Venture capital works by pooling money from wealthy investors and institutions into a fund that buys equity stakes in early-stage companies, trading cash and guidance for ownership and governance rights, then returning profits to its backers when those companies are sold or go public. Most startups can’t borrow from banks because they have no revenue, no collateral, and an unproven product, so VC fills the gap by betting on future value. The returns on a winning bet can be enormous, and the whole model is built around the expectation that a handful of those wins will carry a long list of losses.
How a VC Fund Is Put Together
A venture capital fund is a limited partnership with two sides. General Partners run it: they source deals, negotiate terms, sit on boards, and manage the portfolio. Limited Partners put up the money. The LPs are usually institutions like public pension funds, university endowments, insurance companies, and family offices. They don’t pick the startups and don’t manage the portfolio. Their liability is capped at what they committed.
A Limited Partnership Agreement governs the whole relationship. It sets investment strategy, reporting duties, profit splits, and what the General Partners can and can’t do with the capital.
Most funds run on a ten-year clock. The first few years are the investment period, when capital gets deployed into companies. The remaining years are the harvest period, when those investments grow, exit, or die. One- or two-year extensions are common when portfolio companies still need time to reach a sale or an IPO.
Fees follow a pattern known as “2 and 20.” General Partners draw a management fee of roughly 2% of committed capital each year to cover salaries and operations. The bigger payday is carried interest: once the fund returns all invested capital to the Limited Partners, the General Partners keep about 20% of the profits. That split is why fund managers obsess over picking winners. Most of their compensation rides on performance, not on simply running the fund.
Who’s Allowed to Invest in a VC Fund
These funds aren’t open to ordinary retail investors. Federal securities law limits participation to accredited investors. An individual qualifies by earning more than $200,000 per year, or $300,000 jointly with a spouse, in each of the two most recent years with a reasonable expectation of maintaining that level, or by holding a net worth above $1 million excluding a primary residence. Certain professional license holders, including those with a Series 65, also qualify.1U.S. Securities and Exchange Commission. Exploring Accredited Investors and Private Market Securities
The Funding Stages a Startup Goes Through
Startups don’t raise one big check. They raise in rounds, and each round matches a different phase of the company’s growth. Amounts rise at every step, and so do expectations.
- Seed. The earliest institutional money. It funds initial product work, market research, and early hiring. The national median seed round sat around $2.5 million as of 2024, though plenty of deals still close under $1 million depending on sector and geography.
- Series A. Raised once the company has a working product and some real market traction. The money goes toward refining the business model and scaling the customer base. Rounds typically run $5 million to $20 million.
- Series B. Capital for rapid expansion: aggressive hiring, grabbing market share, and building infrastructure. Rounds often land between $20 million and $50 million.
- Series C and beyond. By now the company usually has significant revenue. These rounds pay for international expansion, acquisitions, or getting ready to go public. They frequently top $100 million and pull in private equity funds and hedge funds alongside VC firms.
Each new round brings a fresh valuation and the issuance of new shares, which dilutes everyone already on the cap table. A founder who held 80% at seed might be down to 30% or less by Series C. That dilution is the price of growth capital. You own a smaller slice of a company that, if things work, is worth far more.
What Investors Check Before Writing a Check
Before any money moves, investors run a deep investigation of the company. Due diligence usually takes 30 to 90 days and happens inside a virtual data room, a secure digital environment where the company uploads whatever the investors want to see.
The capitalization table is the centerpiece. It tracks every share issued, every option granted, every convertible note outstanding, and the ownership percentages that follow. A sloppy cap table can tank a deal because investors need to know exactly what they’re buying. Founders also hand over financial records. Audited statements are ideal, but early-stage companies more often supply tax returns and internal financials to back up revenue claims.
Investors check intellectual property filings to confirm the company owns its core technology. Patents, trademarks, and copyright registrations get reviewed alongside employee agreements, so departing engineers can’t walk away with trade secrets. Customer contracts, supplier agreements, and market analysis fill in the rest.
