Note: This article is the fifth 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 addressed trends in VC fundraising, the roles played by GPs and LPs, and key questions fund managers should expect during the prospecting process. Now let's take a closer look at the primary elements of a fund prospectus and the critical skills every fund manager should possess.
Consider my situation, for example, since I am a very active investor with a lot of my own direct investments and experience in the space, and I am a GP running a couple small funds. I do not fit the profile of the typical passive LP just looking for a way to get into this asset class and put some money to work. And, I am not going to pay a lot of fees for that access. Instead, in the past I sought out three very specific things: geographical diversification, some specialized vertical expertise, and a bit more quantitative diversification (i.e. more companies) than I would be able to get managing that number of investments directly myself.
Because I am already an active investor, I am not wild about the fees and carry associated with the passive investment model, so I was looking for low cost fund opportunities. And, I was looking for funds investing in early stage companies. I have portfolio allocations for each asset class, and these fund commitments were coming out of my angel allocation.
So when I looked at funds, I was going with managers I knew, using approaches I understood, in markets I was familiar with and fund designs that fit my criteria. In one case I committed to a couple of very low cost angel funds based in California that would bring geographic and quantitative diversification which I would not otherwise be able to get. I also invested in a couple of specialized EdTech funds in Boston run by managers who were experts in this interesting (to me) field and running a nationally respected EdTech accelerator that would attract some of the best companies around.
What are the elements you need to have in a pitch deck or fund prospectus to convince prospective LPs to invest in your fund?
Your fund’s marketing and prospectus materials need to address all three of the main topics I’ve discussed above (the team’s capabilities, the fund’s design, and the current status of the fund) in sufficient detail to at least cover the biggest and most obvious of the questions before they are asked. And, managers should be ready with answers for all of the rest of the more detailed questions - not every LP will think to ask every question, but across all the LPs as a whole, you will be asked most of those questions.
In addition, the fund materials will need to cover legal details like the requirements of LPs, a summary of the legal and structural terms of the fund, basics like investment mechanics and deadlines, and the legally advisable boilerplate protections such as risk factors and disclaimers. Each fund document will be a little different, but there are norms, and competent legal counsel with experience in the fund formation area can provide you with models and examples from which you can start.
Once you have a great set of documents, you still need to keep in mind that your documentation falls into that old category of “necessary, but not sufficient.” Fundraising is a time-consuming inefficient face-to-face process. These LPs are committing serious money to you and giving you a great deal of discretion to exercise your judgement. They are going to want to get to know you and become comfortable with you. So the face-to-face meeting is the key, and the fund materials are merely what gets left behind.
When you decided to start your own fund, what qualifications did you have that were important to your prospective investors?
The primary qualification I had in the eyes of my LPs was tons of experience in the early stage investing space from many years of investing my own money in startups, evaluating companies, advising startups, serving on boards and leading Launchpad Venture Group, a large group of very capable and well-respected angels. And, I had invested in some good companies with demonstrated success delivering strong returns.
Second, was personal connections. I had a large network of well-respected people in the early stage space. In one instance, the anchor LP knew someone well who had in turn known me very well for many years. So I was a trusted “friend of a friend” rather than a stranger.
Third, I possessed other applicable professional skills and professional experience from years in industry which lent me additional credibility. This included having spent time as a corporate and securities lawyer doing venture capital fund formation work and supporting investments in startups, as well as having spent a long time inside a public technology company, including serving as the CFO dealing with Wall Street. So I was not just an inexperienced young person walking in off the street. I was someone who had been around a little bit.
And of course I was working with an equally accomplished and experienced partner with many of the same skills and also many complementary skills, and we had a long track record of working well together.
How is investing from a venture fund different from angel investing?
It is at once both remarkably similar and totally different. When you are an angel representing yourself, you can be as exact or inexact with your investments and your process as you want. If you want to make money, there are certainly some best practices available, but you can decide whether or not to follow them. If you want, you can chase your interests and indulge your passions. You can build a lopsided portfolio. You can vary your investment pace. You are under no time pressure from a fund expiration or IRR deadline. You don’t have any reporting responsibilities other than to yourself, and maybe to your significant other. You can jump into things without as much diligence if you want and follow your gut when the mood strikes you.
