Most successful tech startups end up sitting across the table from a venture capital (VC) fund somewhere along their journey. With a little luck, they also enter into negotiations about a round of funding. But most of those startups know little, or nothing, about how venture funds actually work.
Like most business negotiations, lack of knowledge about the opposing party creates a disadvantage and potential for missed opportunities. The purpose of this article is to educate fundraising founders how venture funds work – how they’re structured, how they operate and how the economics work between them and their investors.
Purpose of Venture Funds
People invest in funds so that professionals can invest that money on their behalf. That’s the case with mutual funds, hedge funds, and also venture funds.
Venture funds are a form of private equity, which means they invest in companies that are not publicly traded (ie – private companies). In fact, most venture funds focus on early and mid-stage tech companies during their seed, Series A and early growth stages (Series B/C). The word “venture” implies a higher risk and potential for a higher reward than many other investment asset classes.
While mutual funds and hedge funds can move into and out of their various investment positions, when a venture fund makes an investment in a startup, they have to hold on until that startup either exits or crashes and burns, with few exceptions. This is another key difference that contributes to the risk part of the risk/reward equation of venture funds.
Within the venture fund industry, there are sub-segments and niches, such as the following:
- Corporate Venture Capital – Funds that operate inside a corporation, usually using the company’s balance sheet as the source of funds.
- Venture Studios – They also embed executive talent inside the startups they invest in.
- Accelerator Programs – They both invest and provide advisory-level services for some period of time.
This article attempts to explain the more mainstream and more prevalent venture funds, which have some similar attributes to the fund types listed above. But if you are entertaining an investment from one of those other forms of funds, you will want to further educate yourself on the key differences.
Investment Thesis
Just like other forms of funds, venture funds must inform their investors about the types of investments they plan to make with the investors’ money. This is referred to as the fund’s investment thesis, or strategy. A summary version of the thesis is described in the pitch deck presentation the fund managers use to solicit investment, and in more detail in a legal document called a Private Party Memorandum (PPM).
The investment thesis for a given fund involves a combination of strategies or focus areas, such as the common ones listed below:
- Company stage
- Industry
- Customer target
- Product type
- Technology
- Business model
- Geography
A given fund’s thesis might only incorporate one or two of the above strategies, or most of them. Imagine a website for a venture fund that has the following statement: “We invest in seed and Series A rounds for Texas-based startups focusing on AI-based healthcare solutions.” This fund is basically informing you of their investment thesis in one sentence. It includes their focus on stage (seed and Series A), geography (Texas), technology (AI) and industry (healthcare).
The fund managers usually have some ability to deviate from the thesis, but only up to a certain portion of their assets under management (AUM).
The thesis also usually mentions one or more of the following strategies:
- Investment Lead – Lead investor negotiate terms directly with startups whereas others might only follows funds that write such term sheets
- Number of Expected Investments
- Minimum and Maximum Investment Amounts per Deal
Entities
Although we often refer to a venture firm or fund as if it’s a single entity, it usually isn’t. There are typically two types of entities that make up a venture fund.
Limited Partnership
This is the entity that actually receives the funding from investors and makes investments into startups using that funding. The terms that dictate the detailed administration and economics for this entity are spelled out in a 30-50 page legal document called a Limited Partnership Agreement (LPA). The stakeholders (the investors) in this entity are referred to as Limited Partners (LPs). You could say that this LP entity is actually the fund itself.
General Partnership
This is the entity that is responsible for managing one or more funds (LP entities). The General Partnership creates the various fund entities that it manages, raises the capital from investors, prepares financial reports, files tax returns, provides updates to LPs, and administers cash distributions when successful exits bring money back to a fund that it manages.
Roles
Below are the most common roles you might find at a mid-sized or larger venture fund:
- General Partner (GP) – Sometimes referred to as Managing Partners. They are ultimately responsible for managing the funds that are controlled by the GP entity. They also are usually required to invest in those same funds. If you see someone with just a “Partner” title, it implies less seniority and perhaps a lower (or no) requirement to contribute individual funding. Partners and GPs are usually the ones that serve as board directors for the companies they invest in, if that’s called for by the fund’s thesis and is successfully negotiated into an investment term sheet.
- Venture Partner – Often a part-time role, they source investment opportunities and get some form of compensation for successfully doing so.
- Principal – They are mid-level employees that source investment opportunities, perform due diligence, and match recommended opportunities to the best partner or GP.
- Associate or Analyst – They do all forms of grunt work, much in conjunction with a Principal. The word “senior” before this title simply implies seniority within the role.
- Vice President – They usually focus on accounting, legal, reporting, and other administrative tasks related to the fund.
Note: Since it is a Partner or General Partner of the lead investor that typically takes a board seat, fundraising founders should care about who, specifically, at the partner level is sponsoring their investment within the firm.
Economics
Venture funds make money in two ways:
Management Fee
Most venture funds collect a 2.0-2.5% management fee each year of the fund’s stated term. Since these management fees go to the GP entity, it means they aren’t used for investment. So, a 10-year fund only gets to actually invest 75-80% of the total funding it brings in from LPs.
