Note: This article is the sixth 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. In Part II we looked at the primary elements of a fund prospectus and the critical skills every fund manager should possess. Now let's dive into fund size and sources of capital.
How did you determine the appropriate size for the fund you manage, and how would you advise a new GP to set their fund size?
Assuming hypothetically that you can raise as much money as you want, your maximum fund size is still going to be limited by two factors:
How big the fund’s GP team is, and
What stage of company you are investing in.
Here is why: each GP can only manage a certain number of investments at a time and the fund can only put a stage-appropriate amount of money into each company. Very early stage companies tend to raise smaller rounds as they develop the business and figure out what is working and then may later go on to raise larger amounts of money down the road.
If you are trying to invest a very large fund (say, several hundred million dollars), and you try to put it into very early stage deals, you are going to end up with a very large number of small checks into an unmanageable number of companies. This is because there is only so much money you can squeeze into a round whose total size is $500,000 or $1,000,000. Even if you could take the entire round, you wouldn’t necessarily want to. At the early stages, other investors can help add value and oversight to these companies, and you’d otherwise have far too many small investments to be solely responsibility for all of them.
Conversely, if you have a very small fund (say, a few million dollars), and you try to build a portfolio of later stage investments, you are going to have a major problem with diversification. Those later rounds are much larger and, even if you could get into them (which is questionable unless you have a stellar reputation or have been with the company since inception), the minimum check size you would want to put in to be relevant to the company and the deal would gobble up your whole fund.
So overall, you are striving for a stage-appropriate balance between fund size, deal size and portfolio size (i.e. quantity). As we discussed in Charting a Course: Building a Winning VC Fund Strategy, your goal is to build a portfolio with enough companies in it that you are sufficiently diversified, but still have a manageable number of companies per GP so that you can oversee them properly.
Where are some of the sources of capital that are available to new venture funds?
The question of capital sources is a good news/bad news story. The good news is that there are many different sources of capital, and the historical data cited in Part I of this article suggests that, in the current climate, some of these sources are more eager than ever to hand their capital over to funds, including those run by new fund managers. The bad news is that fund-raising is an opaque, inefficient, time-consuming, uncertain and very manual, face-to-face endeavor. Worse, many of the sources are hard to categorize, hard to reach and slow to come on board.
Established fund managers can get huge chunks of money from big well-known players like pension fund managers, endowments and sovereign wealth funds. New managers don’t have that option. The big players are very sophisticated, very knowledgeable about the VC business, and very focused on the kind of industry performance benchmarks discussed previously in the context of reporting.
However, there are sources of capital which are more open to betting on newer managers - if you can find them. One large source are so-called family offices which are private wealth management offices dedicated to the needs of a single family or small group of families. These offices are increasingly open to allocating some of their investment dollars into higher risk/higher return asset classes such as early stage investing. In some cases they are adding a social impact requirement layer onto the fund selection process.
In terms of locating family offices, there are some family office associations and there are conferences which cater to them, but I would not want to overstate the potential value there. The easier it is to find a family office through one of these organizations, the more likely they are to be besieged with requests for funding and the less likely they are to respond to your request, let alone respond favorably. Family offices, especially the older, larger and more sophisticated ones, are extremely hard to find and connect with. So as with many things in life, reaching family offices often boils down to old-fashioned networking: do you know any people who might know any people who might have connections to one or more family office?
Various social impact organizations and philanthropies are also increasingly open to the idea of supplementing their giving and grant-making with social impact investing approaches. Finding and approaching these organizations is somewhat easier because they are inherently more public and impact-oriented in what they do. But that ease is more than offset by the need to have a very good match between the goals of the organization and the impact goals of your fund. In particular, you are going to need to have a set of metrics to measure your fund that will need to be deemed adequate by the organization.
Another source of capital can come from other fund managers looking to diversify their fund by having another manager with a different region, skillset or focus invest part of the fund. Be forewarned, however, that these funds will be looking for discounts on fees and carry since returns would be crushed by two overlapping sets of management fees and carry. But they are still worth targeting because they understand your business, can make decisions quickly and have potentially large amounts of money to contribute to your fund.
