VCs have 3 principal jobs: picking startups to invest in, helping startups after investing, and raising capital for investing. Each of these jobs will be covered in its own post. This post, the third and final one in the series, focuses on how VC funds are structured and raised. It also covers some venture capital FAQs, which were sourced from the following Twitter thread:
I'm writing a post on what happens behind the scenes at a VC firm: partner meetings, funnel, deal flow sources, etc. Ideas for add'l topics?
— Leo Polovets (@lpolovets) March 23, 2017
Table of Contents
Part 1: Deals, Deals, Deals
A post on how VC funds source, analyze, and choose companies to invest in.
A post on how investors interact with companies after investing, and how they allocate their time on a day-by-day basis.
Part 3: Fund Structure, Fundraising, Investor Relations, and FAQs [this post]
Venture funds have two principal parties: general partners (GPs) and limited partners (LPs).
LPs are the fund’s financial backers. These are the people whose capital is being invested. LPs can range from university endowments to pension funds to wealthy individuals.
GPs are the fund’s day-to-day managers. These are the people who make startup investments. They can be thought of as the middlemen that connect LPs’ capital to the founders who need funding for their startups. On top of allocating capital, good GPs usually try to provide value to founders in the form of advice or introductions or services.
Funds typically last for ten years. The first portion of that decade – typically 2-4 years – is an active investing period where funds make new investments. Most funds make 20-40 investments during this period, with a typical investment being 1-2% of the fund’s total capital. The remainder of the ten years is more passive. During this period, funds can’t make new investments, but they can follow-on and invest their remaining capital into existing portfolio companies’ subsequent funding rounds.
Most seed funds reserve a portion of their fund for follow-on investments. This is the portion of a fund allocated to follow-on investments rather than new investments. For example, a $60m fund with a 2:1 reserve ratio will use $20m for initial startup investments, and save $40m for future investments in those companies.
The mission of a venture fund is to invest in startups, have those investments appreciate over time, and have those startups exit within the fund’s ten-year lifetime. (An exit would be an acquisition or an IPO.) If some companies are still operating after ten years and need more time before an exit, then the ten-year period can be extended by 1-2 years with LP approval. When the fund is wrapping up, the GPs try to liquidate all of their remaining investment stakes.
Like many hedge funds, a typical VC fund has a “2 and 20” fee structure. This means 2% of the fund is charged as a management fee each year, and the fund’s GPs and employees split 20% of the profits they generate. The profit-sharing portion is usually referred to as “carried interest” or “carry.”
Fun fact: according to Wikipedia, “The origin of carried interest can be traced to the 16th century, when European ships were crossing to Asia and the Americas. The captain of the ship would take a 20% share of the profit from the carried goods, to pay for the transport and the risk of sailing over oceans.”
The 2% annual management fee usually tapers off after a few years. For example, the fee might be 2% per year for 4 years (the active investing period), and then it goes down by 0.25% per year for the remaining 6 years. This fee is meant to cover GP salaries, employee salaries, legal and accounting fees, office space, and additional costs like event planning or consultant services. As you might expect, funds often increase in size over time because that means more management fees, more employees, higher salaries, and bigger budgets to help stand out to founders. (Ah, incentives.)
The way carry works is that all exit proceeds are returned to LPs until their capital is paid back, and then they get 80 cents on the dollar for future exits. For example, if a $50m fund has $20m exits in years 6, 7, and 8, then the first two $20m exits will be redistributed directly to LPs. The first half of the final $20m exit will also be redistributed directly to LPs, and the second half will be redistributed 80/20 between LPs and GPs. Future exits in the fund will be redistributed 80/20.
On a side note, if you thought employee option vesting was long, carry vesting is usually much longer. A typical vesting schedule might last for 8 years, and also include a clawback of 1 or 2 years of carry if a general partner leaves to join another competitor fund. This is why GPs rarely move from one fund to another.
Funds are usually “stacked,” which means that once a fund is mostly done with its active investing period, the GPs begin raising their next fund. That means 7 years after starting, the GPs might be finishing year 7 of Fund 1, year 4 of Fund 2, and year 1 of Fund 3.
Raising a Fund
Fundraising usually happens every 2-4 years for most funds, in conjunction with active investing periods. The goal is to have one fund’s active period begin immediately after the previous fund’s active period ends.
The fundraising process for venture funds has many parallels to the fundraising process for startups. For young funds, a fundraising cycle can take the better part of a year, or even longer. For established, successful funds, fundraising might take weeks or even days.
Fundraising involves building a pitch deck and having a compelling story about why your fund partnership is a good one to back. Once the pitch deck is ready, GPs will approach their existing LPs from previous funds (if applicable), wealthy individuals, family offices, fund-of-funds, and university endowments. These groups often allocate a small portion of their assets (e.g. 1%-10%) to alternative asset classes like venture capital and private equity.
When starting a new fund, GPs who don’t have strong track records in the industry usually focus on high net worth friends, family, colleagues, and friends-of-friends. As the GPs build a good track record over time, they become more appealing to fund-of-funds, endowments, and other “professional” LPs.
As with startup pitches, fund pitches can vary a lot. That said, the core things most LPs care about are the GPs’ hypothesis about promising areas to invest in, the fund’s structure (how many investments will it make? what’s the average check size? etc.), the GP team, and the team’s investing track record so far (if applicable).
