VC Primer from an Entrepreneur’s POV – Source of Funds

If you’re an experienced entrepreneur who’s had venture funding, skip these posts.  If you’re a VC, please read on and tell me if I got anything wrong but remember that I’m writing from an entrepreneur’s point of view.  If you’re an entrepreneur who hasn’t had VC funding – even a wannabe entrepreneur – read on.  These posts are for you.

BTW, if you’re thinking of investing in a VC fund, you’re welcome to read on but you are going to sign a bunch of papers before you invest saying that you are an experienced investor and, by implication at least, understand all of this.  But you may enjoy (or be horrified by) an entrepreneur’s POV.

You already know that venture capitalists were invented to supply entrepreneurs with the money we need to make dreams happen.  You probably also know that they won’t provide any of that money unless they think your dream has the potential to become a hard reality which returns TO THEM many times their initial investment and unless they believe you are a dreamer who can execute. 

But it’s also important to know where they get that money which you need to have them pass on to you and how they actually get compensated.  You should always understand the needs, motivations, and constraints of the people that you negotiate with.  Moreover, the VCs who supply you with money will become a part of your very full start-up life.

Some venture capitalists (rich ex-entrepreneurs, for example) simply manage their own money or family money.  Other venture capitalists are hired by a single very rich individual  to manage a venture fund for the individual.  A third type of venture fund manages the venture investments for a company like Intel or Cisco or Microsoft.  What these three types of fund have in common is that they DON’T have to spend time raising the money they are gonna pass on to you.  They already have it.  In theory, this leaves them free to spend all their time on their investments.

The most common type of venture fund DOES have to raise money – in some senses it is an entrepreneurial enterprise itself.  A VC firm (not the same thing as a fund) is the GENERAL partner of the fund.  The bulk of the money in the fund, however, comes from the LIMITED partners – they are the actual investors.  When a new VC firm sets up shop, it has to spend a huge amount of its time recruiting these limited partners and selling partnership units to them.

Although a VC firm may talk to you about your dream before they have actually closed their own funding, it is unlikely they will be able to give you the money until they get it themselves (sometimes the general partners have contributed enough capital for some starting investments).  You certainly want to know whether the firm you are talking to is actually in a position to invest or whether the money you need is contingent on their closing their funding. 

Ed Jordan, my CFO at ITXC had an excellent way of judging VCs: “would you give them your money to invest?” he always asked me after a meeting.  If the answer is no, run – don’t walk – away from the potential deal.  Trust Ed (and me) on this: you don’t want to be stuck with dumb or incompetent VCs.  As part of your evaluation of a VC firm – if it is one of those firms which raises money from limited partners, ask to see the material they give to their potential investors.  For liability reasons they are careful with their claims here so these are somewhat hype-free.  You will also find out from this material exactly how the VC firm is compensated.  Guess what; that drives behavior.

Usually VC firms raise funds of $100 million or more.  This lower limit is both because there are many fixed costs including outrageous legal bills associated with fund raising and because the compensation of the VC firm which is the general partner is usually contingent both on the size of the fund as well as its results.  In the early days of a fund, there are no results so the VCs have to live on their percentage.

A $100 million dollar fund is actually a fund whose limited partners have committed to supply a $100 million dollars.  This doesn’t mean that they have actually written checks which add up to this amount.  The limited partners know that the venture firm – the general partner - won’t be able to invest $100 million all at once and these limited partners don’t want their money sitting in a VC fund bank account earning small returns.  What actually happens is that the fund makes capital calls – requires the limited investors to cough up part of their committed money – when the fund actually has a use for the cash – giving it to you, for example, or paying management fees.

Remember that there is a difference between a VC FIRM and the FUND(S) it raises and manages.  This is important and it’ll be on the test.

A VC firm may raise and run several funds.  The fund may outlive the firm or vice versa.  In almost all ways, the performance of one fund run by a particular VC firm is isolated from the performance of other funds run by that same firm.  For example, funds that put money to work in 1998 generally had great performance when the money came cascading back from IPOs.  Funds sponsored by the same VC firms which invested in late 1999 and 2000 did terribly because the entrepreneurs could command huge premiums to customary valuations and NASDAQ (and most of the companies) crashed before there was any return on the outsized investments.

Which type of fund do you want to get your money from?

Can’t answer because the quality of the individuals you deal with is what matters most. So I’ll give you major plus and minus on each.

Ex-entrepreneur running her own money:

Plus – doesn’t have to worry about being second-guessed by a boss or investors so can afford to be innovative and patient.

Minus – can’t forget she was an entrepreneur so thinks she can do your job better than you can.

Hired hand running a rich person’s money:

Plus -  doesn’t have to worry about fund-raising or communication with a limited partner community.

Minus – tends to be so mortally afraid of offending the single investor or not following a “vision” that he doesn’t quite understand and so can be an investment coward.

Company venture arm:

Plus – may be able to get you a preference when dealing with the sponsoring company since it is presumably interested in whatever you’re developing and has a strategic as well as financial stake in your success

Minus – the people in the company venture arms are usually not experienced investors, may be fresh out of business school.  Don’t make policy and may not understand it. Big company politics can be in your way.

“Public” venture fund with limited partners:

Plus – the actual VCs in the VC firm have to have a pretty good track record – at least some of them – or they can’t raise the money to begin with.  The partner you deal with will usually be able to make decisions on his or her own.

Minus – can be distracted either by a high management fee which is independent of performance (other than raising money) or by earning the praise or avoiding the complaints of the limited partners or raising yet another fund.  These firms all find raising money easier at the same time so there is either a flood or dearth of money from them.  From an entrepreneur’s point of view, a flood of money is great until you get yours.  Then you’d just as soon that a pack of imitators don’t get funded on terms even more favorable than yours.

If you want to learn how venture capital works from the POV of venture capitalists – and in much more detail than I’ll explain it, you can’t do better than go to the blogs of Fred Wilson and Brad Feld. They are both very smart and successful VCs AND are very readable and prolific communicators.

You ALWAYS want to read the blog of a VC who may fund you – if he or she doesn’t have a blog and you’re in the web/tech space… hmmm.