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It has come to our attention that in certain parts of the world, the "How to Avoid a "No" from VCs" series, originally written for Seattle 2.0, is "not accessible." Hopefully those same folks in far-off lands will not see the OVP blog as in any way subversive. So, for the record, here is the multi-part series all in one place.
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.
Addendum..................................................................
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.
Much more (6 articles) after the break....
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