Venture Capital Fundamentals: How VC Funds Work
If you're prepping for VC interviews, this is the baseline you're expected to think in: venture is a portfolio game where a few outliers drive most returns, so ownership and follow-ons aren't details — they are the strategy.
Note
Module Reading: This article accompanies the VC Fundamentals & Mindset module in our Venture Capital interview prep track.
Venture capital isn't just "investing in startups." It's a portfolio game built on a fundamental truth: most investments fail, but a small number of outliers drive nearly all returns. This power-law dynamic shapes everything about how VC funds operate—from deal selection to ownership targets to follow-on strategy.
If you're preparing for VC interviews, you need to think in these terms. Interviewers aren't just testing definitions; they're testing whether you understand the logic chain that connects power law → ownership → follow-ons.
Interview Signal
The best VC candidates don't just recite fund mechanics—they demonstrate they understand why VCs behave the way they do. Every question about ownership, pro-rata, or reserves ties back to the power-law distribution of returns.
The 60-Second VC Fund Overview
A venture fund is a pool of capital formed as a partnership:
- LPs (Limited Partners) commit capital—pension funds, endowments, family offices, fund-of-funds, etc.
- GPs (General Partners) run the fund: source deals, make investment decisions, help portfolio companies, and return capital.
Mechanically:
- LPs make commitments, but cash is drawn over time via capital calls as deals are made.
- The fund invests over the early years (typically 3-5 years), then spends most of its life helping companies grow and realizing returns via acquisitions, secondaries, or IPOs.
- The economics are typically management fees (to run the firm) + carried interest (share of profits).
VC Fund Structure Basics
| Term | Definition | Note |
|---|---|---|
| LP (Limited Partner) | Capital providers who commit money to the fund | Pensions, endowments, family offices |
| GP (General Partner) | Fund managers who make investment decisions | Source deals, support portfolio, return capital |
| Capital Call | Request from GP to LPs to contribute committed capital | Drawn as needed for investments |
| Fund Life | Typically 10 years with possible extensions | Investment period + harvest period |
The VC Mindset: Power Law + Outliers
VC returns don't look like a bell curve. They follow a power-law / fat-tail distribution:
- Many investments return little or go to zero
- A small number of companies create most of the value
- Missing a "fund-returner" can make it almost impossible to have a top-quartile fund
Key Intuition
In venture, "hit rate" matters less than capturing enough of the upside when you're right. A VC with a 20% hit rate but massive ownership in winners will outperform a VC with a 50% hit rate but small positions.
That's why VCs optimize for:
- Access to the best deals (getting into competitive rounds)
- Ownership in the winners (not just "being right")
- Follow-on capacity to maintain ownership as winners raise more money
Fund Returns ≈ Σ (Ownership % × Exit Value)A fund's returns are driven by the product of ownership and exit value across the portfolio. Because exits follow a power law, a few large outcomes dominate.
Ownership %=Your stake at exit after all dilutionExit Value=Company value at liquidity eventHow VC Funds Make Money (LP/GP, Fees, Carry)
Management Fees
Management fees fund salaries, diligence, operations, and platform work. They're typically quoted as an annual percentage of committed capital (often around 2%), at least during the investment period.
Note
Management fees cover the cost of running the firm. They're not how GPs get wealthy—that comes from carry on successful funds.
Carried Interest ("Carry")
Carry is the GP's share of profits after returning capital to LPs. The industry reference point is typically ~20% carry, though top-tier firms may command more.
GP Carry = Carry % × (Total Distributions − Returned Capital)GPs earn carry only on profits above the capital returned to LPs. Some funds also have a hurdle rate or preferred return.
Carry %=GP's share of profits (often ~20%)Distributions=Cash + stock returned to LPsWhy This Matters in Interviews
When someone asks "How does a VC firm make money?" they're also testing whether you understand why VCs behave the way they do:
- They need outliers to generate meaningful carry (power law)
- They care about entry price, but even more about owning enough of the upside
- They fight for follow-on rights and allocation in winners
Why Ownership Matters More Than "Being Right"
Because outcomes are skewed, the same "winner" can have vastly different impacts on your fund:
- Great for your reputation at 2% ownership
- Fund-making at 10% ownership
Ownership Impact
Imagine a company exits for $1B. At 2% ownership, your stake is worth $20M. At 10% ownership, it's $100M—the difference between a solid outcome and a fund-returner for a $200M fund.
So VCs think in terms of:
- Target ownership (at entry and at exit)
- Dilution path (what happens across Seed → A → B → …)
- Check sizing as a tool to reach ownership, not a goal on its own
Quick Dilution Math (Simple Example)
You buy 10% today. Next round, the company issues 20% new shares.
