What size VC fund is right for your company?
Venture Capital Market. Venture Capital funding continues at all-time highs. According to Crunchbase, the total number of company funding events in Q3 2019 was 9,100 and over 5,000 of those were Seed stage financings. The total dollars invested in Micro/Seed stage deals in Q3 was $4.4B. Clearly, there is no shortage of venture capital for those entrepreneurs in the hunt; however, the type of venture funding you take can radically impact the outcome. Many entrepreneurs are unaware of the nuances between venture funds of different sizes.
Definition of a “Micro VC.” VC funds under $100M (many are under $50M) are referred to as Micro Funds. Most of the well-known VC funds that are household names of the venture industry — Sequoia, Accel, Benchmark, NEA, Kleiner Perkins, etc. — are much, much bigger than that — in fact they are all at least 5–10X bigger and frequently have multiple funds with a cumulative value of $1B+ active at one time. A fund’s size is a major factor driving its partners’ behavior and this is something many (especially first-time entrepreneurs) are unaware of. Let’s first look at the inner workings of a VC fund to understand what is driving behavior.
Make-up of a Fund. The structure of a venture fund is critical to how it operates. There are a lot of stakeholders and, believe it or not, there is some basic math that applies to the entity and drives decision-making. Here are a few of the important terms to understand:
General Partner or “GP.” The GPs are typically referred to as the “Partners” at the VC fund. They raise money from LPs, find/meet/pursue portfolio companies, invest dollars into those companies, take board seats, hopefully help companies grow and get to liquidity, report at least quarterly to their LPs, and generally run the operations of the Fund. You can think of them as the entrepreneurs of a VC business.
Limited Partner or “LP.” Commonly referred to as LPs, they are the individual or institutional investors that invested in the venture fund. The money from LPs is then invested into portfolio companies by the GPs. LPs and GPs sign a Limited Partner Agreement (“LPA”) that governs the relationship between them including funding requirements, reporting requirements, distribution requirements, decision-making processes and the like. The fundraising process that GPs go through is at least as grueling as the gauntlet entrepreneurs run to raise capital from VCs. I covered Moonshots Capital’s journey to raise Fund 1 in a separate article you can read here.
Portfolio Construction. LPs invest money in venture funds on the premise that the GPs they back will invest in companies that will eventually exit, and will provide LPs with outsized returns from those liquidity events. The Venture asset class has historically outperformed most other classes across all time horizons and is the reason so much money has poured into Venture Capital over the last several decades. In order for GPs to properly deploy, manage, and harvest money from their investment activities they need a plan. Every fund constructs a strawman portfolio to show LPs how they plan to invest the money they receive. The plan typically includes a target number of companies (within a narrow band), total amount of money invested into each company (both first check in as well as follow-on set aside — typically referred to as “dry powder”), the target ownership % they want to own of each portfolio company, the timeframe that the GPs plan to spend making investments into new companies (“investment period”) and how much they need to have committed (both invested and set aside as dry powder) before the GPs can start raising the next fund.
As you can see, there are A LOT of variables and assumptions that are made in constructing the VC portfolio. Every fund can have a somewhat different strategy about how they approach portfolio construction (and frequently that strategy is one critical element that LPs focus on in making their investment decisions). Some VCs employ a “spray and pray” strategy, in which they invest in a large number of companies with smaller checks in each hoping that one of them is a big hit like a Google or an Uber. That strategy has worked well for some funds; however, a different strategy, and one we employ at Moonshots Capital, is to invest with conviction (bigger checks) in a smaller number of companies.
Moonshots Capital Fund 1 Portfolio Construction looked like this:
Fund 1 Size: $20M
General Partners: 2
First checks: $500K-$1M
Dry Powder: 100%+ of first check for each company
Lead Investor: Yes
Target Ownership: 10–15%
Total Companies: 11–14
Why is this important to the entrepreneur? The size of the fund and the associated strategy for its portfolio construction should matter to the entrepreneur and the reasons why should be clear if you look at the math.