The employee stock option pool gets its own look. Investors usually want to see a pool reserved for future hires, often 10 to 15% of equity at seed and Series A, growing to 20% or more in later rounds. That pool is carved out before the investment closes, which means it dilutes the founders rather than the incoming investors. First-time founders are often surprised by this.
Everything feeds into the term sheet, which lays out the valuation, the investment amount, the type of stock issued, and the protective terms attached to it.
What Investors Get in Return
VC investors almost never buy common stock. They buy preferred stock, which comes with rights that common shareholders don’t have. The most important is the liquidation preference.
Liquidation Preferences
A liquidation preference sets who gets paid first when the company is sold. The standard is a 1x non-participating preference: investors get their original investment back before common shareholders see anything. If the sale price is high enough, investors convert their preferred shares into common and take their proportional share of the total instead, whichever is greater.
Participating preferred is more aggressive. Investors get their money back first and then also share in whatever remains alongside common shareholders. That double dip cuts hard into what founders and employees take home in anything short of a blockbuster exit. Experienced founders push back against it.
Board Seats and Protective Provisions
Investors formalize their influence through board seats. A typical early-stage board has five: two founders, two investors, one independent. The board votes on hiring or firing the CEO, approving budgets, authorizing debt, and approving a sale.
Beyond board seats, investors often negotiate protective provisions that require their specific consent for things like amending the company’s charter, issuing new classes of stock, or taking on debt above a threshold. Those provisions give investors a veto over decisions that could hurt their investment, even when they hold a minority of shares.
Anti-Dilution Protection
If the company raises a later round at a lower valuation, a down round, earlier investors get hurt unless they have anti-dilution protection. Two versions exist. Weighted average anti-dilution adjusts the conversion price of existing preferred shares through a formula tied to the size and price of the new round. It’s the more common and more founder-friendly version. Full ratchet is harsher: it retroactively reprices all existing preferred shares to the lower round price, as if the earlier investors had paid that price all along. Full ratchet can gut founder ownership and is generally a red flag on a term sheet.
Founder Vesting and the 83(b) Election
Investors require founders to vest their own equity, even though the founders built the company. The standard schedule runs four years with a one-year cliff. Nothing vests in year one. On the first anniversary, 25% of the founder’s shares vest at once. After that, shares vest monthly over the remaining three years. The point is to prevent a co-founder from walking out six months after a round closes with full equity in hand.
Founders receiving restricted stock at incorporation should pay attention to the Section 83(b) election. This IRS filing lets you pay income tax on the stock’s value at grant, when it’s usually worth almost nothing, rather than paying tax on each batch of shares as they vest at potentially much higher valuations. The deadline is strict: 30 days from the date the stock is transferred, with no extensions and no exceptions. Missing it can mean a far larger tax bill spread across the entire vesting period.2Internal Revenue Service. Form 15620, Section 83(b) Election
The Rules That Govern These Deals
VC investments are sales of securities, so federal regulation applies even though the shares aren’t publicly traded. Startups avoid the cost and complexity of full SEC registration by using exemptions under Regulation D.
Under Rule 506(b), the company can raise unlimited capital but cannot publicly advertise the offering. It can only approach investors it already has a relationship with, and it can take up to 35 non-accredited investors alongside accredited ones, though in practice nearly all VC deals stick to accredited investors only. Issuers can rely on investors self-certifying through questionnaires.
Rule 506(c) allows general solicitation. Companies can advertise on the internet, on social media, and through other public channels. The trade-off: every purchaser must be accredited, and the issuer must take reasonable steps to verify that status independently, by reviewing tax returns, brokerage statements, or a letter from the investor’s attorney or accountant.3U.S. Securities and Exchange Commission. General Solicitation – Rule 506(c)
Either way, companies must file a Form D notice with the SEC within 15 days after the first sale, defined as the date the first investor is irrevocably committed. The filing goes through EDGAR and carries no filing fee. Most states also require a separate notice filing, with fees that vary by jurisdiction.4U.S. Securities and Exchange Commission. Filing a Form D Notice
How the Money Comes Back Out
The whole model depends on exits. A fund needs liquidity events to turn paper gains into actual cash it can send back to its Limited Partners. Three outcomes are possible.
