Venture capital 101
Wednesday, January 21, 2009/
The inner workings of a venture capital fund provide insight for entrepreneurs looking to raise capital and grappling with the rationale behind VC criteria (see previous blog: All I want for Xmas is VC).
This is a big topic, but I’ve cut it down to seven main points. So here goes…
- VC funds are typically 10 year closed funds, meaning the fund manager is obliged to return the invested capital plus profits to its investors (limited partners or LPs) within 10 years of the fund’s commencement.
- The first five years is the investment period, and the second five years the VC is focused on rapidly scaling (series B and C financing rounds) and/or selling its interest in each of the portfolio assets.
- Management fees are typically 2% of funds under management, which must pay all salaries, administrative costs, travel etc. The management fee generally tapers after the investment period, providing incentive for the manager to both sell out of the existing portfolio (hopefully generating profits) and raise a new funds so that investment activity may continue. To raise a new fund, there must be encouraging results from the existing fund etc.
- If the fund makes a profit, the VC typically receives an incentive payment of 20% of profits after the investors have received their original capital plus an agreed hurdle rate of return.
- To mitigate portfolio risk, VCs must balance the number of deals done against the available capital and the number of investment professionals on staff. A rule of thumb is that an investment professional can be directly responsible for between four and six deals. Beyond this number, the capacity of any individual to add real value to a business is questionable.
- Statistically most deals will return invested capital, some will fail completely, and one or two will deliver substantial returns. Notwithstanding the statistics, an individual fund manager has to make judgements every day about where resources should be best allocated to maximise the overall fund return. This reality has the potential to cause conflicts of interest with respect to specific companies – the founders of which expect “unconditional, undying love”.
- VCs are generally not mandated to hold assets for the long term and deliver investors dividend streams. The VC structures are designed for capital gain transactions so attention is always focused on maximising achievable enterprise value.
The above is really only an overview, but it highlights some important constraints.
For most businesses, the VC timeline is too short. The VC imperative to show enterprise value uplift and the prime motivation to maximise overall portfolio value may cause a divergence of interests between founders and their VC partners.
Since partnerships generally fail if interests are not reasonably well aligned, understanding how your prospective partner sees the world is a good start!
Doron Ben-Meir has been an active venture capital manager for the last eight years. He founded Prescient Venture Capital and prior to that was a consulting investment director of Momentum Funds Management. He was a serial entrepreneur over a 12 year period, co-founding five new technology based businesses.
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