Excerpt from the Growth Company Guide 4.0
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Think Like a VC

When planning a capital raise for a privately-held company it can help to understand how a venture capitalist thinks. The more a management team understands about the world of its potential investors the more likely it is to target its efforts effectively. Here is a brief description of some of the factors that influence venture capital fund managers in their day- to-day business.

·        Compensation is based on portfolio company success. The typical fund management team receives a regular annual payment from the fund of between 2% and 3% of committed capital to cover the expenses of running the fund day-to-day plus a bonus, called the carried interest, of a percentage of the profits it makes when its portfolio investments are liquidated. The opportunity for fund managers to get big payouts comes from the carried interest, which makes the success of the portfolio company critically important to the ability of the fund manager to generate personal wealth.

·        Staffing resources are limited. The regular annual payment received by the fund managers reduces their available investment capital and has to cover all of their expenses, including salaries, benefits, office rental, travel and fees paid to outside professionals. This limits the number of people they can hire and puts a premium on reviewing investment prospects efficiently. For a fund receiving hundreds of plans a month, this creates the need to employ methods of screening business plans quickly.

·        Fundraising is an ongoing activity. The vast majority of funds are structured so that they have to return their committed capital to their investors once a portfolio company has an exit. In other words, they only get to invest their funds once. In practical terms, this means that most venture capital funds are always in full fundraising mode or thinking about their next fundraising.

·        Many periodically stop investing to raise money. Particularly for smaller funds that may only have a few professionals on staff, the constant need to refresh available capital often translates into the periodic need to focus all efforts on fundraising and monitoring existing

·        Good investments generate returns more slowly than bad investments fail. A fund may have to return to the market for new funds every 4 to 6 years but the good companies it invests in may not be ready for profitable exits until later, depriving the managers of an attractive track record with which to attract new investment. To compound this problem, those companies in a fund’s portfolio that do not succeed tend to fail earlier on average than the successful ones tend to liquidate and generate a tangible investment return. This is a function of proper fund management and the illiquidity of private companies as a class.

·        Some shift their focus as their fund matures. A related phenomenon is that many funds limit their investments to later stage companies as they approach the need to replenish their pool of capital. This is because earlier stage companies are less likely to create a liquidation event in time for the return it generates to be used to demonstrate the fund manager’s ability to generate attractive returns. Funds who have just raised their money are often more willing to invest in earlier stage companies.

·        Their results are measured carefully. Venture capitalists are measured by, and their ability to raise additional funds to support future activities depends upon, how successful they are at returning their investors money with a healthy profit. Results are compared on an annual rate of return basis giving the pension funds and others who invest in venture capital funds a ready comparative measure to use when deciding which venture capital funds will receive its money.

·        They have lots of competition. Competition is fierce among venture capitalists for the attention of potential investors and for opportunities to invest in the best companies. Despite the flood of unsolicited business plans most venture capital funds receive, only a small percentage of these over-the-transom-plans offer the combination of quality and opportunity venture capitalists are looking for. Many of the best opportunities are secured in other ways that require an affirmative effort to seek out and find the best companies.

·        Many share investment opportunities. Fund managers do this for many reasons. First, many of the best opportunities they see come from other fund managers. Second, sharing spreads the risk between more than one fund and leads to relationships that lead to more sharing. Finally, sharing is often necessary because of practical limits on the amount of money a fund is comfortable investing in one opportunity. Sharing, when it involves a syndication put together by one of the investors, also makes it easier for the investors to dictate terms.

·        They have to be actively involved in monitoring their investments. Because of the rules that provide them exemptions from otherwise onerous regulation, venture capital funds have to maintain an active involvement with a majority of their investments. This translates into the need to sit on boards of directors, obtain regular reporting from portfolio companies, and the inclusion in financing agreements of covenants that give funds that do not have board rights, the right to attend board meetings and participate in discussions.  

·        They can be personally liable for mistakes. Fund managers routinely sit on the boards of the companies in which they invest. Like other board members, they have fiduciary duties to the company’s shareholders by virtue of their position. Consequently, they can be sued by disgruntled shareholders and held personally liable for their malfeasance. Directors and officers insurance and indemnifications from the company help to mitigate this risk. Fund managers who serve as directors can be more at risk than other directors when the best interests of their fund conflicts with their director duty to all shareholders.

·        Illiquid investments can be riskier than liquid investments. A minority investor in common stock of a privately held company has little influence and little ability to liquidate his investment. This basic truth has led to the development of sophisticated investment instruments and deal structures that contractually attempt to mitigate the venture capitalists risk. Many of the components of these deal structures constrict management’s freedom and reduce the value of their common stock shareholdings.

·        They are only human. They make mistakes in the companies they choose and in the ways they organize and manage their businesses. They do not expect perfection in the management teams they back but they do expect them to deal openly and to address their mistakes when they are made.

See: Deal, Financing Agreements, Venture Capital Deal Structures. See also: Ten Strategies for Negotiating with Investors, Seven Deadly Sins of Fundraising.