The essential elements of venture capital strategy
President Woodrow Wilson delivered his famous “14 Points” speech to congress in an attempt to bring peace to Europe toward the close of World War I. The 14 points themselves formed Wilson’s negotiation approach to the Treaty of Versailles, which formally ended the war. While the majority of the points were focused on diplomatic and territorial issues, the final item — the League of Nations — ultimately led to the creation of the United Nations and a century of international cooperation.
Venture capital also features 14 points: the key elements that define the strategy of any professional venture investment program.
When a venture capital investor gets started, he is like a new dog at the dog park. The other dogs (established VCs) will sniff around and try to assess the new guy: Is he a friend? Can we play well together? Did he bring fun toys? In venture capital, the “sniffing” occurs when established VCs ask questions about your strategy. And because you don’t want to make inaccurate representations, it’s important to think about your strategy carefully and in advance. One of the worst things you can do in venture capital is to say you will do one thing and then do something different. It’s the fastest way to erode your credibility in an industry that is based on relationships and trust.
Sometimes, VCs will just ask, “what’s your strategy?” and ask you to fill in the blanks. It’s an open-ended question, but often this refers to the three pillars of venture strategy: sector, stage, and geography. But there are ten other key components of venture strategy as well, and eleven if your venture capital fund is part of a corporation or offers operating assistance to portfolio companies.
Here is an introductory overview of the main elements of venture capital strategy. While each of these topics deserves its own in-depth exploration, these are the initial set of questions you should begin to consider if you are starting a venture capital fund:
There are three main pillars of venture capital strategy: sector, stage, and geography. When someone asks, “What’s the strategy of your venture fund?” they are typically referring to these three elements.
1. Sector — The most distinguishing characteristic of a venture capital firm is often what industry sectors you fund. Because investors often draw bright lines for themselves by sector, it can be very efficient to get this information first. For example, if you fund life science deals and I do not, we can have a very quick conversation. According to Pitchbook’s 4Q 2016 Venture Monitor, the most common sectors that received investment in the United States during 2016 were software (33%), pharma and biotech (8%), and healthcare devices and services (7%).
2. Stage — The next focus “pillar” is stage, which defines the maturity of the startups you fund. Stage is typically defined as seed, early, or growth. You can find a lengthier discussion of some of the main considerations for stage preferences in our article “It’s a Trap” here. PwC’s 2016 MoneyTree Report showed that in 2016, seed stage investments accounted for 30% of all transactions in the U.S., while early stage deals were 27% and growth and expansion stage deals were 29%.
3. Geography — The final strategy “pillar” is geography, which defines where the startups you fund can be located. Some funds have a prohibition against international investments, for example, while some prefer to invest in companies that are located within a one-hour plane flight, to ensure a close relationship. Per Pitchbook’s previously referenced Venture Monitor, in the United States, 53% of all investment flows to companies based in California, with 13% invested in New York startups, and 10% in Massachusetts deals. Only 24% of investment is directed to companies outside these three states.
4. Budget—How much capital has been allocated to your pool of funding? While seed stage funds are often $100 million or less, growth stage funds can reach into the billions. According to the same Pitchbook report previously cited, venture capital firms collectively invested between $65 and $80 billion per year from 2014 through 2016.
5. Investment size and pace — How many investments will your fund make every year? What is the average “check size” you will write to fund each individual investment? Have you set aside emergency resources for unexpected funding events? How many years will the budget last?
6. Reserves Allocation — When a company returns to its investors to seek additional funding, will your fund participate? If so, what ratio of reserves will you set aside, as a multiple of your original investment? It is critical to set expectations with entrepreneurs and co-investors about whether your fund will continue supporting its portfolio companies after the initial investment, and under what circumstances.
Internal Structural Decisions
7. Entity Structure — Institutional venture capital funds are most often formed as limited partnerships (“LPs”), with the venture capitalists serving as the general partner (“GPs”). Corporate venture capital programs are frequently formed as company-controlled limited liability corporations (“LLCs”), although sometimes the corporation will invest directly from the balance sheet. Which structure is right for your fund?
