15 Sep VC fund "flavors"
In the early days of the modern venture capital industry, way back in the 1950s, most venture capital funds were generalists. That is, while the specific experiences and skills of the managing partners no doubt influenced the kinds of deals that interested various funds, the typical fund was interested in a variety of industries and tended to invest at all stages. Fast forward to today, and while there are still a few generalist funds around, most funds tend to specialize in one or a few areas. This note examines some of the common “flavors” that most of today’s venture capital firms come in.
One common form of specialization is by stage of investment. While there is to some extent a continuum among funds, the stages can be thought of as (i) Seed/Start-up, (ii) Expansion Stage, and (iii) Mezzanine. Specialization by stage typically reflects several factors, including (i) risk/reward profile of the fund’s investors, (ii) the fund’s “value add” proposition, and (iii) the size of the fund.
Seed/Start-up Specialists. These funds, which are also referred to as “First Round” funds, generally want to be the “first institutional money” in deals. As such, they typically have a higher risk/reward profile (increases in valuation are largely a function of reducing the risk of failure). Managers of First Round funds are more likely to have start-up experiences and skills themselves: their value add proposition to entrepreneurs usually emphasizes their “hands on” ability to supplement the entrepreneur’s often incomplete team and provide practical assistance at the most vulnerable stage of a company’s development. As with investors at other stages, the value add also can include credibility with downstream investors and identifying new team members.
First Round funds also tend to be smaller than their downstream counterparts. The reason is simple: first round financings are usually smaller than later round financings, and it takes as much management time, more or less, to source, close and manage a first round investment of $1 million as it does a later round investment of $10 million; indeed, often more time. From a human resources perspective, it is hard to invest a $500 million fund $1 million at a time.
Historically, First Round funds – at least the successful ones – have tended to move downstream over time. The reason is that as VC teams with strong track records raise second, third and later funds, fund size tends to increase. Why? Because their track record makes it easier to raise new funds, and because bigger funds offer bigger management fees and, while perhaps lower on an IRR basis, the potential for greater gross carried interest income. For all of the industry’s “we only make money if our investors do” polemics, the fact is that managing partners of larger funds typically have “base” income (that is, management fee-based income) substantially greater than their smaller fund counterparts.
Among the higher risks assumed by First Round funds, one in particular is due to their usually smaller fund size. Financing risk is particularly problematic for First Round funds because smaller funds will have less “dry powder” available to support companies in later rounds than larger funds. The typical fund agreement limits a fund from investing more than, usually, ten percent of the fund’s capital in any one company. A financing fact of life for early stage companies – and their investors – is that if/when larger later stage financings are required they are less likely to have the option of “passing the hat” around to existing investors to raise the needed capital. The less dry powder available, the more pressure there will be to find new investors – and the more leverage those new investors will have over pricing and other terms by virtue of the fact that the new investors know the company’s existing investors cannot provide any, or at least the optimal amount of, new capital. This issue is particularly serious given the need for First Round funds to achieve higher rates of return than downstream funds: otherwise, why would they take the higher risks of investing earlier than the later funds? This analysis is at least one of the reasons the number of funds focusing on early stage investments has, at least on a relative basis, significantly declined over time – and one of the reasons so many angels have banded together and filled some of the abandoned territory.
Generalizing about the milestones First Round funds expect of the companies they invest in is difficult because those objectives can vary substantially depending on the industry a given company operates in. A start-up with a fully-developed product for a proven consumer market might see a first round as an only round prior to the exit. On the other hand, a start-up biopharmaceutical company with an unproven theory and no lead compounds might be ten years and hundreds of millions of dollars from the market, and be looking for start-up capital for the sole purpose of generating convincing (peer-review publishable) evidence that the theory has some merit. Despite that wide variability in potential milestones, First Round capital is often thought of as capital aimed at proving the underlying concept of the business model, whether that is as simple/fast as “if you build it will they come” or as complex/slow as “is there any tangible evidence that this theory is true.”
Expansion Funds. Expansion funds focus on companies that have successfully met – at least more or less – their first round milestones. In the early days of the modern venture industry, that often meant that they had developed a product and were ready to push that product into the market; they were ready to expand their operations to address the full market opportunity. Today, what constitutes expansion capital, how many rounds of it are needed, and what are the milestones for each round, are quite industry/deal specific. For most industries – biotechnology is the biggest exception – the ultimate milestone of expansion stage funding is to achieve sufficient scale and operating efficiency to generate operating profits.
The value add proposition for Expansion funds is typically less hands on and more strategic. While Expansion investors can get very hands on when things go wrong, their more common roles are to serve as a sounding board for management and to leverage their relationships in the portfolio company’s industry to identify and help close corporate partnering opportunities, recruit managers, etc.
Mezzanine Funds. Mezzanine investors focus on being the “last money in” prior to a company’s exit. The purpose of mezzanine financing is typically to position the company for a public offering or sale or other exit. The value add proposition for Mezzanine funds typically centers on their close relationships with the investment banking community that almost always plays a critical role in identifying and executing an optimal exit transaction for the company and its private investors. These funds typically have the contacts to make the exit happen soon if the exit window is open, or the capital resources to sustain the company until the appropriate exit window opens.
