Question

Imagine you're creating a venture capital fund and you need to raise capital from investors (your prospective LP's) to invest in private companies. How would you pitch your fund - what is your overall strategy/philosophy of investing (how are you going to find companies to invest in and what will you be looking for), How much capital do you have to raise to execute that strategy, and why should the prospective investors give you their money.

Answer 1

Venture Capital (VC) Funds

What are Venture Capital (VC) Funds?

Venture capital funds are investment funds that manage the money of investors who seek private equity stakes in startup and small- to medium-sized enterprises with strong growth potential. These investments are generally characterized as high-risk/high-return opportunities. In the past, venture capital investments were only accessible to professional venture capitalists, although now accredited investors have a greater ability to take part in venture capital investments.

BREAKING DOWN Venture Capital Funds:

Venture capital is a type of equity financing that gives entrepreneurial or other small companies the ability to raise funding. Venture capital funds are private equity investment vehicles that seek to invest in firms that have high-risk/high-return profiles, based on a company's size, assets and stage of product development.

Venture capital funds differ from mutual funds and hedge funds in that they focus on a very specific type of early-stage investment. All firms that receive venture capital investments have high-growth potential, are risky and have a long investment horizon. Further, venture capital funds take a more active role in their investments by providing guidance and often holding a board seat.

Venture capital funds have portfolio returns that resemble a barbell approach to investing. Many of these funds make small bets on a wide variety of young startups, believing that at least one will achieve high growth and reward the fund with a comparatively large payout at the end. This allows the fund to mitigate the risk that some investments will fold.

The Process of Getting Funded by a Venture Capital (VC):

First and foremost, identify the VC that might be investing within your vertical. There are plenty of tools you can use to identify who might be a fit. (You can use Crunchbase, Mattermark, CB Insights, or Venture Deal.)

Once you have your list of targets, you will need to see who you have in common and close to you who would be in a position to make an introduction. The best introductions come from entrepreneurs that have given good returns to the VC. VCs use these introductions as social proof and the stamp of approval on the relationship. The better the introduction is, the more chances you have of getting funded.

As a next step to receiving the introduction, and in the event there is a genuine show of interest from the VC, you will have a call. Ideally you would want to go straight to the partner to save time, or the goal would be to get an introduction to the partner ASAP. If you are already in communication with the partner after the first call, he or she will ask you to send a presentation (also known as pitch deck) if the call goes well and there is interest.

In this regard, I recently covered the pitch deck template that was created by Silicon Valley legend, Peter Thiel. I also provide a commentary on a pitch deck from an Uber competitor that has raised over $400M.

After the partner has reviewed the presentation, she will get back to you (or perhaps her assistant) in order to coordinate a time for you to go to the office and to meet face to face. During this meeting, you’ll want to connect on a personal level and to see if you have things in common. The partner will ask questions. If you are able to address every concern well and the partner is satisfied then you will be invited to present to the other partners.

The partners meeting is the last step to getting to the term sheet. All the decision-making partners will be in the same room with you. Ideally the partner you have been in communication with has spoken highly of you, unless there have been issues (which you’ve hopefully covered by this time).

You’ll receive a term sheet if you were able to satisfy the concerns put forward at the partners meeting. Remember that term sheet is just a promise to give you financing. It does not mean that you will get the capital. It is a non-binding agreement. If you want to dig deeper into term sheets I recommend reviewing the Term Sheet Template piece.

Following the term sheet, the due diligence process begins. It will typically take a VC one to three months to complete the due diligence. Unless there are no major red flags you should be good to go, and receive the funds in the bank once all the offering documents have been signed and executed.

How VCs Monetize:

VCs make money on management fees and on carried interest. Management fees are generally a percentage of the amount of capital that they have under management. Management fees for the VC are typically around 2%.

The other side of making money is the carried interest. To understand this concept, carried interest is basically a percentage of the profits. This is normally anywhere between 20% and 25%. It is normally in the largest range if the VC is a top tier firm such as Accel, Sequoia, or Kleiner Perkins.

In order to cash out and receive the carried interest, the VC needs to have the portfolio of each one of the funds making an exit, which means that the company is acquired or will through an IPO where investors are able to sell their position.

Normally exits take between five to seven years if the company has not run out of money or the founders have run out of energy. Typically VCs want to sell their position within eight to 10 years, especially if they are early stage investors.

Start-ups are a very risky type of asset class and nine out of 10 will end up failing. For that reason, VCs will go for those companies with the potential of giving them a 10x type of return so that it can help them with the losses of other companies inside their portfolios. If you are not able to project these kinds of returns, a VC might not be the route to follow for financing.

VC Involvement with Your Company:

VCs would like to have a clear involvement with your company in order to stay close to their investment and to have a say in major decisions that could impact their returns in the long run.

With this in mind, VCs will normally buy in equity between 15% to 45% of your company. Normally in earlier stage rounds, it tends to be on the higher end but VCs need to be mindful of the stake they leave with the entrepreneur so that they are still motivated enough to stick around and to continue focusing on the execution.

VCs will request board involvement in return for the investment that they are making in your company. There are two types of board levels. One will be the board of director seat in which they participate in major decisions of the company. This is especially important when it comes to future rounds of financing or merger and acquisition transactions (also called M&A).

The other level of board involvement is what is known as board observer, which means they will have an open invitation to attend meetings without a vote. In my experience they still have a lot of influence. Below is an image comparing directors vs. observers.

Understanding the Value a VC Brings:

Most VCs say the main reason why an entrepreneur should consider working with a VC is because of the value they can bring to the overall strategy and execution of the business. However, that is far from true.

You will need to do the due diligence in order to really understand if a VC is going to add value in addition to capital. This value can be introductions for potential partnerships, their network of other successful founders, or the infrastructure the firm brings.

The infrastructure could be the most attractive part. VCs like Andreessen Horowitz or First Round Capital have a dedicated team of marketers, recruiters and other resources to bring into a company they invest in. Ultimately this helps in fueling the growth of the business.