Note: This article is the ninth 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. In Part II we took 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. Now let's focus on the time required for networking and fund affiliations.
Why is networking so important for a VC?
This question might sound obvious to most readers, but it does deserve some discussion. Great entrepreneurs have access to capital from many different sources. How you differentiate yourself and make your firm a first choice for those seeking capital will make all the difference in your fund’s long term success.
You will have your work cut out for you before you become well-known in the community of entrepreneurs in which you want to invest, unless you are already a well- known individual (or team) before you start your fund. It can take years to build your reputation and get access to top deals. Great deal flow is one of the greatest assets a venture fund has. One of the best ways to build your reputation and get access to great deal flow is to be seen on a regular basis in your community. So how do you go about doing that? Here is a short list of a few approaches we have seen work in our community:
Attend events where your target entrepreneurs spend time
Sit on panels where a large audience can gauge your knowledge of their industry
Organize small meetups where entrepreneurs and investors discuss challenges faced by a specific industry
Organize events, conferences, open houses, or workshops
Get your voice heard through an active blog and/or social media presence that speaks to your area of expertise and provides practical advice to entrepreneurs
In addition to networking with entrepreneurs, you should meet regularly with other VCs. Yes, some of these VCs might be competition for the best deals, but many of them will be sources for good deal flow and become syndication partners for future investments. Some of the best VCs are willing to act as mentors to new VCs, even if they aren’t partners in their own firm. Spend time getting to know other investors and make sure they know what your focus is. If they have a deal outside of their focus area, and they know it is a fit for you, they can refer it. Also, if you are an early stage VC, knowing the top later stage and Corporate VCs is important as you look to help your portfolio companies raise larger rounds of growth stage capital.
And finally, all great VCs have a network of trusted resources they go to for helping out their portfolio companies. In addition to the colleagues you worked with over the years, it’s important to build a network that will help you address the many challenges faced by your portfolio companies’ early days all the way through to their exits. Our network at Launchpad Venture Group is incredibly diverse. It gives us access to talented people with backgrounds in sales, marketing, engineering, talent development and finance. They’ve worked in industries such as enterprise software, biotech, medtech, and robotics. They were/are CEOs, CTOs, CFOs, VP Sales & Marketing and many other job titles. So when I need a resource to help one of our CEOs deal with a difficult problem, I know where to go.
What are some of the problems and issues that are specific to a fund which is closely affiliated with another entity such as an Angel Group sidecar fund or an incubator or accelerator fund?
If you are thinking about starting a fund that is closely affiliated with another institution (i.e. a sidecar fund), there are some special considerations to be aware of. In most cases, they can be addressed with specific agreements about operating rules of the road, but not in all cases. Here are some examples of issues to consider, along with a few mitigations that can help.
Angel group sidecar funds are prone to tensions between people using more active and more passive approaches to investing. The angels in groups tend to be more hands-on and active than the investors in the fund (angels who are essentially acting as fund LPs). This difference in approach can create situations where the active investors end up feeling like they are doing all the work while the passive investors are riding their coattails (and the GPs are being paid fees.) This can be addressed through complex mechanisms to pay the active investors for their diligence and company advising efforts. But, that is not always easy. Not only does the value for compensation have to come from somewhere, it can wreak havoc in the group because it starts to convert the best peoples’ amateur volunteer “for the love of the game” status into a professional status.
There can also be issues around who should take a board seat - the fund, which is writing a single big check, or one of the more knowledgeable, active small check investors who has been working closely with the company. Closely related to this board seat issue is the question of communications. When someone discovers that the company is having a problem, it can be unclear what the lines of communication are or should be. And, if a problem comes to light after a follow-on round, there can be questions of who knew what when and why they didn’t warn others.
Speaking of follow-ons, there can be issues there as well. Investors in the fund might feel angry if individual investors don’t follow-on after their initial investments or happen to say critical things about the company. Similarly, individual investors might feel angry and abandoned if the fund chooses, for its own reasons, not to follow-on in a company they supported in the previous round.
Funds affiliated with incubators, accelerators, universities or economic development agencies can present additional tricky problems. To the extent that they are expected to serve an institution, or its alumni, or serve a social purpose such as job creation, they may find that they have some conflict between their non-financial obligations and their drive to achieve the highest possible returns. For example, they may feel obligated to invest in a company because it resides within their organization or to follow-on in a company to keep it alive, when a purely financial investor would have passed on the opportunity.
As you might imagine, some of these issues can be fairly thorny and can lead to some seriously frustrated expectations if they are not mitigated. Not all of these issues can be completely avoided, but there are a few things you can do to try to minimize them:
Keep the fund independent, if possible, so that it is a closely affiliated “partner” of the institution but able to operate as an independent agent. For example, as a way of ensuring most of the benefits of a tight partnership, without all the drawbacks, you could have a bilateral agreement that not only will the institution share or refer all its companies to the fund on a first refusal basis, but also the fund will agree to make time to scout and maybe advise all of the companies in the institution. This would work somewhat like a right of first review or offer, and thereby create a greater proximity and likelihood of investment, but not an obligation.
Take time to plot out all the different investing, communicating and decision-making scenarios you can think of that might come up in both the short term and the long term (such as those noted in the special considerations above). Take the time to plan, agree on, and document what the rules will be in each situation. And, because it will not be possible to think of every single scenario, establish a governance mechanism such as a decision-making process, an ethics board or referee who will be the agreed-upon mechanism for guiding behavior in tricky situations.
Make sure no matter how you set yourself up to run, you painstakingly document and explain your approach to your LPs before they commit their money. At the end of the day, you can run a fund however you want, but you should have a documented plan, and that plan should be clearly explained to your LPs before they invest.
As noted above, venture capital is one of those professions idealized by many and misunderstood by most. To the uninformed, it seems like it should be great, but in actual fact, it is a fairly hard job that is only fit for people with certain temperaments, skills and abilities. Sure, you get to set your own schedule and spend your time doing interesting things, but you really are not your own boss. You are essentially in a service industry, and a very transparent and public one at that. You are a service provider providing investment services to relatively unforgiving LPs who will walk away and never come back if you don’t deliver the performance they expect. Not quite as sexy and free-wheeling as many casual observers assume it to be. Still, for the right people, it can be a heck of a ride.