Initial Public Offering
An IPO is the marquee exit. The company files a Form S-1 registration statement with the SEC, disclosing financials, business operations, and risk factors.5U.S. Securities and Exchange Commission. Form S-1 – Registration Statement Under the Securities Act of 1933 Once approved, shares trade on a public exchange. Insiders, including VC funds, usually can’t sell right away. Most IPOs include a lockup agreement that blocks insider sales for 180 days after the offering, a contract between the company, its insiders, and the underwriting banks meant to prevent a flood of selling that would crater the stock.6Investor.gov. Initial Public Offerings: Lockup Agreements
Acquisition
More VC exits happen through acquisitions than through IPOs. A larger company buys the startup for cash, stock, or a mix. The purchase price flows through the liquidation waterfall: preferred shareholders collect their preferences first, and whatever remains goes to common shareholders. A $200 million acquisition sounds big, but if the company raised $150 million in preferred stock with liquidation preferences, founders and employees split a much thinner pool than the headline suggests. The math of liquidation preferences lands hardest here.
Failure
The outcome nobody puts in a pitch deck, and the most common one. Research from Harvard Business School found that roughly 75% of venture-backed companies never return cash to their investors, and 30 to 40% of those liquidate entirely, leaving investors with nothing. A successful VC fund doesn’t need every company to win. It needs a few outsized winners to carry the losses. That power law dynamic is what makes VC different from most other investing. One company returning 50x can carry an entire fund even if most of its other bets go to zero.
Tax Provisions Worth Knowing
Three parts of the tax code shape how VC deals get built and how much the people inside them keep.
Carried Interest
The General Partners’ 20% share of fund profits gets taxed as long-term capital gains rather than ordinary income, but only if the underlying investments are held for at least three years. If the holding period falls short, those gains get recharacterized as short-term and taxed at ordinary income rates, which can be nearly double the long-term rate. The three-year requirement runs longer than the standard one-year threshold for other investments, and was enacted specifically to narrow the tax advantage for fund managers.7Office of the Law Revision Counsel. 26 USC 1061 – Partnership Interests Held in Connection With Performance of Services
Qualified Small Business Stock
Section 1202 gives a significant break to investors who buy stock directly from qualifying small businesses. For stock issued on or after July 5, 2025, under the One Big Beautiful Bill Act, a taxpayer can exclude a percentage of the capital gain from federal taxes based on holding period: 50% at three years, 75% at four years, and 100% at five years or more. The maximum excludable gain is the greater of $15 million per issuer or ten times the investor’s adjusted basis in the stock.8Office of the Law Revision Counsel. 26 USC 1202 – Partial Exclusion for Gain From Certain Small Business Stock
To qualify, the issuer must be a domestic C corporation whose aggregate gross assets don’t exceed $75 million at the time of issuance. The stock must be acquired at original issuance in exchange for money, property, or services. The thresholds are inflation-adjusted starting in 2026.8Office of the Law Revision Counsel. 26 USC 1202 – Partial Exclusion for Gain From Certain Small Business Stock
Section 1244 Losses
When a VC-backed startup fails, founders and early investors holding qualifying small business stock under Section 1244 can deduct their losses as ordinary losses rather than capital losses. The annual limit is $50,000 for single filers and $100,000 for joint filers. Anything beyond those amounts is treated as a capital loss, deductible against capital gains or up to $3,000 per year against ordinary income. For founders who put personal savings into a company that didn’t make it, this softens the tax hit considerably compared to standard capital loss treatment.