When I was much younger everyone, myself included, wanted to be a hedge fund manager. And who could blame us. After seeing the kind of houses these folks lived in, any sensible bloke with aspirations of ditching the 30-year old Fiat for a Porsche wanted a hedge fund of their very own. They clearly brought only wonderful things to those who had one… except maybe Raj Rajaratnam.
A near mythical status was attributed to these God-like people, hedge fund managers that is. Even the excessively rotund, cabbage-faced geek, with the hygiene of a garbage bag would find himself swarming with girls should he let it slip that he indeed manages a hedge fund.
Today a similar status seems to have descended like a blanket of fog over venture capitalists. Like the aforementioned hedge fund managers, they’re largely misunderstood. Fog does that. It makes things… well, foggy.
A conversation I had with a couple of entrepreneurs shows the thickness of the fog.
The conversation went something like this:
Me: So how are you financing this?
Founder: We’ve raised some family and friends money a few months ago and now we’re looking for VC money.
Me: Why VC money? Why not angel money? (this is a very early stage company which is nowhere near being ready for VC capital)
Founder: Well VCs have a lot more money than angels, and we don’t want to waste our time with angels. We’re going straight to the top.
Me: The top of what?
Founder: Well VCs are it really. They’ve at the top. I mean they’ve got to where they’ve got to by being really good. No, we need VC money.
Me: Really? What do you believe they’re going to bring you that angels can’t?
Founder: The expertise we get from VCs is going to help us a lot.
Me: Really, how do you figure that?
Founder: Well, VCs have more money, they have more contacts and they can get us strategic relationships.
Me: So you’re expecting them to be quite active in your business?
This sort of thinking is complete horseshit and I told the founder so.
Companies have different capital requirements during their life-cycle, but as I mentioned last week, it is an entrepreneur’s job to identify the most efficient and attractive source of capital at any given point in the company’s life-cycle.
The gentleman mentioned above had an extremely early stage business. Just a few months old, and not much more than an idea. What he needs is pre-seed capital which almost never comes from VCs as the amounts in question are very small, often only a few hundred thousand dollars. He would have been better off sourcing angel money for two reasons:
- His business was not yet mature enough to take to VC money, and
- He needed additional help in his company on the skill side. This would most likely be easier for him to get from an interested angel investor who could join the board, than it would be from a VC fund.
The problem, I realised, that this entrepreneur faced, was that he didn’t understand the nature of what venture capital was, and had lumped venture capital together with anything related to private funding.
The trouble is if you don’t understand the person you’re trying to raise money from you land up wasting both parties time.
And furthermore, when the time does come and your business is at the stage where it needs to secure venture capital you can pretty much write off the VC you pitched earlier; he’s already had a bad experience with you since he realised you never did your homework before talking to him.
I’ve always felt that the relationship between entrepreneurs and investors is or should be that of a partnership. Those funding your business are partners in your business and as such you should educate yourself about who they are, what their motivations are and what they can and cannot bring to the table.
Who, Then, Are Venture Capitalists?
Perhaps let’s look at the structure of a typical VC fund as this will shine some light on the subject.
What takes place is that a bunch of smart, and sometimes not so smart guys, and sometimes gals, get together and form a company with the objective to get filthy stinking rich and they intend to do this by investing in exciting early stage ventures.
These guys are called the General Partners (GPs) and in order to leverage what they’re doing, they take in partners who wish to co-invest. These partners are passive and called Limited Partners (LPs) and they are usually charged 2% of capital and 20% of the carried interest, which in the industry is commonly known as 2:20.
The more money the GPs can raise from Limited Partners the better for them. More capital means more fees and returns. For example, a VC fund with $1 million under management that generates a 2x return will only earn the GP 20% of $1 million or $200,000.
On the other hand, a GP with $100,000 who earns only 6% will earn $1.2 million or 20% of the $6 million, not to mention the 2% of fees, which on a $100 million fund amount to $2m. Assets under management (AUM) are therefore super important to VCs.
What Does This Mean to You As a Founder Looking to Raise VC Money?
It means that your company should be large enough to be investable and it means that as an entrepreneur you need to understand who you’re talking to.
As an entrepreneur, right NOW may very well be THE best time to raise money because there are those who are throwing it out like a lolly scramble at a 5-year-old’s birthday party.
All that said, VCs are going to protect themselves. They understand they are investing in a risky asset class and will limit those risks as much as is possible. They’re going to demand liquidation preferences, maybe even 2x, and they’re going to take board seats.
Realise also that VCs, evil as they may look, are not their own boss. They answer to the LPs, and if they answer to their LPs and you take their money, you now do as well. Oh, and remember, LPs are often made up of pension funds, endowment funds, funds of funds and the like. As such LPs tend to know about as much about your business as they do about the city of Ouagadougou… not so much.
What do LPs want?
If LPs want exits it means your investor want exits. Now that sounds a bit like stating the obvious but realise that one of the biggest risks behind venture capital is the lack of liquidity and there will be a push for liquidity whether you the founder like it or not.
Everyone wants to eventually see liquidity. This is why companies will IPO even if it means, like in the recent case of Square, the valuation is lowered.
Consider for a moment some of the VCs in Square who got in at the Series E financing. Many invested with a 1.3x ratchet. Some elected to waive the ratchet and they’re staring at losses as a result, but many did not. It’s the VCs who are making money and the difference comes out of, you