Note: This article is the eighth 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 talked about the challenges and responsibilities General Partners face. Now let's take a closer look at the time commitment involved when you're ready to invest in a company, what's required when serving as a board director, and how GPs should handle communications with their LPs.
Tell us a bit about the time commitment and issues you run into when you find a company you really like and want to make an investment in.
From an initial group of 100 qualified investment opportunities, we might become seriously interested in 3 or 4 companies. After a series of hour long meetings with the CEO and her founding team, we will start a due diligence process with the company. This is a fairly time-consuming effort that can easily take 30 or 40 hours of work to complete. And, not every due diligence effort results in an investment. About 50% of companies we take into diligence end up with an investment.
When diligence is wrapping up, we start the process of negotiating the terms of a deal with the company. Experienced early stage investors should be efficient at this process, but it takes time for new investors to learn the nuances of deal negotiation. And, to complicate matters, early stage investors frequently run into situations where novice investors offer the entrepreneur deal terms that are too generous. Experienced investors know it’s best to walk away from the deal if the entrepreneur is willing to have dumb money drive the deal terms.
Assuming all goes well with due diligence, and you are able to negotiate reasonable deal terms, it’s time to move onto deal syndication to fill out the round. Successful VCs have a network of co-investors that they like to work with. This allows you to share some of the effort and transaction cost needed to invest in a company and support the company’s future growth. It also streamlines the process of raising enough capital to properly fund the company. Just be aware, if you are the deal lead, you can expect to spend significant time and effort in this process.
After you make an investment, should the General Partners (GPs) take a board seat on every company they invest in?
If you want to be involved in helping the companies, yes. Or if you don’t, someone else you know well and trust very much needs to. Investor money needs to be paired with advice and oversight if it is going to generate a return. And it is not a trivial matter - taking a board seat is a big responsibility and a major time commitment. In some ways, making the initial investment is the easy part of being a VC. The real work starts after you make the investment. Between regular board meetings, phone calls with the CEO, and a cornucopia of other tasks, an engaged board member can easily put in 100 to 200 hours of work per year, per board seat. If you are sitting on 3 boards, that time really adds up!
Now, back to your original question… “should GPs take a board seat on every company they invest in?”... my answer is a qualified yes. You can’t help companies in your portfolio drive towards exit unless you know what the issues are and are involved with helping them through their struggles to succeed. The exception to this rule occurs when you have a lot of faith and trust in the current board members. But even then, your LPs will have every right to expect you to have semi-regular check-ins with both the CEO and the board member with whom you are working.
Note that in some situations, you may be in the boardroom, but not actually a corporate director. Sometimes, a fund manager will take a board observer seat instead of an actual voting corporate board seat. This allows them to stay engaged, but the time commitment is significantly less than a full board seat. You advise on the problems, but you don’t own responsibility and liability for them.
How should a venture fund’s General Partners handle communications and reporting with their Limited Partners?
First off, you need to set a proper level of expectations with your investors. And that comes down to being able to objectively answer questions related to what level of returns investors should expect and over what timeframe they should expect to receive those returns. I am not suggesting you know exactly what kinds of returns you will have or precisely how long it will take; I am telling you that you will need to be honest with your investors about that. You can share your expectations and your plans for getting there, but at the end of the day, you need to be clear that this is a risky business full of unknowns. Failure to make that crystal clear will work out very poorly for you and may be the end of your venture career.
A key thing you need to understand and explain to your investors, is that it’s rare that a fund invests in a small number of huge winners in venture capital. Most funds are lucky to have one big winner in their portfolio. As a General Partner, you need to know what level of returns are produced by successful venture funds. Over the past decade, top quartile funds generated annual returns in the 15% to 27% range. And, the majority of capital is typically returned to investors in the later third of a fund’s history. Make sure you don’t over-promise to investors on your fund’s expected returns and the timeframe for those returns. Success does not happen overnight - your investors will have to be patient.
My second piece of advice relates to communications. Your investors have entrusted a fair amount of capital to the fund. Unless you set very clear expectations to the contrary, it is reasonable for your LPs to expect regular proactive communications from you. So, what level and frequency of communications should you plan to deliver? Most funds produce a regular report with the following items:
A table with a list of all portfolio companies. This table should include company name, website, industry, main product/service, cost basis of investment, and current value of investment.
A table with a list of transactions from the latest time period. This table should include company name, type of transaction, date, and value of transaction.
A table with a list of recent valuation changes for companies in the portfolio.
A table with a list of exited companies and the capital returned from those exits.
A series of charts and tables that report on portfolio metrics such as investments and returns by calendar year, IRR, distributed to paid-in capital (DPI), total value to paid-in capital (TVPI), etc.
For each company in the portfolio, a brief written update on the company’s status and financials.
As to frequency, we believe a quarterly report with the above items covers the key elements needed by LPs to evaluate a fund’s performance. The delivery of that report is sometimes supported by a conference call to discuss the results in more detail with any interested LPs. And finally, some bigger funds, or funds that have an active network of LPs, will hold an annual meeting that includes updates by the GPs along with a chance for the LPs to meet many, if not all of the CEOs of the portfolio companies.
It’s important to remember, if you want to build your reputation and raise another fund, your investors will expect open, regular and honest communications from you. Keeping your LPs well informed and making positive results in your fund goes a long way towards raising your next fund.
Now let's take a closer look at why networking is so important for fund managers in Part III of this article.