- If you don't invest in the new round, your stake dilutes to 8% (10% × (1 − 20%))
- If you invest your pro-rata, you can maintain ~10% (depending on round terms)
New Ownership = Old Ownership × (1 − Dilution %)Without participating in a new round, your ownership decreases proportionally to the new shares issued.
Old Ownership=Your stake before the roundDilution %=New shares as % of post-money cap tableThis is exactly why follow-ons exist.
Follow-Ons: Pro-Rata Rights, Reserves, and Doubling Down
What Are Pro-Rata Rights?
Pro rata is the contractual right to participate in a future round to maintain your ownership percentage. You'll see it in standard term sheet language (the NVCA model term sheet references a "Right to Participate Pro Rata in Future Rounds").
Pro-Rata Definition
Pro-rata rights give existing investors the option (not obligation) to invest enough in subsequent rounds to avoid dilution. It's essentially a call option on maintaining your ownership.
Why VCs Care
Pro-rata rights are how a fund:
- Avoids getting diluted out of the few true winners
- Signals conviction (when used selectively)
- Keeps influence aligned with ownership
Follow-On Reserves (The Fund-Level Concept)
Since you can't predict winners perfectly at Seed, funds typically plan to reserve capital for:
- Maintaining ownership in breakouts
- "Doubling down" when new data reduces uncertainty and confirms the upside
Follow-On Strategy Components
| Term | Definition | Note |
|---|---|---|
| Pro-Rata Rights | Contractual right to maintain ownership in future rounds | Negotiated at initial investment |
| Reserves | Capital set aside for follow-on investments | Often 40-60% of fund for multi-stage funds |
| Selective Follow-Ons | Choosing which companies to double down on | Based on new data and conviction |
Interview Signal
Explain follow-ons as risk management + upside capture—not just "more money later." Show you understand that follow-ons let VCs increase exposure when uncertainty decreases and conviction rises.
How VC Differs from PE and IB (Interview Framing)
VC vs PE: Investment Approach
| Aspect | Venture Capital | Private Equity |
|---|---|---|
| Underwriting Focus | Upside potential under uncertainty | Downside protection with leverage |
| Control | Minority stake, influence through board | Majority/control stake |
| Cash Flows | Often negative (growth stage) | Positive and stable (required for debt) |
| Value Creation | Product, growth, market expansion | Operations, multiple expansion, leverage |
| Return Distribution | Power law (few big winners) | More normal (consistent returns) |
VC vs IB
- IB: Process + execution + valuation workstreams. Transactional advisory with defined deliverables.
- VC: Judgment under incomplete information + pattern recognition + market/product assessment + ownership strategy. Continuous portfolio work.
Answering 'Why VC?'
Anchor your answer in: power law, ownership, follow-ons, and learning velocity (how quickly you refine conviction as data arrives). Show you understand that VC is about judgment under uncertainty, not just picking winners.
Interview-Ready Cheat Sheet
Terms You Must Define Cleanly
| Term | Definition | Note |
|---|---|---|
| Power Law / Fat Tail | A few outliers drive most returns | Shapes all VC behavior |
| Ownership | % of cap table you hold (and how it dilutes) | Entry ownership vs. exit ownership |
| Pro-Rata Rights | Right to maintain ownership in future rounds | Contractual, not guaranteed allocation |
| Follow-On / Reserves | Capital set aside to keep backing winners | Risk management + upside capture |
| LP / GP | Capital providers vs. fund managers | Partnership structure |
| Management Fee / Carry | Operating fee vs. profit share | ~2% fee, ~20% carry is common reference |
Common Mistakes (That Get Candidates Rejected)
- Talking about VC like it's PE ("we can engineer returns")
- Over-indexing on valuation while ignoring ownership + dilution
- Saying "we'll follow on in everything" (no strategy)
- Not being able to explain pro-rata in one sentence
- Treating VC as "stock picking" without understanding portfolio dynamics
Sample Interview Questions (With Strong Answers)
Frequently Asked Questions
Key Takeaways
Summary
- VC returns follow a power law — a few outliers drive most fund returns
- Ownership matters more than being right — the same winner at 2% vs 10% has vastly different fund impact
- Pro-rata rights protect ownership — they let you maintain stake through dilutive rounds
- Reserves enable selective follow-ons — double down when data confirms upside
- Management fees run the firm; carry makes GPs wealthy — and carry requires outlier exits
- Connect power law → ownership → follow-ons in every answer to show you understand VC logic
What's Next
Now that you understand how VC funds work, the next modules in your VC interview prep sequence are:
- Market Sizing & Growth Logic: TAM/SAM/SOM + "why now" frameworks
- Startup Financials & Unit Economics: CAC, LTV, burn, runway
- Product & Founder Evaluation: How VCs assess teams and moats