Math. There are some basic math rules that are in place at every VC fund. Here are some of the fundamentals:
Target Fund Return: In order to continue to raise money from LPs for subsequent funds and keep their businesses going, GPs need to perform well. “Well” means being in the top 25% (“top quartile”) of all VC funds. And lately that means returning 3X of capital invested. So, if GPs at a larger (non-Micro) fund raised a $400M fund, they will need to return $1.2B in order to make the top 25% and continue to raise additional funds. At the other end of the spectrum GPs in a $20M Micro Fund will aim to return $60M. This impacts decision-making as you’ll see below.
Ownership Targets. Larger VCs target acquiring and maintain a minimum of 20–30% of any portfolio company. Micro VCs will own as much as they can of a deal but are typically targeting 10–15% ownership unless they are investing the very first money in a company in which case, they could have a higher ownership target. VCs who do follow-on investing want to protect that ownership percentage in subsequent rounds as much as possible.
GP Capacity. This is important for VCs that take board seats or who get heavily involved in helping their portfolio companies. Also, it is very important for the entrepreneur to understand if they are expecting help from their investor. A GP can handle 6–10 active board seats at any one time. Anything beyond 10 limits the GP’s ability to pay attention and add value. The entrepreneur should know and understand their VC partner’s capacity to assist them.
Let’s review how all this math shakes out differently for a large fund and a small fund:
$1B Fund. Let’s assume 25% ownership in a company that the GP is spending a lot of cycles assisting over a 5–9 year period (average time to liquidity). If there is a $1B valuation at exit from the company there will be $250M of return to the VC, or 25% of the fund. Not bad. Just need 4 more of those to break even. 8 more of those to get a 2x. and 12 more of those to get a 3x. That means a $1B VC fund will need TWELVE $1B companies in a single fund to be in the top quartile. That is very, very hard to do. What about a $250M exit valuation for a large fund portfolio company? That translates to a $62.5M value to the VC that owns 25%. And that also translates to an epic failure because the VC will never be able to return the fund at that rate and has spent a lot of time and effort on the company that cannot be recouped. Obviously, multi-billion dollar valuations at exit help the math, but those are few and far between. So, it is pretty clear that each GP at a large fund has to have at least a couple of $1B valuation portfolio companies if they are going to perform well. Let’s look at the same math for a smaller fund.
$20M Micro Fund. Assuming the Micro Fund can maintain its 10% ownership, that same $250M exit value scenario described above for the $1B fund, results in $25M returned to the VC. So, a single company that exits at $250M can more than return the entire fund. The VC only needs two or three of those exits to perform well. In the event one of the portfolio companies gets to $1B, even with 4% ownership (assumes two additional rounds that dilute 60% of the original 10% owned) will return $40M which is 2X the fund. Clearly, the bar for successful performance is much lower for a Micro Fund — both in the valuations required and the number of successful exits.
What does this mean for the entrepreneur? Bottom line, if you take money from a large fund you are implicitly (and explicitly) committing to target a minimum of a $1B company valuation. That can be great! But selling for anything less than that will not be considered optimal; and the intention and actions of the large VC that is investing will be to make that happen. This can impact many parts of the business such as marketing spend ($1B companies are frequently in “one (or few) winner takes all” scenarios so fast user acquisition is critical), less attention on getting to profitability quickly (the VC knows they can continue to fund the company with dry powder and accumulate a higher % ownership), and foregoing acquisition overtures for anything under $1B (the return to the VC fund just isn’t high enough). However, large funds can add tremendous value to their portfolio companies that smaller funds cannot. For instance, a large fund is a deep pocket to bridge the company during a tough time and/or provide capital for growth. Additionally, many large funds will also frequently deploy non-cash resources like marketing, development and recruiting personnel to assist the company. The difference in behavior between the large fund and the micro fund is most apparent when a portfolio company gets an acquisition offer in the $50–250M range. For the entrepreneur that outcome can be a legacy changer, for the micro fund it can be a fund maker, but for the large fund it is a suboptimal outcome.
Fundamentally, the entrepreneur should understand the math driving the behavior of the VC he or she decides to bring on as an investor and all the ramifications of that decision.
