I am not sure how many entrepreneurs understand the structure of venture capital funds but the bottom line is that while VCs manage funds, we ultimately report to our investors or Limited Partners (LPs). It is not our money, and we have a fiduciary responsibility to manage it properly and generate the returns our LPs expect of us. And like you, we have to go out and raise capital every 3-5 years for a new fund and similar to entrepreneurs we need to network with the right people, have the right meetings, and go through extensive due diligence. Every year the Dow Jones Private Equity Analyst puts together a show where fund managers can listen to what the LP community is interested in and where they plan on allocating their dollars. This year's show was billed as an opportunity to meet "more LPs per square foot" but truth be told, it was a place where I could meet more VCs or private equity managers per square foot. In the early morning, a show of hands revealed about a 20% LP audience and 80% fund manager group. It reminded me of a typical VC/entrepreneur conference where you have panels of VCs talking about where they want to allocate capital and entrepreneurs trying to flag them down to hear a pitch. In these conference you typically have a similar ratio, 20% VCs or those with the money and 80% entrepreneurs or those seeking funds.
Anyway, as I had time to think about it, it might be helpful for entrepreneurs to understand how VC funds operate to better understand our motivations and to better align interests. At the end of the day, VCs are in the capital gains business. We make money when our LPs make money which means that the companies we fund and entrepreneurs that we back need to be successful. Clearly when VCs and their LPs negotiate their agreement, economics are the most important topic at stake. While VCs get management fees to pay the bills, it is the carried interest portion or % of profits that VCs receive that really drives our thinking and aligns our economics with performance. In any typical fund, we except 1 to 2 deals to be homeruns with 10x or greater returns, 3-4 to be pretty good returns, and the rest to either get our money back or lose money. What that means is that every one of our deals needs to have significant return potential and market size for us to think about investing in a deal. In addition, companies should be capital efficient (see an earlier post on capital efficient business models) meaning that no more than $25-30mm should go in, especially if a home run deal acquisition is $200-300mm (not $1b). If only 1 to 2 deals have home run potential, the chances of us getting any one of them to really work is slim to none. If the majority have this potential, we get more at bats at the plate and more opportunity to create real value for the fund. As a fund matures, VCs need to demonstrate real cash-on-cash returns to go out and raise the next fund.
This is the point at which conflict could exist. First, there could be situations where the VC says no to a great opportunity to sell the company but for whatever reason wants to hold out for a greater return. On the other hand, there could be situations where a VC wants to exit too early with a decent return but not optimizing the overall value of the company in order to return capital to investors. At the end of the day, what this means is that entrepreneurs and VCs need to get on the same page pre-investment in terms of everyone's expectations for performance and goals. In addition, there needs to be constant communication as the markets and company evolves to ensure this alignment. The good news is that given a VCs economics, we only do well when the entrepreneur and company does well so what better alignment could there be. A point of diligence for entrepreneurs could be understanding where in the fund lifecycle a VC is and what some of their returns to date have been.
