Becoming a First-Time Investor in a Venture Capital Fund
Eugene Malobrodsky is the Co-founder of AnchorFree, whose leading product Hotspot Shield has more than 650 million users in 190 countries. He is also an LP and Venture Partner at One Way Ventures.
After I sold my first company, I found myself in the privileged position to invest in and support other young startups. I’d done a little angel investing myself, but I wanted to create additional impact (and generate returns) by investing in a venture capital fund. The problem was that I didn’t really have a clear picture of what the process was like or what I could expect.
As I started to think about investing in venture capital, my first instinct was to consult my financial advisor. And while having a financial advisor turned out to be a prudent choice for other reasons, I also found it to be limiting. Most advisors still stick to traditional markets like bonds, treasury bills, and stocks–which are an essential foundation for a secure portfolio but lack alternative assets like venture capital.
I found a good way of thinking about the construction of my personal financial portfolio was through the lens of baseball. If there are nine people on my team, I obviously need several strong players with a consistent batting average (hitting those safe singles and doubles). These are the guys I send to the plate first. But my team wouldn’t be complete without at least one slugger that bats third or fourth and goes for the fences (the slugger, in this analogy, being the venture capital in my portfolio).
However, before I was able to make any big decisions, I needed to understand the basics of how venture capital worked. If you’re thinking about investing in venture capital or you still aren’t sure how it works, read below for a summary of who can invest, how the process works, and what an investor can expect.
Language:
Fund = The legal entity and pool of money that invests in startups.
General Partner “GP” = The partner(s) making investments on behalf of the fund.
Limited Partner “LP” = The partners that invest in the fund but don’t take a day to day role in investment and operational decisions. When an “investor” invests in a fund, they do so as an LP.
Management Company = The entity responsible for the day to day operations of the fund (and employs the GPs to manage the fund).
What is a venture capital fund?
When you become an LP in a venture capital fund, your money is invested into a portfolio of early or late-stage startup companies that are not yet publicly traded. The managers of the fund work to find, invest in, and nurture the next generation of innovative and promising companies. Fund managers also perform research and due diligence on the companies they are considering investing in. Every time a company in the portfolio has an exit (an acquisition, an IPO, a secondary sale), the LPs in the fund will receive a share of the profits.
Who is qualified to invest in a VC fund?
To become an LP in a U.S. venture capital fund, you must be an accredited investor. This means you have at least $1,000,000 in investable assets (not counting worth of personal residence) or have an AGI (Adjusted Gross Income) that exceeds $200,000 (or $300,000 together with a spouse). The SEC provides more detailed guidance here.
What is the minimum amount that funds will take as an investment?
Most smaller funds (<$25 million in AUM) allow you to invest a minimum of $100,000 but larger funds typically have higher minimums and require investments in the range of $1 million to $10 million.
Do I have to fulfill my fund commitment all at once?
It’s worth noting that a fund commitment isn’t called from the LP at once. Let’s say you committed $2.5 million to a fund that raised $50 million in total. This means that over the life of the fund (typically around 10 years), the fund will call $2.5 million in capital. While 10 years is the total lifespan of the fund, the investment period (when the managers are most actively investing your money into startups) is usually around 3–4 years. Because of this, most funds will call capital (a portion of your commitment) mainly during the investment period. Assuming a 4 year investment period and a $2.5 million commitment, you would need to provide $625,000 every year for four years.
When can I invest in a VC fund?
Funds, just like start-ups, need to raise money. You can invest in the fund during the raise period, which typically occurs once every 3–4 years.
What kinds of returns can I expect from VC funds?
A good return on investment for an early-stage fund (an early-stage fund is one that invests in early-stage startups) is at least 300% of what you have invested in a period of 10 years. This yields an annual return of at least 12%. Cambridge Associates compiles an index and benchmarks for the venture capital industry for investors to reference. You can find past reports and research here.
What kind of fees do funds charge?
Similar to money managers or financial advisors, venture capital firms charge a management fee and a performance fee. The management fee usually falls between 2 and 5% of your committed capital amount per year. Collected fees are used as operating expenses for the management company to find, research, and fund the different startups that will ultimately go into the fund. In addition to this, you will also need to share 20% of your fund generated income with the fund managers (this is called carried interest).
For example, if the fund invests $1 million into a start-up at a $10 million valuation, that buys the fund 10% of the company. After some time, that company sells for $200 million, and the proceeds from that sale are $20 million for the fund (assuming no subsequent dilution for simplicity). The fund will deduct 20% from the profits ($19 million in profits on the original $1 million investment, 20% of which is $3.8 million) of the sale and distribute the remaining 80% ($16.2 million) to the fund investors (LPs). If you had 5% of the fund you would receive $810,000 from that sale.
What does the process of becoming an LP look like?
When funds start raising money, they go around pitching investors (just like startups do). However, because venture funds are typically private investment vehicles, they do not solicit the public for investment. Once you get connected with a fund manager, he/she will show you their pitch deck (which typically details what types of companies the fund invests in, how much they are planning to raise, and what their competitive advantage or strategy for success is). If you love the fund and the people involved, you make a commitment. Once the fund has raised the minimum it needs to implement its strategy, there will be a closing of the fund and the managers will start calling capital to invest.
What percent of each company am I getting?
When you invest in a fund you are getting a percentage of the total fund. For example, if you invest $2.5 million in a $50 million fund you will own 5% of all investments that fund makes.
Can I choose the companies that funds invest in?
Typically, no. Most funds are “blind pools” and do not allow LPs to pick and choose what those investments are (though funds often appreciate referrals from LPs).
How is my money invested?
The partners of the fund are responsible for finding the most innovative and promising new companies to invest in. Though every fund has a different strategy and return target, a typical venture capital fund looks for startups with potential unicorn trajectories (companies that have the potential to be valued north of $1 billion). Their job is to identify up and coming companies, negotiate their way into a financing round with good terms, and perform fastidious research and due diligence on each potential deal (minimizing the risk of each investment as much as possible).
How long is my money locked up?
Most funds have a lifetime of 10 years, with the option to extend by a year or two, though large exits and distributions can occur much earlier. LPs in venture capital funds can expect their money to be locked up for multiple years (until stakes in startups are sold), but options such as the secondary market may allow LPs to sell their interests earlier (though usually at a discount).
When will I recoup my money?
In most cases, you start receiving your money back after each company the fund owns is sold to an acquirer or has a public offering. Funds typically have investment periods of 3–4 years, and a “harvest” period where companies mature and are then sold towards the end of the fund life cycle.
The content in this article is intended to convey general information about how venture capital works and is not intended/should not be construed as financial advice, or be considered a substitute for financial advice from a professional that is privy to the facts and circumstances of your individual situation.
