The World of Venture Capital: Part 3
- Pranav Gupta
- Aug 4
- 5 min read
Updated: Aug 13
Follow the Money: How VC Funds Really Make (or Lose) Money?
In 2006, Sequoia Capital invested $5 million in a relatively unknown startup that helped people upload and share videos online.
That startup was YouTube.
Less than two years later, YouTube was acquired by Google for $1.65 billion.
That one deal returned more than 40x Sequoia’s investment. But more importantly, it returned an entire fund.
This is what VCs mean when they say: “All we need is one.”
Venture capital isn’t about batting averages, it’s about home runs.
So… How Do VC Funds Actually Make Money?
The VC business model looks simple on the surface:
Raise money from institutions and high-net-worth individuals (called Limited Partners or LPs)
Invest that money in startups
Make a return when those startups get acquired or go public
But beneath the surface, the mechanics are more complex — and very different from how most people think investors make money.
Here’s what really goes on:
Step 1: Raising a Fund
Before a VC can invest in any startup, they need to raise a fund.
This fund typically ranges anywhere from $10 million (micro funds) to $1+ billion (large firms like a16z or Sequoia). The money comes from:
Pension funds
Endowments
Sovereign wealth funds
Family offices
High-net-worth individuals
These investors become LPs in the fund. They commit capital for 8–10 years, trusting the VC firm to invest it wisely and return more than what they put in.
VCs often pitch their fund with a strategy:
“We invest in early-stage SaaS startups in India.” “We focus on deeptech and climate innovation.” “We aim to find the next unicorns at seed stage.”
The better the track record, the easier it is to raise a fund.
Step 2: The 2/20 Model
Once a VC raises a fund, they don’t just sit back. They get paid regardless of whether the fund succeeds or not.
This happens through the 2/20 model:
2% management fee every year
(So for a $100M fund, the firm earns $2M/year to run operations)
20% carry (carried interest)
That means: the VC gets 20% of the profits after returning capital to LPs
Let’s say a VC turns $100M into $300M:
First $100M goes back to LPs (return of capital)
Remaining $200M = profit
VC takes 20% of $200M = $40 million
The rest ($160M) is distributed back to LPs.
The 2% pays salaries, overheads, sourcing, legal, etc. But the real wealth is made from carry and only if the fund performs well.
Step 3: Startup Investing (The High-Risk Bet)
VCs then deploy the fund over 2–4 years across 20–40 startups. A typical breakdown looks like:
1–2 “home runs” that return 20–50x
4–5 do okay (2–5x)
The rest? Go to zero
This is where the risk lies: startups are illiquid and binary. Most never make it past Series A. Returns often take 8–10 years to materialize (via IPOs or acquisitions).
The key is portfolio construction - VCs need a few big winners to make the entire math work.
Power Law in Action
The reason VCs chase “unicorns” is because of something called the Power Law.
It means: in a portfolio of 30 startups, one startup might return more than the other 29 combined.
If a VC misses that one , even if the rest do okay , the fund might still underperform.
This is why VCs often pass on “safe” 3x returns and go all-in on bold bets like OpenAI, Stripe, or Figma.
Exit Strategies (When the VC Actually Gets Paid?)
VCs don’t make money when they invest , they make it when they exit.
There are three main ways:
Acquisition: Another company buys the startup
IPO: The startup goes public
Secondary Sale: VC sells their stake to another investor (less common early on)
But exits are rare and take time. A lot of startups either die or become “zombies” - surviving but not growing or exiting.
This makes liquidity one of the hardest parts of VC.
What Happens When a Fund Underperforms?
If a VC fund doesn’t return at least 3x the invested capital, it’s often considered sub-par.
Why?
Because LPs can get 10–15% annual returns elsewhere (like private equity or public markets). If VC returns aren’t high risk, high reward, they’re not worth it.
If a VC fails to deliver:
LPs may not invest in the next fund
Partners may not get carry
Reputation suffers
Future funds are harder to raise
A VC’s entire business depends on proving they can spot and support outliers.
Real Example: Benchmark & Uber
Benchmark Capital invested $12 million in Uber’s Series A at a $60M valuation.
By the time Uber went public, that stake was worth $8.2 billion.
That single investment returned more than 100x and made up for every bad bet in the portfolio.
That’s the dream scenario VCs chase. But it’s incredibly rare.
Where Do VCs Lose Money?
While the public sees only the success stories, the graveyard of failed startups is vast.
VCs lose money when:
They enter at high valuations with no real traction
They follow hype (FOMO) without diligence
They can’t help startups raise follow-on capital
They over-index on trends instead of market fit
Even top-tier firms make bad bets - WeWork, Juicero, Theranos - the list goes on.
The difference is: good VCs learn, adapt, and construct resilient portfolios.
Final Thought
At the end of the day, venture capital is a business of conviction and long games.
It’s not about being right every time. It’s about being right big - once in a while.
Behind every successful VC fund lies:
Dozens of failed experiments
A few underestimated founders
And one or two bets that changed the trajectory of the entire portfolio
But here’s the thing , not all game-changing startups are born in San Francisco. And not every moonshot is a software play.
Coming Next: Part 4 - The Power Dynamics - How Venture Capital Shapes Founders (and Not Always for the Better)?
What does a founder owe their investor?
And what does an investor owe the founder?
Behind every term sheet and board seat lies a power dynamic that can quietly shape or shake a startup’s destiny.
In this part, we explore the human side of venture capital:how influence, control, incentives, and expectations shift the way companies are built, scaled, and sometimes broken.
Not everything that’s funded turns out fair.
Let’s unpack ‘why’ in the last part.
If you want to dive deeper into The World of Venture Capital, I’m soon launching VC Times, a weekly newsletter that brings you the sharpest insights, deals, and trends from the Indian venture capital world curated with clarity and zero fluff.
Subscribe now to get early access: Click here!
Thanks for reading my thoughts and as always, rooting for you from afar.
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