Why would anyone invest hundreds of millions of yen in a loss-making company whose future success is uncertain? VC—venture capital—provides this financing, which ordinary bank lending cannot readily explain.

VC's business model is to acquire shares early in companies with substantial growth potential, support their development, and realize returns through IPOs, M&A, or similar exits.However, portfolio-company growth, fund profits, and the VC manager's compensation are distinct. We connect “2 and 20” with dilution, follow-on investment, and exits.

1. VC does not earn interest like a bank

With bank loans, the borrower generally repays principal and interest. In equity VC investment, returns primarily come from share-value appreciation as the company grows. Failure can wipe out the investment, while exceptional growth offers the prospect of recovering many times the original amount.

The U.S. SEC's comparison also describes minority investments in startups and similar companies as typical of VC. Its targets' growth stages and involvement differ from buyout PE, which takes control and improves businesses.

Targets also vary. Seed investments around formation, early-stage business development, and later-stage expansion involve different track records and funding needs. Losses do not all represent the same risk: a company with no product differs from one with proven demand investing ahead in distribution.

2. VC itself has investors providing its capital

VC professionals do not necessarily invest entirely their own money. Funds may raise capital from LPs, with a GP and manager selecting investments and running the fund. LPs include financial institutions, corporations, and institutional investors, funding commitments as needed.

Fund life is important. A structure with a finite life of around 10 years, for example, must eventually realize its investments. The UK government-backed British Business Bank's explanation of Microfunds includes an example assuming 10 years with possible extensions. This describes that program, not a uniform term for all VC funds.

Founders should consider not only personal fit with the investor, but which fund vintage is investing and how much life remains. A company needing lengthy R&D may not align with a fund approaching its realization period.

3. VC's “2 and 20”: Operating costs and profit sharing

VC may also combine management fees and carry. Under “2 and 20,” the former is 2% annually on the contractual fee base, and the latter is 20% of specified profits. The SEC glossary also describes carry as a share of investment profits allocated to PE or VC managers. The 20% is not a guaranteed investor return.

For example, a JPY5 billion fund charging 2% annually on commitments produces JPY100 million in annual management fees. This is revenue for the management company, funding investment staff, sourcing, and administration. Even a small team does not retain all of it as profit.

The fee rate or base may change after the investment period; “total fund size × 2%” need not continue indefinitely. Formation and audit costs may also be charged separately. Beyond fee percentages, examinetotal costs across the fund's life and the amount actually available for investment in companies.

The British Business Bank material above also permits management fees and carry while allowing alternative structures. “2 and 20” is a convenient explanation, not a uniform rule; terms vary with fund size, duration, operating model, and investor negotiations.

4. One major success among ten companies can determine overall results

In VC, a small number of major successes can determine overall performance. British Business Bank also explains that early-stage VC returns often depend on a few exceptional companies. Practitioners sometimes call this concentration a “power law.” This does not mean every fund follows a particular mathematical formula.

Suppose JPY100 million is invested in each of ten companies, producing the following results. This is an illustration, not actual success probabilities or standard performance.

JPY2.3 billion recovered on JPY1 billion invested gives an aggregate deal-level multiple of 2.3×. Without the final company, however, proceeds would be only JPY300 million. Management fees, other costs, and carry must then be considered to determine LP net returns.

This structure explains why VCs seek companies pursuing very large markets, rather than only businesses generating modest, steady profits. Even a sound, stable business may not fit VC if it does not match the fund's size and required return.

5. A company's value growing tenfold does not necessarily mean a tenfold VC return

Raising funds by issuing new shares reduces existing shareholders' ownership percentages. This is dilution.

For example, investing JPY100 million at a JPY900 million pre-money valuation buys 10% of a JPY1 billion post-money value. If later financing reduces ownership to 6% and an exit occurs at JPY10 billion equity value, simple proceeds are JPY600 million. Company equity value grew tenfold, but the investment returned 6×. Preferred distributions and selling costs are excluded.

VCs therefore consider entry price, ownership percentage, future funding needs, follow-on rights, and available capital alongside enterprise value. A higher valuation buys a smaller stake for the same money. Even an excellent company may produce inadequate returns if the entry price is too high.

The U.S. National Venture Capital Association's model investment documents separately address investor and voting rights alongside share purchase agreements. The terms governing how much economic value an investor receives when a company grows are part of the investment decision. U.S. models do not automatically apply to Japanese contracts.

