Note: This article is the third in an ongoing series on venture fund formation and management. To learn more about managing a fund, download this free eBook today Venture Capital: A Practical Guide or purchase a hard copy desk reference at Amazon.com.
In Part I of this article we discussed several key concepts of fund investment strategy and how funds are categorized, whether it be by industry, geography, stage, specialty (e.g. social impact, corporate, etc.) or some other criteria. Now let's take a closer look at capital allocation strategy and the life cycle of a venture fund.
When you invest capital out of your fund, what percent of the fund should you typically allocate for each company you invest in?
No matter what the size of your venture fund, it’s important to establish several parameters to guide your capital allocation strategy. It’s not as simple as saying, “We expect to make 20 investments from this fund and will allocate 5% of the fund to each company we invest in.” Fund managers need to think about how they want to stage capital into companies. There are certainly “one and done” funds which only put one check into a company. However, most fund managers build their fund using a process which balances early valuations against later knowledge. Specifically, they do this by putting a comparatively smaller initial amount into a company and then increasing their position in later rounds (sometimes significantly) as they gain knowledge about how a company is performing.
Fund managers who are driven by financial returns as a primary measure of success will think about capital allocation along the following lines:
How many companies do we expect to put into the fund (i.e. our minimum acceptable diversification)?
What is the expected size of our first investment into each company?
How much capital do we plan on reserving for follow-on rounds?
What is our target maximum fund allocation per company?
So let’s see if we can help you answer each of these questions for your particular fund. To help guide this exercise, we will base our discussion on the following example.
We just raised a $75M fund and there are three General Partners (GPs) who are managing the fund. Furthermore, we are active investors and expect to take either a board seat or a board observer seat with each company in our portfolio.
To answer the first question -- “How many companies do we expect to put into the fund?” we have to determine how many companies each of the three GPs can actively manage with close attention, advice, introductions and typically a board seat. Remember, a board seat is a significant time commitment, and will limit how many investments any one individual can make. A rough estimate results in each GP being able to make and supervise a maximum of 3 to 6 investments from the fund, resulting in a portfolio of at least 9 and as many as 18 investments. If you don’t need to have board oversight on every investment, the investment count can climb a bit, as long as you are able to stay on top of your overall portfolio.
To keep the math easy, let’s say we make 15 investments from the portfolio. For the sake of simplicity, we are going to ignore the fact that our $75M fund has to pay management fees to the GPs. We are going to deem the full $75M is available to invest. In this case, if we hypothetically divide the money evenly, we could allocate $5M for each of the 15 companies in our portfolio. That’s a good starting point to help us determine how large our first check could be for each company. Please note that we said “first check.” It’s our strong conviction, and the conviction of most of the experienced investors we have worked with, that successful early stage investors always reserve capital for follow-on rounds of investment.
Why do investors take this phased approach instead of jumping right in when the valuation is at its lowest and they can get the biggest stake? Because they are balancing the trade off between good valuation and better information. As we’ve explained in other writings:
Early seed rounds are very hard to price. The company isn’t worth much because they are still early in their product development and usually have minimal revenue. So investors and entrepreneurs come up with a valuation that works for both, but that valuation is usually well above what the company is truly worth - as Christopher likes to joke: how much should you pay for two engineers, a PowerPoint and a dog? As the company matures and raises additional rounds, valuations tend to approach reality. So these rounds are actually a better deal since the risk/reward ratio improves for the investor. And, because more time has passed, you are closer to exit, so even if your return multiple is lower due to the higher valuation, your IRR is higher because the money was not tied up as long.
Back to allocating capital, the size of the first check is driven by a variety of factors, including:
Although we vary our check size by quite a bit, as a general rule of thumb, Christopher and I put approximately 30% of our overall expected investment into the first round of financing that we participate in. In our experience, this percentage allocation is a reasonably typical thing to do. Continuing with our example, that would result in a $1.5M check for the initial round. We aim to have this size check result in a significant ownership percentage in each early stage company. If you ask experienced VCs, they will tell you they like to target a 15-25% ultimate ownership range in each of their portfolio companies. They look to hit this percentage during the first round, and then maintain this percentage by exercising their Pro-Rata Rights in future financing rounds.
This first check size (representing 30% of the allocation earmarked for potential investment in this company) gets us a meaningful amount of money put to work and takes advantage of the early valuation. It does not put too much money “blindly” at risk when there are still a ton of questions unanswered. As we discuss below, if things go well, we continue to invest the other 70% over time. If things go badly, we have only about a third of the exposure we might have if we had jumped in with both feet at the start.
So for those of you still following along with this exercise, we have just invested $1.5M into the first round of 15 companies for a total of $22.5M. That leaves us with $52.5M of the $75M fund to invest in future rounds. Do we allocate all the remaining capital equally across the portfolio, or do we invest more capital into a few companies at the expense of the others?