8. Investment Committee — Who will be responsible for final approval of investment decisions? What is the voting process? Will any individual be able to veto a deal? How will you set up a structure to ensure proper diligence of investments while also permitting your organization to be responsive to entrepreneurs and avoid missing opportunities?
9. Governance — Will your fund take an active role on the board of directors of its portfolio companies ? If so, who within the organization is qualified to take on that fiduciary responsibility and legal liability? Alternatively, is there a preference to serve as an observer instead, or simply an advisor? Many investors choose a completely passive role. What governance approach is right for your fund?
10. Lead vs. follow — Leading a transaction includes structuring terms, setting price, and often means providing a significant portion of the funding. Followers wait for a lead investor to provide terms and pricing that are attractive to the prospective portfolio company and to potential co-investors. Which approach is most comfortable for your fund?
11. Control vs. syndication — Venture capital transactions often include more than one investor funding together as a group, known as a syndicate. Some deals, however, feature a sole investor controlling and funding the entire round. Each approach has advantages and disadvantages. How will your fund decide which to pursue, and under what circumstances?
12. Target ownership — Some venture capital funds target an average ownership level in its portfolio companies. This can assist with modeling pro-forma financial returns. In addition, corporate venture capital investments sometimes require keeping ownership below certain thresholds. Has your fund articulated target ownership percentages that are consistent with other key strategy decisions like stage, or investment size and pace?
13. Return profile — As noted above, modeling pro-forma financial returns is one way to articulate the financial targets for the fund or investment program. Has your group set investment objectives for financial performance, such as providing top quartile returns for your vintage year?
The last of Woodrow Wilson’s 14 points became the most famous: the League of Nations. This was the term in his vision that required the most extraordinary levels of cooperation among the international community. Similarly, the 14th element of venture capital strategy relates specifically to corporate venture capital programs or those that offer operating benefits (like recruiting or marketing) and requires meaningful multi-party cooperation: this, of course, is the operating relationship.
14. Operating relationship — The “operating relationship” is also known as the commercial or business development deal, and it is the most obvious way in which corporate investors provide more than just a check. Will your corporate investment fund require a commercial transaction prior to executing an investment, or perhaps a letter of intent? Or will any commercial transaction be a fully arms-length, optional extension of an investment? For a list of the five main types of commercial transactions, see our article, Bending Bullets.
It’s important to consider how these 14 strategy elements interrelate. For example, if you’ve decided that your fund prefers to take an active role on the board of directors, that often requires a willingness to lead transactions. Similarly, setting a minimum initial investment of $10 million dollars isn’t compatible with a focus on seed stage investments, because seed rounds are typically much smaller than $10 million. A well-considered strategy ensures that all 14 elements are part of a cohesive and logical plan.
Liked what you read? Click 👏 to help others find this article.
Scott Lenet is President of Touchdown Ventures, a Registered Investment Adviser that provides “Venture Capital as a Service” to help corporations launch and manage their investment programs. Touchdown’s San Francisco-based Associate Jig Majmundar and Philadelphia-based Associate Dan Moskowitz contributed to this article.
Unless otherwise indicated, commentary on this site reflects the personal opinions, viewpoints and analyses of the author and should not be regarded as a description of services provided by Touchdown or its affiliates. The opinions expressed here are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual on any security or advisory service. It is only intended to provide education about the financial industry. The views reflected in the commentary are subject to change at any time without notice. While all information presented, including from independent sources, is believed to be accurate, we make no representation or warranty as to accuracy or completeness. We reserve the right to change any part of these materials without notice and assume no obligation to provide updates. Nothing on this site constitutes investment advice, performance data or a recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Investing involves the risk of loss of some or all of an investment. Past performance is no guarantee of future results.