Industry specialization is another vary common feature of venture funds today. Indeed, if only in a negative sense of making it clear what industries a fund won’t invest in, almost all venture funds are industry specialists. Funds typically specialize for some combination of two reasons; (i) the skills and experience of the fund’s managers, and (ii) the relative popularity of select industries over time. When funds without obvious sector-experience and skills start piling into a specific industry, be on the lookout for a bubble. An enormous increase in funds and dollars devoted to the internet set the stage for the burst of the internet bubble in 2000. We’ll surely see the same phenomenon again, though perhaps not on the same scale.
Over the last decade or so, globalization has begun playing out in a serious way in the venture capital industry. Beginning with funds focused on Japan as far back as the 1980s, today there are funds that specialize in countries (e.g. India and China) as well as regions (e.g. emerging markets generally, or southeast Asia). The rationale for this kind of country/region specialization is similar to the rationale for industry specialization: experience and skills of the fund managers and popularity of the investing style among investors.
A second form of geographic specialization is noteworthy: specialization within certain regions of the United States. Some funds, particularly early stage funds, will only invest “close to home.” For later stage funds that usually means within two hours (and no plane change!). For early stage investors that can mean within an hour by car. One phrase you often here in venture circles is “early stage capital doesn’t travel well.” Investors with this kind of geographic focus typically base it on a perceived need to work very “hands on” with their portfolio companies. Or, in deal rich neighborhoods like Silicon Valley, they may simply not see a need for the inconvenience of looking outside their own backyard. Finally, some funds in emerging venture capital markets (the southeast, for example) will concentrate in that region on the basis of less competition (better pricing) and/or greater “value add” in terms of knowing the market and its players better than outsiders.
Leaders and Followers
A common mistake made by less experienced entrepreneur seeking venture capital is pursuing funds that, while perhaps a fit in terms of industry, stage, value-add proposition, etc. are not likely to either make an investment on their own or lead a syndicate of investors. Being the lead or co-lead investor in a round comes with a certain ego and PR value, as well as the burden of do the heaviest lifting in terms of due diligence and deal negotiation and closing. Many an entrepreneur (your author among them) has lined up a bushel full of money from followers while failing to attract the lead for them to follow.
Being a leader means being in more control of the deal. And, as noted, it can boost an investor’s ego. So, why isn’t everyone a leader? Well, first, in the case where a syndicate of investors is desirable (most cases, particularly in downstream rounds), you can only be an effective leader if you have the reputation to attract followers. There are a number of funds that, if they say they will lead a deal, can attract more than enough followers to fill out a syndicate with a few phone calls. Second, if the round can be completed by one investor, the fund that might otherwise be tempted to do the deal alone might be afraid to pull the trigger, either because they can’t or won’t do the work associated with a lead role or because they are concerned that their involvement will not impress later stage investors. Established, highly reputable downstream funds tend to focus on deals where the earlier funds had at least good reputations.
The problem for entrepreneurs is that many venture investors, even those that realize they are not credible leads for a deal, often don’t effectively communicate that to entrepreneurs seeking funding. If nothing else, it can be a blow to the ego. And, besides, the investor will want to be right there, ready to jump on board the syndicate, if/when a credible lead does show up. Entrepreneur can waste a lot of time and energy identifying and marketing to investors who are very unlikely to take on a lead role in a deal.
Mixing and Matching Styles
While there are examples of strict “pure play” funds (e.g. a First Round fund that invests only as a lead, and only in biotech deals in Southern California) most funds mix and match the various flavors discussed above. For example, an Expansion fund may do first round investments in a particular industry. A fund that typically leads in deals close to home may follow in deals further away. The permutations are many.
Corporate Funds. Corporate funds are more or less captives of their corporate parents, and typically have dual objectives: maximizing returns and providing the parent a window on and potential access to emerging technologies. From an entrepreneur’s perspective, corporate funds have plusses and minuses. On the plus side, research suggests that corporate funds tend to pay higher prices than independent funds, probably because they have a dual purpose. They can also serve to validate a company’s technology for other investors. From the perspective of the independent funds, though, the higher prices can offset the validation, and, fairly or not (the research I’ve seen suggests more fairly than not), independent fund managers, even to the extent they appreciate the technical validation provided by a corporate fund’s investment, tend to doubt the other investing bona fides of corporate investors.
Fund of Funds
Another fund “flavor” is noteworthy, and that is the so-called “Fund of Funds.” These are not strictly venture capital funds as they do not make investments directly in operating companies. Rather, they pool funds from other investors which they then invest in venture capital funds. Funds of Funds have several rationales. First, they can give smaller investors that may not have sufficient capital to build a diversified portfolio of fund investment, an attractive access point to venture investing. Second, they offer an access point to the venture sector to investors that do not have or want to build the internal resources to efficiently and effectively seek out and qualify multiple fund investments. Finally, Funds of Funds often have better access to the more established venture fund families, many of which are if not closed to new investors are not readily accessible to newer, smaller investors.
Other columns by Paul A. Jones
- Two sides of an often contentious issue
- Term-sheet etiquette and other rules of capital raising
- Technology transfer: Why private profit is good public policy
- Commercial Biopharma in Wisconsin: The next big step