Editor’s Note: This post was originally published on Seattle 2.0, and imported to GeekWire as part of our acquisition of Seattle 2.0 and its archival content. For more background, see this post.
By Gerry Langeler
Let’s start at the beginning, a very good place to start (as Julie Andrews in The Sound of Music would say). For those start-ups interested in raising venture capital (VC) dollars, it pays to understand your customer. In this case, the customer is for your stock, not your products – but the same principals apply. The better you know your customer and their “care abouts” the more likely you are to match your offering to their needs.
Most dollars managed by venture capital firms of any size come from institutional sources such as pension funds, charitable trusts, university endowments and so on. And just as you need to understand your customer, it never hurts to understand your customer’s customer. Those major institutional sources of money have a couple of things in common.
- They put a rather small percentage of their total capital into private equity overall (which includes buyouts, etc.), and usually less than half of that into venture capital. As an asset class, we are a very small piece of what they do every day. So, while they invest in venture capital funds to try to get better returns than they can in public markets, and are ready to accept some added risk and illiquidity to do so, if we don’t deliver they get more internal grief than the dollars involved probably justify.
- They are judged internally on internal rate of return (IRR) in most cases. A select few get judged also on multiples on capital (more about this another time). But by being on the IRR clock, they care about not just how much we make, but how fast we get that cash back to them. If you ever wonder why VCs seem to be impatient, here’s a place to start.
- In the venture capital asset class, those institutional investors have literally hundreds of funds to choose from. And while we have all heard the mantra that “past performance is no guarantee of future results” we also know that most decisions by these folks are driven very strongly by what you last fund or two did, not how convincing your presentation is.
Now, for one thing about how we the VCs deal with our customers. About every four to five years, we have to go back to raise a new fund. That is because each fund we raise has both a total expected “life” of about 10 years, and a contractually limited investing in new companies period of about five years. So, it is at times like those that we very literally get to find out if we get to stay in business. If our investors (called Limited Partners) don’t find the performance and prospects of our recent prior funds compelling, their easy option is to say “no” to the new fund. Remember, they have hundreds of other choices, and we are small potatoes in their eyes.
So, when you wonder why VCs are both VERY selective about where we place our funds, and VERY involved in how well those investments perform, you now have a picture of our world.
We have to raise money just the way you do. We have competitors just as you do (in fact we have many more). And we all recognize that no matter how successful we may have been in the past, “what have you done for me lately” applies to us as much as any other industry.
…..Part 2…………………………………………………………
OK Mark, good questions, so here you go:
Mark asked:
More about fund internals e.g. How funds receive the money (all at once, or in tranches), how the money is allocated over time, how profit is returned to investors and what happens if there is none, what happens if an investment (a startup) doesn’t perform in the expected time-frame but is still promising. Also how the VC firm itself profits from it’s activity and what the margins are, what happens to that margin if the fund performs well vs badly.
- VC funds receive cash from our investors in tranches. We don’t want the money all up front, because that would start the IRR clock ticking on all that money, most of which would be sitting in the bank earning meager interest. However, we get to call the tranches as we need them (called a “capital call” in our parlance). So, we wait until either we have an investment coming up, or need money for our day-to-day operations, and then call an amount that matches our need.
- The money isn’t exactly allocated over time, but we do plan on a spread of need in the following way. We get a “management fee” on the total amount of committed cash – usually in the 2% area, and that covers our salaries, office rent, travel, etc. We plan on that being available year after year over the 10 year life of the fund, although it usually tails off in later years, for reasons I won’t detail here to keep this succinct. Then there come the investments. We tend to plan to average about one new investment per partner per year. So for us, with 5 partners and a 5 year investing life, we target about 25 total investments per fund. Of course, you entrepreneurs aren’t quite so manageable, so some years (like 2008) we do more: 9 in our case. Other years, we do fewer. Every time we make a new investment, we allocate follow-on funds to that company, not withstanding the fact that all of you claim you’ll only need one check! :-) In fact, for every dollar we put in initially, we usually put $2 in “reserve”. Often, even that is not enough.
- When our companies are sold or go public we return those funds to the Limited Partners. Initially, they get their money back in proportion to the amount invested by them and from our private contributions to the fund. However, once we have paid back all their capital in (think of that as the total size of the fund), then we get what is called “carried interest” on the gain. For most funds, that amounts to about 20% of the profits.
- If there is no profit on an individual deal, such is life. This is a high risk business we are in, and most individual projects fail. But, if we don’t generate a profit on the whole portfolio of deals (see: bubble funds) then our Limited Partners get very cranky with us – as they should. But, beyond not investing in any future funds of ours, that is the extent of what can happen at that point.
- If a start-up doesn’t perform in the expected time, but is still promising, we call it, “Normal”. :-) Not widely known fact, but of the 120 some-odd companies we’ve backed over 27 years, not one (that’s right NONE) made their original business plan. Yet, we’ve had the pleasure to grow some very successful enterprises that made our investors a lot of money. This is why we reserve those extra dollars you don’t think you’ll need!
- VC firms and partners profit in essentially only one way. It’s what I call the Vidal Sassoon model, “If you don’t look good, we don’t look good.” If our portfolio companies (in aggregate) return considerably more than what we paid in, then we look good. You’ll hear about how we like to make 10 times our money or better (this is true!). But, the reason we have to shoot for those numbers in each project is that usually we’re wrong, and the company either loses money (often all of it) or doesn’t make much. So, to cover our losers, and our day-to-day expenses, we need our winners to be big winners. A good venture fund will return to its investors somewhere north of 2x what they invested. At 3x or better, everybody gets very excited. Another way to think about this is a bogey over the S&P 500. Most investors will tell you that if they can net 500 basis points (5%) or better over the S&P, compounded over the life of the fund, they are happy.
