus shifts to helping startups grow and achieve exits.

Exits are critical for meeting the fund’s financial goals. Whether through acquisitions, mergers, or IPOs, these events allow the fund to return capital to its LPs. If an exit doesn’t occur within the 10-year timeframe, the fund may have to write off the investment, which impacts both the fund and its backers.

Follow-On Investments and Fundraising

In the second half of a VC fund’s lifecycle, typically spanning four to six years, the focus shifts to two key activities: follow-on investments and raising new funds.

Follow-On Investments

VCs reserve a substantial portion of their capital for follow-on investments—additional funding rounds to support the most promising startups in their portfolio. For instance, a VC might initially invest €1 million in a startup and later follow up with an additional €5 million to help it scale further.

The balance between initial and follow-on investments varies by fund strategy. Some VCs allocate around 40% of their capital for initial investments and 60% for follow-ons, while others may reverse this ratio. Regardless of the split, VCs always reserve enough capital to participate in pro rata investments, ensuring they can maintain their equity stake in high-performing companies.

Raising New Funds

While managing follow-on investments, VCs simultaneously begin raising their next fund. Building on the performance of their current portfolio, they pitch a larger vision to attract more significant investments from limited partners. This step is crucial for sustaining the firm’s operations and expanding its influence.

This dual focus ensures that VC firms maintain a steady cycle of investment and growth, with follow-on funding bolstering portfolio companies and new funds preparing for future opportunities.

Term Extensions and Exits

As the fund nears the end of its lifecycle, exits become the primary focus. Some funds may negotiate term extensions if they see promising exit opportunities just beyond the 10-year mark. However, exits are non-negotiable in the VC model—investors expect their returns within a defined timeframe.

For founders, this means the clock starts ticking the moment a VC invests. If your startup doesn’t plan to exit within the 10-year window, traditional VC funding may not align with your business goals.

Exits can take many forms, but they all serve the same purpose: to provide returns to the fund’s LPs. Whether through acquisitions, mergers, or IPOs, this final stage marks the completion of the VC fund’s journey.

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Key Considerations for Founders Seeking VC Funding

When you’re raising funds, it’s easy to get caught up in the excitement of securing a cheque. But behind every venture capital deal is a timeline—and a business model—that shapes how VCs operate and interact with startups. To make the most of a VC partnership, it’s essential to understand how the fund cycle impacts your journey. Here’s what to keep in mind:

Exits Are Non-Negotiable

One thing to know about VCs: they’re not in it for the long haul. Their goal is to grow your company and cash out. VC funds typically run on a 10-year cycle, meaning they need to return capital to their investors by the end of that period.

If your startup isn’t built for an exit—whether through acquisition, merger, or IPO—a traditional VC fund may not be the right fit. Maybe your business needs more than a decade to mature, or you envision a slower, steady growth path. In those cases, it’s worth exploring alternative funding options.

Timing Is Everything

Where a VC is in their fund cycle can make or break the dynamics of your partnership.

• Early in the Cycle: If a fund is just starting out, you could have up to 10 years to grow and exit, giving you flexibility to scale at a sustainable pace.
• Later in the Cycle: Funds nearing the end of their commitment phase (usually in years 4–6) may offer less time to achieve milestones, increasing pressure to prioritise speed over strategy.

Ask VCs about their position in the fund cycle to ensure their timeline aligns with your startup’s goals.

The Pressure to Spend

VCs face a ticking clock to deploy capital, particularly as they approach the end of their commitment phase. Unused capital sitting idle fails to generate returns, creating what’s known as "deployment pressure."

For founders, this urgency can work in your favour by strengthening your negotiating position. However, it’s essential to ensure the partnership aligns with your long-term growth needs, as a rushed investment may lack strategic fit.

To assess this, ask how much of the fund has already been deployed. If most of it is invested, the VC may be more selective. If not, deployment pressure might influence their decisions.

Follow-On Investments Matter

Getting that initial investment is only part of the equation. Many startups need follow-on funding down the line, and having a VC with reserves to reinvest can make future rounds far less stressful.

• Funds with strong follow-on reserves can lead your next funding round, saving you time and effort while ensuring your existing investors stay invested in your success.
• Funds with limited reserves might not be able to support you as your business grows, leaving you to find new backers on your own.

When evaluating a VC, ask how much of their fund is earmarked for follow-on investments. Knowing they have the capacity to reinvest can provide peace of mind as you plan your long-term growth.

That’s a Wrap 

The VC fund cycle is a structured journey that drives the venture capital industry, from preparation to exits. Each phase has a direct impact on how funds operate and how they interact with startups. For founders, understanding these stages—from revenue models and deployment strategies to the inevitable need for exits—provides a roadmap for navigating VC partnerships with confidence.

Ultimately, VC funding is about more than just capital. It’s about finding alignment: with the fund’s timeline, goals, and incentives. By asking the right questions and ensuring a mutual fit, you can secure a partnership that doesn’t just fund your startup’s growth but also supports your long-term vision.

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