We invest more heavily in some than others, and here’s why. With your first investment, what you are really buying on one level is an informational advantage. You have a front row seat to see how the company does. As the losers become obvious, you will fight the urge to throw good money after bad. As the winners become apparent, you begin following on with “smarter” money as your knowledge and conviction builds, leading to larger holdings and a higher portfolio concentration for those winning investments.
Ultimately, our portfolio of companies might end up with one group of companies receiving $1.5M+/-. In another group, we invest at a level close to our $5M per company target. And, in a small group of our high performers, we might invest as much as $10M. Betting big on your winners and allocating less on your losers is a capital allocation strategy designed to create a winning portfolio. We know picking the winners is easier said than done (especially when they come back looking for more money before their fate is fully assured), but with patience and a thoughtful approach it is doable much of the time. And as you are going along, you might want to make adjustments, for example, due to changing market conditions. Best practices dictate that you should always review your allocation strategy as you’re deciding whether to invest in a new round of financing.
Can you explain the life cycle of a venture fund and how it affects the timing of your investments?
Most venture funds have a 10 year time horizon to invest all of their capital and then return the profits to the fund’s investors. There are exceptions to this 10 year life cycle, but that is fairly standard. Many 10 year funds end up being extended an additional 2-3 years, by consent, to clean up and distribute out the final portfolio holdings. There are also so-called “evergreen” funds, which behave in a different way from traditional funds, but we will discuss them in a bit.
So, we are looking at a 10+ year horizon for our hypothetical fund. If that seems long, keep in mind that investing in early stage companies is rarely a quick path to riches. Your returns only come at the end when someone pays to buy your shares in the company (either an acquirer of the company, a later investor, or an over-the-counter investor in the company after an IPO.) Given that time period, understanding what it takes to have a successful exit with companies in your portfolio is a critical skill that all VCs need to develop. Although the occasional early exit can happen within one or two years of your initial investment, most companies take at least five years, and often eight or more years, to both reach a scale that will attract buyers and a transaction that can provide significant returns to the investors. Returning to the question about timing of investments, and keeping the long time horizon in mind, it should come as no surprise that most venture funds look to build their baseline portfolio of companies within the first 1.5 to 3 years of launching the fund.
That means, continuing with the example of our $75M fund from the previous question, the fund will need to invest in 15 companies in about 3 years. During this initial investment period, phase one of the fund, your primary focus is to discover new companies, invest in the best opportunities, and build a great portfolio of companies. You should add 5 to 7 new fund investments to the portfolio each year. After phase one, you should be careful about adding any new investments in very early stage opportunities. Because from about year four onward, there isn’t enough time in a 10 year fund to get those early companies all the way through to an exit. You will be stuck with illiquid and hard-to-transfer holdings when you are trying to wrap the fund up.
Phase two of the fund is the period when investors help their portfolio companies grow by continuing to provide guidance and support, and by investing additional capital through follow-on rounds of financing. During this phase, some of your companies will stumble and a few might even fail. That’s to be expected. However, if you’ve done your job right and selected some solid companies with good management teams, parts of your portfolio will show signs of real progress. During this phase, you should deploy most of the fund’s remaining capital. You should hold a little back for emergency portfolio company top-ups and fund expenses, but not too much - any money you hold back is money you cannot use to generate a return for your fund’s LPs. This deployment of remaining capital occurs during years 2 through 5. You might also have a few positive exits during this phase, but you typically wouldn’t expect to be in a position to return much capital to your investors with these earlier exits.
The final phase of a fund’s life cycle is all about harvesting your returns. Phase three is a time when investors work closely with portfolio company management teams to drive towards an exit. Exits don’t just happen. They require constant supervision from the company board and alignment with the management team.
A quick final note on those evergreen funds we briefly mentioned above. These funds have investors who put in an initial amount of capital into the fund and are happy to let any returns from the fund be recycled and reinvested into new companies. This structure is very common in funds set up by government organizations (such as economic development agencies) or other types of non-profit groups who do not need a direct financial return, but rather are looking for indirect returns such as new jobs created, alumni and professors supported, or life-saving technology developed. These evergreen funds have very different life cycles and are driven less by the fund’s GPs and more by original investors.
As you can see, there is an almost infinite number of ways to go about designing a fund, and many of the issues are quite complex. Decisions taken early on in the process can have significant and long-lasting effects. New fund managers are wise to seek out resources like this blog article as well as the advice of experienced fund managers and LPs to ensure they are putting together a fund concept that will stand the test of time and deliver the expected results. This is a very quantified and transparent industry. A little extra thought and planning is worth the effort because if you succeed, you will be rewarded handsomely, but if you fail, you are pretty much done with this kind of work as a career option.