From what I’ve been reading over the last 18 months, as well as what I’ve been hearing from people trying to do deals, both here and in the U.S., I get the feeling that the Venture Capital market is changing. I’m going to spread this out over several posts, beginning with this one, a re-cap on the basics of VC funds. Now, I’m going to greatly over-simplify here, but bear with me, as I don’t really want to write a treatise on venture capital, but rather get to the discussion on how the startup funding market seems to be evolving.
A Venture Capital (VC) fund is created when a number of investors, called Limited Partners (LPs), agree to pool their money in a fund for a certain period of time. The purpose of the fund is to invest in new business ventures, which in the tech community we usually call startups. Actually, I much prefer the French name for venture capital – capital de risque – or risk capital, because that is really what VC funds do: high risk investment with potentially high returns. Now the people actually managing the fund are called General Partners (GPs) and the way they are compensated is what we are interested in. The GPs take a cut of the assets under management to cover their expenses and as salary. These management fees are typically in the 2-3% per year range. This is nice, but there is little incentive for the GPs to get out of bed, as they collect these fees whether they make any investments or not. So, in addition to the management fees, the GPs get a share of the carried interest, or carry. When the fund is dissolved, the LPs get back what they originally put in, the GPs get 20-25% of the remaining funds and then the rest is distributed to the LPs on a pro rata basis. So the more money the fund makes, the more the GPs’ carry is worth. Think of it as performance based pay.
Let’s look at a simple example. John and Daniel decide to raise a VC fund. They manage to convince a couple of financial institutions and some high net worth individuals to invest and ultimately raise $30M. As far as VC funds go, this is small potatoes by the way. Now the Limited Partners agreed to leave their money in the fund for say, 7 years. John and Daniel, as the General Partners managing the fund, will take 2% of the assets under management annually as management fees and a 20% carry when the fund is dissolved in 7 years’ time for their efforts. For those of you keeping track, that works out to $600K annually to cover expenses (office space, travel, due diligence, etc.) with whatever is left over being salary for our two GPs. Now John and Daniel being decent investors, let’s assume that the fund averages 20% growth annually over its lifetime. So after 7 years, the fund is worth roughly $107M. Subtracting the initial $30M invested, leaves us with $77M of which John and Daniel will take 20% for their efforts, or $7.7M each. Not a bad payday. The remaining $61.6 is returned to the LPs on a pro rata basis.
So the GPs are well paid, but they have to earn it, meaning the fund didn’t achieve an average annual return of 20% on its own. The GPs spent the last 7 years helping the entrepreneurs grow their companies and looking for exits, i.e. ways for the fund (and company founders) to convert its stake in the startups into cold hard cash. The classic exits are the IPO (the startup goes public and the fund sells its shares on the open market) and the acquisition (the fund sells its shares in the startup to the acquirer). In both cases the goal is to sell your shares for substantially more than you paid for them, although sometimes you are just trying to cut your losses and get out. Achieving a successful exit requires a lot of hard work (and luck!) and so most GPs cannot reasonably handle more than 6-8 investments at a time. So with a $30M fund, John and Daniel each have to manage $15M worth of investments. Assuming they each manage 8 companies simultaneously, that means the average investment will be approximately $2M. Again this is a very simplistic analysis that ignores such things as follow on rounds of funding which soak up cash but don’t add another company to the fund portfolio. The point I am trying to make, is that the GPs’ time is an important constraint on fund activities.
Now from the GPs’ perspective, because both the management fees and the carry are a percentage of the assets under management, the bigger the fund, the better (actually, it’s the ratio of fund size to the number of partners, but you get the idea). Bigger funds mean, each GP has more money to invest, but there are still only 24 hours in a day, so each investment now has to be bigger. This is why, entrepreneurs looking for seed level funding regularly get turned down by VCs with plenty of cash to invest. Take John and Daniel. They may like an idea and the team behind it, but if they start investing in $200K chunks, each one of them is going to end up sitting on 75 boards! Spread that thin, they won’t be able to really help any of the startups, which greatly decreases the chance of succesful exits for the fund.
Traditionally, seed funding comes from friends and family (“Love money”) or angel investors. Seed funding allows an idea to be explored, a prototype to be built or the launch of a beta version of a service. Once the kinks have been worked out and a company is ready to ramp up its offering, that’s when the VCs usually step in. They provide the resources to dramatically accelerate a business’ growth. So in a healthy investment environment, you have angels speculating and VCs accelerating and, in later funding rounds, consolidating through mergers and acquisitions. Now if you are an entrepreneur in Montreal, you know that raising seed funding is tough, because there are few angels in the city and most aren’t very active. This is one of the things that Montreal Start Up (MSU) is trying to change by the way. For those of you who haven’t heard already, MSU is putting together a fund that will provide seed level funding for local technology entrepreneurs. We are also working with local angel groups to see how we can help them do more deals. Expect an announcement early this autumn.
by heri
thanks for the lecture about VCs. ok so that means there are not enough GPs in Québec and too much money so nothing is left for entrepreneurs who begin.
so what about $30 million. why did you choose that figure? does that mean financial institutions wanted you to handle $30 million?
by Mat
Nice summary of information there Daniel. Look forward to the follow on piece(s)… and the announcement of course
@heri: my bet is that $30M is just a number, as good as any other…
by daniel
The $30M is just a convenient number I picked out of the air. Some funds make no bones about their size, for others you need to dig through their press releases to get an idea. All list their management teams however. Check out some local funds like Garage Canada, ID Capital, Brightspark, etc. if you want real numbers. Check out VantagePoint Venture Partners or Kleiner Perkins for a glimpse of the big leagues.
