Note: The third piece in a continuing series on the creation and administration of venture funds is this one. Get a hard copy desk reference at Amazon.com or download the free eBook Venture Capital: A Practical Guide to discover more about managing a fund.
Developing a Successful VC PlanSeveral fundamental ideas of fund investment strategy were covered in Part I of this article, along with the various ways that funds are arranged according to industry, region, stage, specialization (such as social impact, corporate, etc.), or other factors. Let's now examine capital allocation strategy and venture fund life cycle in more detail.
What percentage of your money should you normally set aside for each firm you invest in when making capital investments?
Regardless of the size of your venture fund, you should set a few guidelines for your capital allocation plan. Saying, "We anticipate making 20 investments from this fund and will allocate 5% of the fund to each company we invest in," is not enough. Fund managers should consider the way they want to arrange investments in businesses. There are undoubtedly "one and done" funds that make a single investment in a business. Nonetheless, the majority of fund managers create their funds using a method that weighs early estimates against new information. To be more precise, they do this by investing a relatively lower sum of money in a firm at first and then gradually growing their stake in subsequent rounds as they learn more about the company's performance.
When it comes to capital allocation, fund managers that see financial returns as their main indicator of success will consider the following:
What is the minimum acceptable level of diversity, or the number of firms we intend to add to the fund?
What is the anticipated amount of our first investment in each business?
What amount of money are we going to set aside for subsequent rounds?
What is each company's intended maximum fund allocation?
So let us try to assist you in responding to each of these inquiries for your specific fund. We will use the following example as a basis for our conversation in order to help direct this activity.
We just raised a $75 million fund, which is managed by three General Partners (GPs). In addition, we anticipate having a board observer or a seat on the board for every firm in our portfolio since we are active investors.
We must ascertain how many firms each of the three general partners can actively manage, providing tight supervision, counsel, introductions, and usually a board seat, in order to respond to the first question, "How many companies do we expect to put into the fund?" Recall that being on a board is a substantial time commitment and places restrictions on the amount of contributions that one person may make. According to a conservative estimate, a GP may make and oversee no more than three to six investments from the fund, for a total portfolio size of at least nine and up to eighteen investments. As long as you can maintain control over your whole portfolio, you may increase the number of investments if you don't need board review for each one.
Let's assume we take 15 assets from the portfolio to make the calculation simple. We will overlook the fact that our $75M fund must pay management fees to the GPs in order to keep things simple. We will decide that the whole $75 million is available for investment. Assuming an equal distribution of the funds, we may allot $5 million to each of the 15 firms in our portfolio. That's a nice place to start when figuring out how much our initial check should be for each organization. Notice that we said "first check." We firmly believe, as do the majority of seasoned investors we have collaborated with, that prosperous early-stage financiers consistently set aside funds for subsequent investment rounds.
Why do investors use this step-by-step strategy rather than making their move at the lowest value, when they can get the largest stake? due to the fact that they are weighing the trade-off between improved knowledge and sound value. As we've said in previous articles:
It is exceedingly difficult to price early seed rounds. Due to their early stage of product development and often little income, the firm isn't worth much. Thus, in order to make a deal that benefits all parties, investors and entrepreneurs arrive at a valuation that is often far higher than the actual value of the business. As Christopher likes to say, "How much should you pay for two engineers, a PowerPoint, and a dog?" As the business develops and gets more capital, values usually go closer to actual. As a result, these rounds are more advantageous for investors because of the improved risk/reward ratio. Additionally, as you are nearing exit now that more time has elapsed, your IRR is larger even if your return multiple is lower because of the higher value since the money was not locked up for as long.
Returning to the allocation of capital, many variables influence the amount of the initial check, such as:
The deal's conditions' quality (including value)
The current stage of the company's risk/return profile
The original team's strength
As a general rule of thumb, Christopher and I contribute around thirty percent of our total projected investment in the first round of financing we engage in, though we vary our check sizes somewhat. This % allocation is quite common based on our experience. Using our example again, it would translate into a cheque for $1.5 million for the first round. Our goal is to have a sizeable ownership stake in every early-stage firm as a consequence of this size check. Expert venture capitalists will tell you that they want to aim for an eventual ownership range of 15–25% in each of the firms they invest in. Their goal is to get this proportion in the initial funding round and then hold onto it in subsequent rounds by using their Pro-Rata Rights.
This first check size, which accounts for 30% of the funds set aside for possible investment in this business, gives us a sizable sum of money to deal with and capitalizes on the early value. When so many concerns remain unresolved, it does not place an excessive amount of money "blindly" at danger. If everything goes according to plan, we will gradually invest the remaining 70%, as we will cover below. We only have around one-third of the exposure we might have if we had thrown caution to the wind at the outset.
For those of you who are still with us on this exercise, we have now invested a total of $22.5 million, or $1.5 million, into the first round of 15 firms. Of the $75 million fund, it leaves $52.5 million for future rounds of investment. Do we invest more money in a select few firms at the cost of the rest, or do we distribute the remaining funds evenly across the portfolio?
