Note: This article is the second 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.
Growing up in rural New England followed by 4 years as an English Major in college, I was always drawn to the writings of Henry David Thoreau. Fortunate to enjoy the luxury of spending much of his life as a naturalist, essayist and philosopher, Thoreau made some very keen observations that can apply to many aspects of our modern world. You might think there is no connection between Thoreau and managing a venture fund, yet one of my favorite quotes by Thoreau provides an ideal foundation for this article.
“It’s not enough to be busy, so are the ants. The question is, what are we busy about?”
As a newly minted manager of a venture fund, your initial response to the question “what are we busy about?” might be, “finding great companies, investing in them and waiting for big financial returns.” And, while your response would be directionally correct, it would be woefully incomplete. There is so much more to running a fund than leaping in, chasing companies and slinging cash around. Putting in place a well-thought-out investment strategy is a crucial component when building a high- performing portfolio of early stage companies, especially if that portfolio is going to generate acceptable returns.
Many investors think having the connections, foresight and skill to invest in big winners such as Facebook, Amazon or Google are the key factors in the success of an early stage fund. And, yes, any fund would be successful if it ended up invested in one of those 1000x return deals. But, in reality, that type of successful investment is extremely rare. No fund manager should set out to build their portfolio by assuming they will invest in one of these deals as the core part of their investment strategy. That is like setting out to win a golf tournament by getting holes in one. Instead, they should pace themselves while they work their way through the course shot by shot.
Ham’s career in the startup world began in the early 1980s launching three successful software companies. He transitioned to investing in startups in 2000. So over the past four decades he was funded by or co-invested with and sat on company boards with dozens of venture funds and hundreds of venture capitalists. Through managing his personal investments and working with and discussing the investment business with VCs all over the world, he developed an understanding of how many VCs go about building their fund’s investment strategy. Let’s take a look at the key insights he learned over many decades of experience with funds.
Ham, when you meet with a VC what are some of the first questions you ask to determine what their core investment strategy is?
When I sit down for the first time with a VC, I get right to the heart of the discussion with the sort of 20 “person/place/thing” questions that will allow me to broadly categorize the fund. In figuring out their core investment strategy, I start off by asking the following questions.
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Industry - What industries will you focus on? Does your fund go after a wide range of companies, or do you have certain areas of expertise where you focus? It’s not unusual for a fund to have an investment thesis where they invest in one or more core technologies such as artificial intelligence, blockchain or consumer-focused e-commerce just to pick a couple examples. Or a fund can focus on companies chasing specific types of customers or markets. And, there are types of funds that are more opportunistic and will make investment decisions based primarily on the quality of the management team.
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Stage - How early do you invest in the life cycle of a company? Do you like to invest at the earliest point in time (i.e. two founders and a powerpoint presentation)? Or do you prefer a more developed business with predictable revenues, etc.? Essentially, I am trying to gauge whether the fund is a Seed stage fund, a Series A/B stage fund, or a growth/later stage fund.
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Geography - Where do you invest? If you specialize in a very specific niche type of company, you might have to look for investments all over the world. That means a lot of time spent traveling, both to find deals and then to sit on boards. Many VCs like to stay closer to home where they can leverage their local personal network to help portfolio companies and spend less time on airplanes.
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Size - How large is your fund? What size investments does your fund make? How many investments do you target making annually and over the life of the fund?
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Fund Maturity - I like to get a sense of where a fund is in its own life cycle. Funds tend to add new companies most actively during the first third of their life cycle, do follow-on investments during the second and harvest exits during the final third. Enterprises operating multiple funds at once can blur this pattern, so I like to get a sense of what kind of operation they are running and where the specific fund in question is in its life cycle.
By setting specific targets for industry, stage and geography and knowing where they are in the life cycle of their fund, most investors are able to narrow down the field of potential investments for their funds. In addition, there are other overlay criteria for company selection that I see being put in place these days. The following specialty funds further narrow their investment strategy in a variety of ways.
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Social Impact Funds - By combining the ability to generate measurable social outcomes alongside financial returns, these funds hope to benefit specific segments of the world’s population (e.g. improving healthcare or promoting education in developing nations). They don’t invest like traditional VCs and their limited partners (i.e. investors) tend to value social responsibility above financial returns. My questions for a social impact investors tend to focus on:
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What causes are most important to their fund?
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What level of financial return is acceptable to them?
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How do they measure impact?
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University Funds - Taking advantage of the incredible resources of local research has led many universities to put in place funds to invest in the professors and students who are looking to start new ventures based on the research they undertook in university labs. The goal of these funds is twofold: 1) to generate successful outcomes that burnish the reputation of the institution and its people, and 2) to generate financial returns that can support the long term university budget. In addition, many alumni groups are launching funds to invest in companies that are closely tied to their alma mater based on one or more alumni co-founders. My questions for university investors tend to focus on:
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What resources from your alumni network can you apply to an investment?
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What are the terms of the university’s ownership in the company? (e.g. do you have equity, will there be royalty payments, etc.)
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Corporate Funds - With the ever-increasing pace of technology development, and the broader trend of larger companies “outsourcing” some of their R&D to startups, large corporations struggle to stay up-to-date with rapidly changing markets. Given the slow and cumbersome nature of internal development projects, these corporations are looking to work more closely with startups around the world who may be more nimble and fast-moving innovators. Corporate venture funds are one way for these organizations to connect with companies that have a strategic fit with the corporation’s current or future plans. My questions for corporate investors tend to focus on:
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In which areas related to your industry are you most interested in making an investment?
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When you invest, is it with the intention of acquiring the company at some future date?
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Is there a services component to your investing agreement?
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Country/State/Regional Funds - Ensuring that the local population has access to well-paid employment opportunities in emerging industries is a role that many governments (both local and national) are engaged in today. These funds tend to value job creation above financial returns, but ultimately, a gainfully employed population will generate significant local tax to help fill government coffers. My questions for government investors tend to focus on:
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What industries do you see becoming most important for future job creation in your region?
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Besides job creation, what factors help influence your investment decision? (e.g. investment returns, community development)
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What future restrictions, if any, do you place on the companies in which you invest? (e.g. headquarters location, job creation targets, etc.)
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As a fund manager, if you are able to outline your industry, stage and geographic focus, apply any specific additional criteria (e.g. social impact) and understand the implications of size and fund maturity, you are well on your way to establishing your core investment strategy. Knowing what types of companies you will focus on is the cornerstone of your strategy. When you announce to the world that you are looking to make investments in early stage companies, you will be inundated with potential opportunities. Trust me… I get emails every day of the year from aspiring entrepreneurs all over the world! 99% of them don’t fit my investment criteria. Putting in place a screening criteria that allows you to give a decisive “No” quickly and efficiently is a critical time saver for you and the companies who approach you.
In the Part II of this article we'll address capital allocation strategy and the life cycle of a venture fund.
Want 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.