As to whether or not funds need more GPs, that depends on a few things. For one, the top people in the investment world are very much in demand and so they command top dollar. Too many GPs per fund and the compensation is no longer enough to retain them.
Then there is the fund’s focus. If you are investing in Biotech, you had best have deep pockets because you are going to shell out a lot of money and wait a long time before you see any possible returns. Developing hardware is also very costly. So depending on the type of businesses you are investing in, $15M, for example, might be enough for one or several investments.
While the proper ratio of dollars per GP varies enormously, one thing is certain: if you are serious about seed level investments, that ratio cannot be too high.
by heri
hi Daniel
I have another question. i understand that GPs are strongly invested in the startups they manage (you talked about being in the company’s board, and diligence, and giving advice, and looking for business parterners for the startup). so that’s why they can only invest in a few startup.
à
now, i might be naïve but what if an investor decides to invest in more startups, say 3 times more, but then has 3 times less time investment in each. what if the startup founders didn’t need so much guidance and if you actually trust them for their daily business and let them do the hard work. what if the investor gets more diversification and less risk this way.
i also want to say that the model you described seems old to me. i guess investors worked like this also 2 centuries ago. but i am thinking that in the internet age, where information is flowing freely and everyone is willing to interact with each other, there might be ways for startup founders to get advice, to tweak their business model, to find business partners. and also think about a more open company structure and processes.
by daniel
@Heri. Good questions. I’m not a VC and don’t pretend to have all the answers, but here’s what I think.
I guess a lot of it depends on what you call a startup. A company getting $200K to develope a prototype is certainly a startup. What about a company that decides it wants to expand into the European market? The are profitable, privately owned but can’t finance the expansion internally, so they raise a third round of VC financing. Then there is the case of serial entrepreneurs vs. first-time entrepreneurs. The amount of time a GP needs to devote to an investment depends on many things (including the GPs personal management style), but a few variables come to mind.
How experienced are the founders? For example, how many first time entrepreneurs know how to handle a payroll? What deductions need to be made, which government forms need to be filled out, workplace liability issues, etc. An experienced entrepreneur either knows this stuff or knows who to hire that can handle it. Experience counts, especialy with stuff like building a team, growing sales, developing a marketing strategy, etc.
How far along is the company? If you invest in a founder and an idea, then you are probably going to want to participate in, or at least worry about, hiring key people, developing a marketing strategy, product development, building a board of directors, etc. On the other hand, if the company has been running for three years, has a strong management team in place and is hitting all its targets, then you obviously don’t need to be as involved. You want to keep an eye out for exits, but at least you don’t have to worry about the company going bankrupt if you take a week off to spend time with your family.
How well is the company doing? Sometimes the founders can’t pull it off and the company flounders or maybe it’s a disagreement over the direction to take the company in. Regardless of the reason, if the company is not doing well, the GPs will have to keep a close watch and, if necessary, be prepared to step in and replace the management team in order to turn things around. Sometimes everyone agrees it’s the right thing to do, sometimes it turns bitter (think Ars Digita or Steve Jobs being ousted from Apple).
There is also the maturity of the fund. initially, you have money but no investments, so you spend all your time looking at business plans and listening to pitches. Later, you spend all your time looking for exits to your few remaining investments. In between, it is a mix of managing what you have and looking for new investments.
Depending on the size of the fund, the management fees may be sufficient for additional resources, such as Venture Partners who help source deals and staff to handle due dilligence and paperwork.
As far as risk is concerned, as you increase your number of investments, your risk diminishes but only up to a certain point. Beyond that, additional investments probably increase your risk, as you can no longer devote enough time to each one (Note that there are also financial questions that arise when you spread you money over more investments. We’ll ignore those for now as we want to keep things simple).
Finally, let me get through the next few posts and then we can revisit whether the model is “old” or not.
Thanks for the comments.
by Daniel Haran
Daniel – I’ll echo what Heri said here. The approach you describe seems old, and I’d compare it to what Paul Graham is doing. More smaller investments in startups. The emphasis is on getting users and building a popular product, rather than all the overhead I see in funded startups (due diligence, plans, plans, plans).
It would be good if you could address that model in the next few posts.
by daniel
@Daniel Haran
Definitely. Talking about funding Web startups without mentioning Y-combinator, is like talking about the Web in general without mentioning Google