6. Follow-on investment: Reserving capital for promising companies

Using all capital for initial investments leaves nothing to invest further in companies that begin to thrive. Some funds therefore reserve a portion for follow-on investments.

British Business Bank's ECF assessment criteria also consider the proportion reserved for follow-ons alongside investment strategy. How many companies receive initial funding, and which receive further funding, when, and how much, are portfolio design decisions.

Follow-on investment is not always the right choice. Increasing exposure to a company with improving prospects differs from continuing to fund it because failure is hard to admit. Check whether a desire to preserve the carrying value of an existing investment is clouding the rationale for committing new money.

7. Preferred shares: More than ownership percentage times sale price

Shares acquired by VCs may carry rights to specified distributions before common shares. The SEC glossary's explanation of liquidation preferences also describes preferred shareholders receiving payment before common shareholders.

For example, consider investing JPY300 million for a 20% stake with a simple choice between a 1× nonparticipating preference and conversion to common shares. If JPY500 million is available to shareholders, the investor chooses the JPY300 million preference rather than 20%, or JPY100 million, leaving JPY200 million for common shareholders. If JPY3 billion is available, conversion and a 20% share of JPY600 million is more favorable.

Actual outcomes vary with multiple preferred classes, distribution seniority, participating versus nonparticipating terms, and clauses applying similar allocations on M&A.A preference does not return principal if there are no proceeds to distribute.It is not a principal guarantee.

Founders should therefore model who receives how much at exit, not merely whether the fundraising valuation is high or low.

8. An IPO is a step toward liquidity, not the finish line

VC exits include post-IPO share sales, M&A sales to companies, and secondary sales of existing shares to other investors. Listing does not necessarily allow immediate sale of all shares; lockups and market liquidity affect realization timing.

A higher valuation in the next financing round is also different from receiving cash. A record of investing in several unicorns does not reveal distributions to LPs. Valuations can decline, and realization can take a long time.

Corporate venture capital, or CVC, may seek business collaboration and technology alongside investment returns. This can appeal to founders, but consider potential conflicts if the investor's strategy changes or the startup wants to partner with another company.

9. When is carry received?

Suppose investors contribute JPY1.2 billion, with JPY1 billion invested and JPY200 million used for fees and similar costs, and final proceeds are JPY2.3 billion. Under a simple contract allocating 20% carry on the JPY1.1 billion profit after returning contributions, carry is JPY220 million and LP distributions are JPY2.08 billion. This hypothetical excludes hurdles, taxes, and the GP's investment.

The calculation is not “the portfolio became worth JPY2.3 billion, so 20% is the VC's profit.” What is returned before profit sharing, including management fees, matters.

Contracts may include a preferred-return hurdle, a catch-up bringing the GP's share to a specified proportion, and a clawback returning excess carry paid earlier. ILPA's principles advocate clarity on these distributions and costs. However, there is no rule that VC must always have an 8% annual hurdle.

Carry received by the manager is not necessarily one individual's income. Internal allocation, tenure conditions, timing, and taxes mean reported investment successes cannot be directly equated with an investment professional's income.

10. Where do founders' and VC interests diverge?

VC seeks strong returns across the fund. A founder may instead want to run the company for many years or sell earlier at a particular price. Even when both seek substantial growth, their preferred scale, pace, and exit may differ.

An acquisition offer attractive to a founder may be too small to meet a large fund's return needs. Conversely, while a founder wants to keep building, the fund may seek an exit because of its remaining life or allocation needs across other companies.

This is why management involvement, follow-on policy, consent rights, and exit procedures should be discussed at investment. Discovering only after receiving funds how much growth is expected makes adjustment difficult.

11. High VC returns do not necessarily arise from debt leverage

VC seeks high equity returns by investing in companies that can scale revenue through technology, software, brands, or networks. This should be distinguished from financial leverage that enlarges the invested amount through borrowing.

Portfolio companies may use venture debt, and funds may use bridge loans. However, VC does not inherently mean operating at high debt ratios. A loss-making growth company can face a cash crisis despite growth potential if debt maturities do not align with its development timeline.

VC's essence is combining investments that may fail, supporting companies that grow, and ultimately realizing returns.Along the way, valuation, ownership percentage, capital reserves, contractual terms, and remaining fund life all matter. “It invests in famous companies” or “2 and 20 makes it profitable” does not explain the business model.