The final source of capital comes directly from high net-worth and ultra high net-worth individuals who are willing to put a small amount of their wealth under your management - either because they know you or because they like your approach or focus area. Some of these people may be totally passive investors focusing on other areas of their life or just other investment areas, and will look to you as a pathway to invest in the very labor intensive early stage asset class. Others may already be active angels doing some of their own angel investing, but looking for additional diversification and reach beyond the number of deals they can do themselves.
In some cases these angels can be accessed through personal contacts in your community and traditional angel networks and groups which might be based in your city. (The Angel Capital Association maintains a list of angel networks organized by geography.) Good old-fashioned networking may allow you to track down some especially high net-worth angels who might be open to allocating a little money to an interesting fund.
In other cases, angels can be accessed using newer more technology-centric methods. In recent years platforms like AngelList and some crowdfunding platforms have emerged. With them come methods of aggregating angels into deals by allowing them to follow a particular investor into deals by pledging a certain per deal amount to a “syndicate” following that investor. This world may allow you to locate some angels, but it could also allow you to get a start as a lead investor trying to build a track record of picking companies and building a portfolio. (Note this is not necessarily an endorsement of this kind of investing. While it can be really interesting and has a lot of potential, in my view there can be some important downsides to long-distance investing by remote-control. You are paying fees to follow amateur investors you know nothing about, into companies you and maybe most of your co-investors have never met. As we have noted many times, meeting the team is a very important (most likely the most important) part of evaluating a startup. So you will want to apply a bit of caution and common sense in this space.)
Are there people you can hire to help you raise your fund?
Yes, but...you will want to select your broker with care. The world of private equity (of which VC is but one subset) is incredibly broad and diverse. As you have seen above, there are myriad different sources of capital and there is an almost infinite number of different kinds of investment opportunities. In an industry that large, there are bound to be middlemen who offer to broker introductions between money and opportunity. And many of them are undoubtedly very good and highly specialized at what they do. Of course they all charge fees which are generally a function of the amount money raised.
The reason I suggest caution is that the skill with which a broker represents you can vary and you need to make sure you get good value for your fees. You will also want to be careful because these kinds of brokers can introduce issues around investor (LP) fit for your fund and/or misplaced expectations. A broker who does not have a good collection of contacts among the right group of LPs may not be able to introduce you to LPs who will be a good fit for your fund.
The reason working with brokers can be tricky for a fund are the same as with any third party middleman situation. Sophisticated investors with pools of money tend to be patient. They know the best GPs will figure out how to find them directly and they tend to be a bit skeptical of GPs who need help with fundraising. Further, you are still going to have to do the work necessary to close the deal. So, in effect, you are really just paying for an introduction. Closing the deal with a stranger you were introduced to by a third party is going to be harder than closing the deal with someone you networked to through a warm contact. Given that you have no nexus with the LP, it increases the risk that they are not a good fit for you either, or have some unknown attributes that make them more likely to want to hide behind a broker. There can also be situations where a third party in the chain enhances the probability of a miscommunication or a misalignment of expectations.
Some of this can be mitigated by having brokers who are very specialized and whose business model is to not introduce investors to any fund unless the broker has some of their own money in that fund. That can go a long way toward upping the quality of the representation and introductions. But you still have to weigh and decide if representation is for you. You are paying for introductions you might be able to get yourself with some good old-fashioned networking. A reasonable approach is to try to raise the fund on your own using as much networking as you can possibly muster. If that doesn’t work, research brokers to see if you can find a really good one who has a solid gold reputation and puts money in alongside its clients. Even then, you will naturally want to do a lot of research on the prospective LPs introduced to you by a third party before agreeing to let them into your fund.
By now it should be clear that raising a fund is quite a bit more involved than it might first appear. It takes a professional with a certain kind of experience and temperament as well as the connections to get through the right doors. The design of the fund and strategy takes a fair bit of artistry. And the actual money raising is a long, grueling and inefficient process. However, if you can get through the fundraising gauntlet, the actual running of a fund is going to be much better by comparison - it can be pretty interesting and rewarding work!