Note: There is a concept called “recycling”, which involves using the first exit proceeds to make more investments, which could mean the fund ultimately invests more than 75-80% of its total funding.
Carried Interest
Generally referred to as “carry”, it is essentially a profit share. The LPs usually get their money back first as cash is returned to the fund from exits. But after that, a share of the profits conveys to the GP entity. The carry percentage is almost always 20% and it gets divvied up between the GPs and other roles (usually only the more senior ones) that are eligible for it.
The graphic below reflects both the operational and economic relationships between the two key fund entities. Remember that one management entity can oversee multiple fund entities, over time.
Capital Calls
Mid-sized and larger funds don’t require their LPs to transfer their full investment commitment all at once, but rather following what are called “capital calls”. These calls for capital could occur on a recurring frequency, like quarterly or annually, or as new investment commitments to companies are made.
During sudden economic hardships, this can create an issue for venture funds. Although capital calls are legally required as part the LPA, doing so can create severe stress for the LPs and, therefore, burn bridges for their investment consideration in future funds.
Key Fund Metrics
There are many metrics that fund managers and their LPs care about, but the following are the most typical:
- IRR – Internal rate of return. It can be calculated different ways (gross, net, interim), but is intended to reflect fund performance over time. Achieving exits and associated cash distributions to LPs quicker during the fund’s life will boost the IRR.
- DPI – Distributions to paid-in capital. For example, a fund that raised $100M from investors and has distributed $135M back to them so far would have a 1.35 DPI.
- TVPI – Total value to paid-in capital. This metric includes both realized and unrealized performance, which means it includes some forward-looking component for companies in the portfolio that haven’t yet exited.
New versus Follow-On Investments
Investors usually get pro rata investment rights, which entitle them to invest in their portfolio companies’ future rounds of funding. The fund might do so if they still believe in the company and also don’t want their equity ownership to get diluted. Part of the fund’s thesis that is spelled out in the PPM is the planned ratio of new versus follow-on investments. This also means that a fund with a follow-on investment strategy will reserve a certain percentage of their total available capital for such investments.
Some venture funds allow for crossover investment from one fund to the next, but many don’t, in order to avoid conflicts of interest between the funds. This can create some funky nuances.
Note: This is a fairly important thing for fundraising founders to find out. Will the funds you’re talking to be able to invest in your future funding rounds and, if so, can they only do so from the exact fund that would be making the new investment? How much do they reserve for these follow-on investments? Their answers to these questions don’t imply a commitment for future investments in your company.
Lifecycle of a Fund
Most venture funds have a 10-year base term. That term can usually be extended by a couple of years or more, sometimes requiring approval from the LP’s. This becomes important when there are high-quality companies still alive at the 10-year mark. Rather than be pressured to liquidate the fund’s remaining equity positions, it could be better to extend the term to maximize investment returns.
Most venture funds only make new investments during the first 2-4 years of the fund’s life, and this will be spelled out in the PPM. Funds that also make follow-on investments could do those pretty much anytime during the fund’s life, until the allocated reserve is exhausted.
Another byproduct of the above-mentioned fund lifecycle is that venture funds typically overlap each other. In other words, as Fund 1 approaches year two or three, the partners will be raising Fund 2 in hopes that it closes around the time Fund 1 is done making new investments. This means that GP management entities can actively be managing 3-4 funds that are each at different stages of their lifecycle.
Note: An important thing for fundraising founders to find out is where a given fund is in its lifecycle. A fund that is already in year four will get serious about winding down roughly six years later and might have already deployed most of their follow-on investment reserves.
More on Lead Investors
There are a few other things to know about lead investors. Remember, they are the ones that propose and negotiate the investment term sheets that all other follow-on investors for a given round will inherit.
- Due Diligence – After a term sheet is signed, the lead investor dives deep into investigation and interrogation to confirm their intent and to make sure there aren’t big surprises to address. To best prepare for this phase, read my article titled “Demystifying Investor Due Diligence“.
- Board Seat – It is typical that the lead investor gets a seat on the board of directors. For more about establishing a real board of directors, read my article titled “Early Stage Board Composition“.
- Investor Intros – Lead investors often invest 50-65% of the total round size. That means the startup needs to fill in the rest. One value a lead investor can quickly deliver is making introductions to other quality funds that don’t require being the lead.
- Special Economics – Some lead investors ask for (or require) a little extra equity versus what their investment alone will provide. They do this to compensate for their extra due diligence efforts and oversight role (board seat). This is usually done via a form of Warrant, which is somewhat like a stock option but without the vesting.
Summary
Venture funds aren’t terribly complicated to understand and, other than very different investment thesis amongst them, their operations and economics are amazingly similar. Fundraising founders don’t need to be experts on this topic, but certainly can benefit by at least a basic understanding. Asking appropriate questions along these lines will not only be beneficial, but will inform the investor of your knowledge.