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February 09, 2006

VC Primer from an Entrepreneur’s POV – The Funds

Most venture firms are general partners running one or more funds whose money is supplied by limited partners (aka investors aka LPs).  In a previous post, I talked about three other types of types of VC fund you might find yourself dealing with; but, in this post, we’ll concentrate on this type because, if you’re an entrepreneur raising VC money, you’re almost sure to deal with a firm like this.  You need to understand how their funds work.

With rare exceptions, VCs raise money for one fund at a time (there may be a few clone funds set up at the same time but ignore those for now).  The fund will always have a stated purpose.  If the fund is set up to invest in biotech and you’re a web entrepreneur, you’re obviously wasting everybody’s time including your own if you try to get funding from it.  If the fund specializes in late-stage investment and you’re looking for your first round, you don’t want to be there either.  The firm’s web-site will give you pretty good guidance both on what the firm specializes in and – if it has funds with different purposes – what they invest in.

When raising money for a fund, the VC firm usually sets a minimum amount of commitments without which the fund won’t close – come into existence – but often there are provisions which let LPs in after the close with a complicated arrangement (which entrepreneurs don’t need to understand) to be fair to the earlier investors.  There is also usually a maximum size set out for a new fund.  The size of the fund has an effect on the size of investment it wants to make.

Even if it’s not on the website, you won’t have any trouble finding out what size investment the fund is interested in – you have only to ask or Google the firm and see the size of deals it’s been closing.  Some funds have huge amounts of money to put to work.  They can’t afford to do small deals both because it’ll take too long to put the investors’ money to work and because there will be so many deals that the partners won’t be able to track them and serve on all the boards.  If you are looking for a million dollars, you probably don’t want to get it from a billion dollar fund.  Even if they’re willing to deal with you, you’ll get “handled” by an associate, not a partner, in the VC firm and won’t get the strategic attention you want.

Remember, extra money doesn’t usually sit in a fund even though the LPs are on the hook to supply money as it’s needed up to the amount of their commitment (incidentally, they are “limited” partners because the amount they can be asked to risk and their liability is limited).  When and if the decision is made to invest in your wonderful idea, a call is usually made and the LPs cough up what’s needed to fund you in proportion to their total commitments to the fund.  I used to worry what happens if they don’t come up with the money but have never heard of that being a problem – even in bad times like after the bubble burst.  The provisions in the contracts the limited partners have with the funds are pretty draconian if an LP doesn’t pay up. The others LPs make up the difference but share in the benefits of the deadbeat’s earlier investments.

VCs don’t like to invest alone so you will usually have two or more firms supplying you with money at the same time – or none.  It’s helpful to assure that one of them is designated as the lead.  It saves you from having to deal with all of them on every issue and from mediating between them.  Sometimes this works out easily; sometimes for ego or other reasons the VC firms will want to share the lead.  Better for you – and probably for them, too – if there’s a single lead.  You want it to be the firm who’s partner you think understands your company the best and will add the most.  Even if every VC firm doesn’t have member on your board, the lead firm certainly will.

Usually – unless your company either generates unusual amounts of cash for a startup or fails quickly, you will need more than one round of VC funding.  Success often translates into a need for more capital in order to deal with increased volumes of whatever you do and move on to the next stage of company development.  VC funds are setup assuming that some of the capital committed by LPs will be used for follow-on rounds of investment in the same companies whose initial investment the fund supplied. The VC firms like to make follow-on investments because they know more about companies they have already invested in than new companies and they get to put more money to work without having to add to the number of companies needing attention in their portfolios. When a followon investment is made, money is called from the LPs just the way it is for an initial investment.

VCs don’t like to make a follow-on investment from a different fund than the one which made the initial investment since each fund has different LPs and LPs have been known to complain that their fund is being cherry-picked against. It’s worth a discussion with VCs to learn how much commitment the fund has left to draw on.  You also can find out what other companies the fund has invested in and make some estimate (although it’s hard) about how much more money those companies are likely to need.

More on followon investments and what they mean to entrepreneurs in a subsequent post.

As a rule, funds DON’T get replenished when a particular investment turns to cash as in an acquisition.  The reasons for this are complex and have to do with tax and partnership law; but the effect is simple. The proceeds when portfolio companies are acquired are distributed back to the LPs (and the VC firm which is the general partner).  These do NOT add back to the commitment of the LP.  So if an LP committed a million dollars, has had $400,000 actually called, and received $150,000 in distributions, the LP’s remaining commitment is still only $600,000.  When portfolio companies are acquired in return for the stock in a public company, that stock is often distributed to the LPs and the GP.  If you company goes public goes public, the fund will, at some point, either sell the stock and return cash to the investors or distribute the now public stock in your firm. (more on that later, too).

Finally, funds always have a duration – usually seven to ten years.  Often the VC firm has the discretion to extend this for a year or two.  But the funds are finite.  When they are done, all the assets have to be distributed in some form to the LPs and the GP.  Anticipating this, funds stop investing in new companies long before the end of the fund life.  They want the companies to mature so they can be cashed out in one way or the other.  If you are still a small private company at the end of the life of the funds that funded you, look for the VCs to try very hard to make their investment liquid and easily distributable.  You may not like that but they won’t have much choice.

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Tom Evslin continues his VC Primer series. This one focuses on the funds: Most venture firms are general partners running one or more funds whose money is supplied by limited partners (aka investors aka LPs). In a previous post, I talked about thre... [Read More]

Tom Evslin has a great series on fundraising from an entrepreneur's point of view. There are three of his posts below. [Read More]


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