If fundraising is taking a long time – and it usually is – GPs will often have a “first close” on 25%-50% of the target fund amount, and then a final close on the rest of the fund. The first close lets the GPs start making investments out of a small portion of the fund while they are still raising the remainder of the fund.
At the core of investor relations is an annual LP meeting. This meeting takes anywhere from an hour or two to an entire day. The GPs talk about all of their active funds, specifically focusing on each fund’s financial performance, portfolio company highlights, and near-term plans. The GPs also discuss their outlook on the market, answer LP questions, and often invite a few portfolio founders to give short talks about their companies.
Aside from annual meetings, GPs typically write quarterly or biannual investor letters. These letters include summaries of how the overall portfolio is doing financially, as well as noteworthy portfolio company updates.
Finally, LPs and GPs are people, so aside from formal meetings and investor letters, they get together casually for occasional catch-up meetings. LPs who write bigger checks might ask to have a regularly scheduled meeting every few months.
Venture Capital FAQs
Before writing this post, I asked people on Twitter what questions they had about working in venture capital. Here are some of the questions that were brought up:
Q: Are there any ethical issues when deciding what companies to invest in?
A: Sometimes LP/GP agreements will spell out areas that can’t be invested in (e.g. no drug or gambling startups). Many (but not all) funds won’t invest in companies that are shady in some way (i.e. companies that exploit underprivileged segments, use dark patterns, etc). However, unless undesirable investment areas are spelled out in the LP/GP agreement, investments are made at the discretion of GPs. If a GP does make an investment that LPs strongly question, then there’s a high risk of those LPs not investing in the GP’s next fund.
Q: What’s an investment thesis?
A: An investment thesis describes the types of companies that a fund wants to invest in. It’s a public hypothesis about the types of companies that have lot of potential over the next 5-10 years. A few examples of theses:
“Companies reimagining the future of work” (Bloomberg Beta)
“Hardware companies” (Root Ventures)
“Companies with sustainable competitive advantages” (Susa Ventures)
“Companies applying deep tech to big industries” (Data Collective).
Q: How frequently do VCs stick to their investing theses vs. investing opportunistically?
A: Not every VC has an investing thesis – some invest opportunistically in any startup that they like. For the ones that have a thesis, most investments will fall into that thesis. The reason for this is perception. Let’s say a fund’s thesis is that SaaS companies are the most promising startup category, and half of the fund’s investments are SaaS companies while half are not. If all of the fund’s best investments over time turn out to be non-SaaS, future LPs will question the fund managers’ judgment.
That said, if a fund meets the next Facebook, they won’t want to pass on it just because it’s out-of-thesis. Putting all of this together, most investors will stick to their thesis “most” of the time (i.e. 75%-100%).
As a corollary, if you’re a founder and your startup falls outside of a fund’s public thesis, it’s probably wise to approach other funds first.
Q: What are the advantages and disadvantages of an investing thesis?
A: The advantages are that if you become known as being a good, knowledgeable investor in a certain area, then you’ll see a lot more investment opportunities in that area: founders will come to you because you’ve shown you understand and invest in their space; other investors will introduce you to relevant companies to get your expert opinion; industry conferences will invite you to be a speaker; and so on.
The main disadvantage of a thesis is that it becomes harder to invest in other areas. If you’re known as a great hardware investor, then it might not occur to Mark Zuckerberg to approach you because Facebook isn’t hardware. What’s worse, if Mark does approach you, it’s probably because all of the more well-suited funds already said no. Because you’ll be missing out on a lot of out-of-thesis startups, you better have a lot of conviction in your thesis being correct.
Q: What motivations does the VC have to invest or not invest?
A: VCs want to make investments because every time they finish investing out of one fund, they can start the next fund (with more management fees and more carry). This is counterbalanced by the desire to be patient and only make good investments. If a VC makes good investments, they’ll raise more funds and earn more carried interest; if they make poor investments, they’ll stop being able to raise funds and they won’t earn much carried interest.
Most funds spend 2-4 years actively investing. Funds longer than 4 years would require raising too much LP capital, and LPs would rather see results every few years before deciding whether to continue investing in a fund. Funds shorter than 2 years are taking on a lot of time diversification risk: if all of a fund’s investments were made in a year that turns out to be a terrible year for startups, then LPs will lose their money. Spreading investments across 2-4 years mitigates this risk.
To slice this question differently, the main reason most investments happen is that a VC genuinely believes that a company has a shot at a $1b+ exit someday. However, sometimes there are other considerations:
Sometimes GPs want a recognizable logo in their portfolio (e.g. one might invest in a late round of Uber or Pinterest just to say they are invested in those companies).
Sometimes investing in a company will provide expertise or connections to good investment opportunities later on. For example, a fund might make several small investments into an emerging space like AgTech or cryptocurrencies, with the goal of building up enough knowledge to make larger investments in those areas in the future.
Sometimes investing is an option bet: the goal is less about returns on the current investment and more about the option to invest a lot more later on. For example, sometimes Series A funds will invest $100k into a seed stage company. Those funds don’t really care about the $100k. What they care about is having the inside track on a company so that if it starts doing well, they can invest $5m or $10m in a Series A round.
If you have other questions about venture capital, please let me know on Twitter. I’ll add popular topics to this FAQ or address them in future blog posts.