Get the money, part 2: shiny toys

In post 1 of this series for founders on how to think about the business of VC, I gave a brief, high-level overview of a VC’s investor base (the limited partners) and the arrangement they have that dictates how VCs make money. There are a myriad of other aspects of a VC’s business that drive their motivations and translate into behaviors around how they work with companies. In this post, I’ll focus on fundraising cycles.

My goal here is to keep these posts relatively brief. To dig in more on venture capital, read Brad Feld and Jason Mendelson’s book, Venture Deals, and take this related Venture Deals course from Techstars and Kauffman Fellows.

Fundraising cycles

Unless they have a single-LP or evergreen structure, fundraising is a necessary and important piece of a VC’s business. Venture funds tend to be on a 2 to 3 year fundraising cycle, depending on the fund’s strategy and pace of deployment. Demand from LPs is also an input. During the recent bull market, this fundraising cycle was compounded to 18 (even 12) months for some, but we’re seeing that correct.

In some ways, VC fundraising is similar to company fundraising — you build relationships, pitch your story, and convince people to write you a check. Potential investors evaluate what you’re building, how you’re doing it, whether you have the right team to win, and whether they can generate a compelling return. They look to past performance to predict future performance and evaluate your track record of success and your reputation. They also consider fit with their own strategy.

A key difference with VC is that with each new fund, LPs are investing in a new fund entity, analogous to owning stock in a brand new company v. the existing company that provides the basis for the underwriting. They underwrite based on prior fund performance combined with a “players on the field” analysis, i.e. the go-forward ability of the current team to source, choose, win, and manage an entirely new portfolio of investments (while continuing to manage prior portfolios). Much of that second piece is tied to brand and reputation.

So, why might this matter to founders and how could it affect you?

TL;DR: Fundraising demands a VC’s time and energy (and yours too if asked to be a reference). Your performance becomes a focal point. A VC’s need to raise more money can put them at odds with what’s best for you or your company.

Fundraising is time consuming, of utmost importance (there’s no fund without LPs), and generally happens over a span of months, not weeks. You don’t just have to land the lead investor and then find some small fill-outs. For many funds, they need to get a lot of significant “yes’s.” For more mature funds, this can be quick and relatively painless if they have strong performance, strong relationships with their existing LPs, and aren’t increasing the fund size so much that they need to bring in a large number of new ones. But for the category of newer funds, which includes many (most?) seed funds today, it’s more challenging, especially in the current market. Newer firms with only one or two funds under their belt haven’t had enough time to generate significant liquidity and return capital to their LPs (we call this “DPI,” which stands for distributed-to-paid-in-capital…more simply, the ratio of cash in to cash out).

For a seed fund that launched in year X, by the time they go to raise fund II, fund I has only been around for 24 months. While some of the investments have been in the ground for 2 years, some are only a few months old. Even by fund III, while it will start to be more clear how fund I is doing, it’s still only been 4 years for the oldest investments, and most companies don’t exit that quickly, so lack of DPI persists. Thus, LPs need to consider factors other than DPI to decide if they’re going to invest with this VC.

So what else do they consider? The portfolio companies, the progress they’ve made, and the potential outcome each company will have and that outcome’s impact on the overall fund return. This is where you come in, founder. You are the product! Or as my partner Lindel says, “the shiny toy.” VCs bring in new investors based on their basket of shiny toys — those portfolio companies’ stories, traction, performance, and (hopefully) markups. They need their toys to be shiny in order to attract capital just as much as they need the ultimate outcome that will drive returns. So, while everyone wants to be patient and supportive, given how long it takes to exit, they need signals that things are going well and that a big outcome is on the horizon, even if that horizon is distant. This dynamic can create significant pressure and stress in the system, especially in markets like today’s, where everything is hard and capital is constrained.

In addition to underwriting the underlying portfolio companies, LPs also think about the go-forward and how likely the team is to not just do well, but outperform the market. Remember, LPs want ALPHA! They consider how well the current team will do in creating strong deal flow, identifying promising opportunities, getting those founders to take their money (even in this market, money is a commodity and there is still competition, especially at the early stages), and then manage the investment by helping the company and making key decisions around that investment (like voting on certain company actions, follow-on capital, and liquidity).

While venture is being disrupted in many ways, I still believe it’s a very human-oriented business, and LPs continue to evaluate both the firm’s and the individual GPs’ network, brand, and reputation. LPs will want to talk to founders about their experience with the firm and the individual GP with whom they work. So, you may be involved there as well.

In some cases, the need for a VC fund to raise additional capital can have negative effects on the underlying portfolio companies beyond asking you to spend time being a reference or being less available to you while they’re in the midst of a fundraise. It can create misalignment where a VC may feel pressure to make a decision that is best for their business and ability to fundraise but is not necessarily what’s best for you or your company long term. An example of this would be selling into a secondary transaction at a level that creates negative signal in the market. Another is pushing you to keep going when you have an offer that’s game-changing for you but not a meaningful return for them. Or the opposite: pushing you to take an offer because they need liquidity but where you believe there’s more upside ahead and you want to keep going.

I’m not in any way saying that all VCs do this — the good ones generally don’t — but it’s hard to know how folks will act until a situation actually presents itself. At the end of the day, you’re dealing with humans. It is important to understand how they might be motivated in ways that aren’t totally obvious without considering what’s going on behind the scenes.

One last thing — if you’re working with a new firm that is raising their first fund, make sure they’ve actually closed on enough capital to make an investment.

For the next posts in this series, I’ll go deeper on portfolio dynamics and thinking about how you fit in. I’ll also touch on partnership dynamics and how they play into decisions that can affect you and your company. From there, I’ll move into a high level view of the VC landscape and how to think about all the different offerings.