Category: Investing

With a great deal of focus on entrepreneurs raising money from venture capitalists, it’s important to step back and look at how it works to be an investor in a venture fund.

Here’s how it works as an investor in a venture fund:

• Venture capitalists can’t (yet) publicly advertise to solicit money so it’s done as a traditional sales process through the usual channels like warm introductions, cold calls, and emails
• When an investor commits to invest in a fund there’s substantial paperwork to become a limited partner, especially regarding the type of accredited investor
• Money committed to the fund by the limited partner, say $250,000, is requested in increments via capital calls over the life of the fund (typically 5 – 7 years)
• Capital calls are usually once or twice a year, depending on frequency and size of investments as well as credit facilities (venture funds can usually borrow a limited amount of money to fund a deal while they wait for money from capital calls to come in)
• Money committed by the investor isn’t always paid in if the fund has one or more exits early in the life of the fund as the money generated via the sale of a portfolio company can be used for future investments
• Money invested in the fund is illiquid for the life of the fund until there are exits or dividends (rare)
• Ultimately, the goal is to be completely done with the fund after 10 years, but some go on much longer than that

As you can see, investing in a fund is very different from investing in the public markets. In return for a lack of liquidity for an extremely long period of time, the goal is to receive returns that are greater than and uncorrelated with the public markets.

What else? What are some other thoughts on how it works to be an investor in a venture fund?

Reading online there’s a number of “rules” about venture capitalists and how they operate. Most of the information is solid, but there are a handful of edge cases that are more nuanced for hot startups. Here are three ideas about how venture capitalists operate that aren’t as black and white as commonly presented:

• Signing Non-Disclosure Agreements (NDA) – Most of the time, VCs won’t sign a non-disclosure agreement, and rightfully so since they see so many startups on a regular basis. Now, if you’re in super high demand, VCs are clamoring to invest, and you truly have confidential information like outstanding financials, VCs will sign NDAs.
• Investing in LLCs – Limited partners, the investors in venture capital funds, are often endowments, charities, and other non-profits that don’t want pass-through losses and the headaches of K-1s, and thus require investing in C-Corps. VCs won’t invest directly into LLCs, but if the deal has enough demand, VCs will create a blocker C-Corp, put the money in that entity, and that entity will invest in the LLC. Overall, the preference is for C-Corps based in Delaware, and if you want to raise serious institutional money, a C-Corp is the way to go from the beginning.
• Complicated Term Sheets – VCs are notorious for long, complicated term sheets with extensive legalese and jargon. Not all firms operate this way. Often, the most successful and well-known firms will have the most straightforward term sheets. Complicated term sheets are also a sign of whether or not the VC is optimizing for the relationship with the entrepreneur (upside) or trying to minimize the downside scenario (many more provisions).

With these three “rules” in mind, there’s one big takeaway: if your startup is doing great and has serious demand from VCs, the traditional rules don’t apply to you. 99% of startups never raise VC money, and the ones that can break the common rules are in the 1% of the 1% that raise money.

What else? What are some other venture capital rules that can be broken for hot startups?

For tech startups out raising money, which is many of them, it’s important to understand the economics of an early stage venture fund or super angel. The model is very different from a retail investor approach where a mutual fund might focus on a specific segment of the market, e.g. large Fortune 500 companies that pay regular dividends. Early stage investing is a high risk, high reward proposition with unusual dynamics.

Here’s how the economics of a $30 million early stage venture fund might work:

• Receive commitments for $30 million from limited partners — usually endowments, family offices, pensions, and other sophisticated entities
• 20% of the commitments are paid in immediately while the remaining 80% of the monies are requested as needed (capital calls)
• Fund goal of returning three times cash on cash over the life of the fund (e.g. take $30M and turn it into $90M)
• Timeline is to make all the initial investments in the first five years and invest the majority of the money while saving 1/4th to 1/3rd for follow-on or pro-rata participation in future financings with a goal of exiting all the investments in 10 years (usually there is an option to extend the fund an extra year a couple times for a max of 12 years)
• Take $20M of the $30M for the initial investments, that might result in the following:
  – Five $1M investments
  – Five $3M investments
  – Remaining $10M saved to participate in the future rounds of those 10 initial investments
• Financially, the majority of the profits would come from one of the 10 investments (e.g. hit a homerun) while a couple would return a modest amount and the majority would not return a profit
• Compensation for the fund partners of 2% of the fund’s value annually plus 20% of the profits (carried interest)
• Example economics for this fund with one general partner:
  – $600,000/year operating budget for the first five years then a smaller budget for the remaining years
  – $300,000/year salary and $300,000/year for expenses like legal, accounting, travel, office space, assistant, analyst, etc
  – Profits at the end of 10 years assuming returned 3x cash on cash: $90M minus $30M initial capital for a total gain of $60M. Now, take 20% of $60M and you get $12M less management fees taken out (e.g. $3M+ of management fees in five years) for a final profit for the one general partner of $9M.
• Limited partners would receive $88M for their original $30M investment (assuming goals were met — the majority of venture funds over the past decade did not meet their goals, or make any money for their investors)

The economics of an early stage venture fund show that it is much more difficult than many perceive for VCs to make great money. There’s a nice salary for a good lifestyle but to do really well, it’s much harder than it looks.

What else? What are your thoughts on the economics of an early stage venture fund?

Continuing with yesterday’s post on Founder Equity at Time of IPO, it’s also important to look at how much money each company raised to get to their S-1 filing for an IPO. As expected, the amount raised and the amount of equity the founders own are correlated, with higher amounts of money raised related to less ownership.

Here are some data points on total financing at time of IPO for these venture-backed startups:

• ExactTarget – $188M (source)
• Yelp – $56M (source)
• Bazaarvoice – $23.6M (source)
• Eloqua – $35.8M (source)
• Jive Software – $57M (source)

Another important element of founder ownership at time of IPO relative to venture funding is how far along the business was when it first raised money. Jive Software, as an example, was very far along before raising money, and thus the co-founders combined still have roughly 30% of the business. Bazaarvoice, which was extremely capital efficient only raising $23.6M, raised money at lower valuations and thus the founders took on greater dilution, resulting in less ownership than the Jive Software founders, even though they raised less than half the money.

Total amount of money raised as well as where in the startup lifecycle the money was raised are two major drivers of founder ownership in a business.

What else? What other thoughts do you have on total financing at time of venture-backed IPO?