When you are running a fund, you are investing in the exact same kinds of companies and deals. That is where the similarities end. Running a fund, you are a professional manager acting as a fiduciary to LPs based on an agreed upon set of operating constraints. It is much more constrained and structured and it is much more responsibility. You have a good chunk of money you need to put to work, and you are on a clock to get that money into the very best companies you can so that those companies can begin maturing and wending their way along that slow journey to exit.
You are responsible for regular reporting and tax compliance. You are looking to build a diversified and structured and balanced portfolio. You have an obligation to do an appropriate level of diligence in every deal you do and to provide as much timely oversight into those companies as you can. You are writing checks of specific sizes and paying attention to the maximum amount you put into a company. You are using a very thoughtful process of deciding whether to follow on with later investments into those portfolio companies. And you are worrying from day one about driving liquidity and sufficient performance in a timely manner. It is an entirely different beast.
Needless to say, being an angel investor on your own account is easier and a bit more fun! But, your upside is limited to the amount of capital you can comfortably invest on your own.
What are some of the critical skills and resources needed by an early stage venture fund’s General Partners?
The critical skills and resources really boil down to four categories:
Business experience and industry knowledge
Connections and reputation
Business Experience and Industry Knowledge
If you have absolutely no interest in or experience with business and know nothing about how companies work, you have probably chosen the wrong field. You do not have to be an expert in everything, but to be successful, you and your fellow GPs collectively need to know something about the industries in which you are investing (including regulatory frameworks such as the FDA approval process in the healthcare space).
You will need at least some basic accounting and finance background, knowledge of how early stage investments are structured and negotiated, and how fast-growth companies finance themselves over time. It really helps to understand the different ways companies can market themselves, the different ways they go to market, the different ways companies can approach building sales capabilities, and some fundamentals about business models, revenue models, and operating models.
And, you are going to need to have at least a rudimentary understanding of how mergers and acquisitions work if you are going to be able to help your companies drive all the way to exit through acquisition. (IPOs are rare enough and the skills are specialized enough, so I am not going to include it in the already daunting list!)
Venture capital is really a people game. You need to be good at:
Evaluating the people behind many prospective investments
Coaching and advising those who are dealing with company challenges and ambiguous situations, often for the first time
Convincing LPs to back you
Convincing your investing partners to join you in taking a chance on a company you believe in, and
Convincing sought-after entrepreneurs to work with you.
There are no two ways about it - having a high emotional intelligence and good communication skills are critical to being a successful VC.
Hyper-growth oriented startups like the kind you will be investing in are very unique creatures which bear little resemblance to larger enterprises you may be familiar with and regularly read about in the Wall Street Journal. To steal a phrase from Facebook, these companies “move fast and break things.” They are often going after new markets with new technologies. They have fewer processes and far fewer resources than large companies. They have less to lose and cannot afford to be as patient. They need to take more risks to out-maneuver the incumbents. Bottom line, they require special care and feeding to nurture them along and that requires special knowledge and skills. Having experience with how startups work and what their typical bottlenecks and common problems are can go a long way toward anticipating and avoiding issues in your portfolio companies before they derail progress or bring companies down.
Connections and Reputation
A portfolio can only be as good as the deal flow it receives. A VC does not have to know every single person in their city, but if they are going to see interesting companies, they need to have a good reputation for integrity, fairness, and value-add. It doesn’t hurt if they are likable and empathetic as well. Further, they need to be plugged into the innovation ecosystem. They need to be connected to a network of investors and entrepreneurs. They need to know the key organizations such as incubators, accelerators, business plan competitions, university and research labs, other investors, funds and networks.
The fund also needs to have representatives speaking on panels, judging business plan competitions, and offering advice and mentorship. GPs may want to have a blog or social media presence. And they need to constantly nurture that good reputation as a respectful, talented, connected, and value-added investor. The better an entrepreneurial team and idea are, the more choice they will have in picking an investor. If you want to build a portfolio of great companies, you need those companies to want to work with you.
In Part III of this article we'll focus on how to determine the appropriate size for your fund and some sources of capital that are available to new venture funds.