Here's why we put more money into some than others. Essentially, what you are purchasing with your first investment is an advantage in knowledge. You may see how the business performs with a front-row perspective. You will overcome the temptation to throw good money after bad when the losses become apparent. When the winners emerge, you start making "smarter" investments as your understanding and conviction grow. This results in bigger holdings and a greater concentration of those profitable investments in your portfolio.
One set of firms in our portfolio may ultimately get more than $1.5 million. We invest in a different group at a level that approaches our $5 million per firm goal. Furthermore, we may invest up to $10 million in a select group of our top achievers. A successful portfolio may be achieved by capital allocation strategies such as placing large bets on your wins and small amounts on your losses. We are aware that selecting the winners is not always easy (particularly when they return seeking further funds before their destiny is completely sealed), but it is often possible with perseverance and careful consideration. Additionally, as you go, you may choose to modify your plan in light of evolving circumstances, such as shifting market conditions. It is recommended by best practices that you evaluate your allocation strategy whenever you are considering whether to participate in a fresh fundraising round.
Could you describe the venture fund life cycle and how your investment timing is impacted by it?
The majority of venture funds have a ten-year timeline for investing all of their cash and paying out earnings to fund investors. This ten-year life cycle does have certain outliers, but it is often the case. A lot of 10-year funds wind up being voluntarily extended for an extra two to three years in order to tidy up and disperse the remaining portfolio assets. Additionally, there are funds referred to as "evergreens" that act differently from standard funds; nevertheless, we shall talk about them later.
Thus, we are considering a horizon of more than ten years for our fictitious fund. If it seems a bit lengthy, bear in mind that there is seldom a fast way to become wealthy by investing in early-stage startups. Your profits only materialize when someone pays to purchase your firm shares (this may be an acquirer, a subsequent investor, or an over-the-counter investor after an IPO). Considering that time frame, one essential skill that all VCs should acquire is knowing what it takes to successfully exit firms from their portfolio. Most firms require at least five years, and frequently eight or more, to achieve a size that can attract buyers and a transaction that may provide substantial profits for the investors, but the rare early exit can occur within a year or two of your first investment. Regarding the timing of investments, given the extended time horizon, it is not surprising that the majority of venture funds aim to establish its foundational portfolio of firms in the first 1.5 to 3 years after fund inception.
In other words, using our $75 million fund from the prior question as an example, the fund will need to invest in 15 firms over the course of three years. Finding new businesses, making investments in the finest possibilities, and assembling a strong portfolio of businesses are your main priorities during this first investing phase, or phase one of the fund. Each year, you should increase the portfolio by five to seven new fund investments. You should use caution when making any further investments in extremely early stage chances beyond phase one. Because there isn't enough time in a 10-year fund to see those early enterprises through to an exit beyond roughly year four. When attempting to close out the fund, you will be left with securities that are difficult to transfer and lack liquidity.
In the second phase of the fund, investors continue to advise and assist the growth of the firms in their portfolios while also contributing more funds via follow-on fundraising rounds. Some of your businesses may falter at this stage, and a few may even collapse. That is anticipated. However, some of the firms in your portfolio should demonstrate genuine improvement if you've done your homework and chosen reputable businesses with strong management teams. You should use the majority of the fund's remaining money during this period. For unexpected portfolio business top-ups and fund expenditures, you should set aside a little amount of money, but not too much—any money set aside will prevent you from earning a return for the limited partners in your fund. Years 2 through 5 are when the remaining capital is deployed. During this stage, you may also have a few profitable exits, but you usually wouldn't anticipate being able to provide your investors a significant return on their investment from these early exits.
Harvesting your returns is the core of a fund's last stage of existence. Investors collaborate extensively with portfolio firm management teams throughout phase three as they move toward an exit. Exits are not random events. They need to be in sync with the management team and under continual watch from the corporate board.
Finally, a little word on the evergreen funds we just touched on. Investors in these funds provide an initial financial contribution and are content for any profits to be recycled and reinvested in new businesses. This type of structure is very common in funds established by non-profit organizations or government agencies (like economic development agencies). These groups are looking for indirect returns like new jobs created, support for professors and alumni, or the development of life-saving technology, rather than a direct financial return. These evergreen funds are primarily managed by original investors, with the fund's general partners playing a less significant role in their life cycles.
As you can see, there are many approaches to creating a fund, and many of the problems are quite intricate. Early in the process, decisions may have a big impact that lasts a long time. To make sure they are creating a fund idea that will last and provide the desired outcomes, new fund managers would be well-advised to consult sources such as this blog post in addition to the counsel of LPs and seasoned fund managers. This is a very open and quantifiable business. You will be well compensated if you succeed, and your career options in this field are essentially over if you fail, so it is worth the additional thinking and preparation.
No comments:
Post a Comment