Where do VCs get their money?

Today’s newsletter is about how VCs get the money to invest in startups and why that should matter to founders.

Before we get stuck in, I have a quick request. I’m looking for 5-15 founders to give me feedback so I can create a useful fundraising resources that gives founders all the knowledge and skill they need to raise capital. If that sounds like you, there are more details at the end of this email.

Let’s get to it!

As a fundraising founder, you probably want to jump right in to designing pitch decks, learning how to get warm intros and understanding how to navigate term sheets.

We’ll get to that, I promise.

But before we do, it’s critical to understand where VCs get the money they’re (hopefully) going to send your way.

That’s because incentives drive behaviour.

Where VCs get their money from, the expectations these investors have, and how and when they expect to be paid back has a huge influence on how VCs behave towards founders.

Given most startups fail, who would give VCs money to invest in such a risky asset class?

Limited Partners: your investors’ investors

Institutional investors called Limited Partners (LPs) invest in VC funds to diversify their portfolio, but more importantly, make money. LPs come in different forms: university endowments, foundations, pension funds, sovereign wealth funds, insurance companies and family offices.

Limited Partners are ‘limited’ in two ways: firstly, they’re granted limited liability in the legal sense, so they’re insulated if the VC they invest in is sued, and secondly, they have limited ability to influence a VC’s investment decisions, providing those investments fall within the realms of their agreement.

As well as venture funds, LPs invest in a range of asset classes, like growth assets (public equities, private equities, hedge funds), inflation hedges (real estate, commodities, natural resources), and deflationary hedges (bonds, cash).

LPs expect the VCs they fund to generate alpha: returns above what they’d have received by investing in a specific market index like the S&P 500 or Nasdaq. According to Scott Kupor of a16z:

This expectation has a large influence on the type of investments VCs make. The only way to generate massive returns that beat the market is to win big, and that means investing in high-growth, high-risk companies like startups.

Given most startups fail, taking their investors money with them, a portfolio company that only returns 2 or 3x their initial investment doesn’t move the needle for VCs. They’re looking for a 10-25x investment or more, to make up for all their investments that went to zero or just returned their capital, and outperform the market indices LPs will judge them against.

This produces a weird dynamic: an outcome that might feel like a win for a founder, like creating a profitable business that does $50 million a year in revenue, may not be materially different from a loss for a VC.

And as most funds have a limited time horizon of ten years, not only are VCs looking for companies with the potential to become huge, they’re looking for companies that can become huge fast.

As Fred Wilson of Union Square Ventures puts it:

If a fund fails to deliver, the VCs responsible for it (known as GPs) may struggle to raise another fund, so the pressure is on. Given those incentives, we can start to see why VCs may push their portfolio companies into riskier routes with higher potential upsides rather than a safer route that could lead to moderate success.

Incentives show up in other ways in the LP-VC relationship too, so let’s look at two ways VC funds charge their LPs for their services: annual management fees, and carried interest.

The Annual Management Fee

VC funds typically charge LPs 2% of the total amount they committed to invest over the lifetime of the fund each year. This management fee is intended to support employee salaries, office space and equipment, travel and other expenses.

A $100 million, ten-year fund would charge $2m in fees each year, for a total of $20 million.

Sometimes funds reduce their management fees over their lifetimes as their activities switch from finding investment opportunities to managing them, and some funds only charge against the funds they have actively invested in startups.

Carried Interest

Carried Interest, normally referred to as ‘carry’, is the portion of the profits the fund gets to keep, assuming their investments have generated any. Normally this ranges from 20-30% of the profits.

We’ll discuss how VCs value their investments, and how other things like ‘clawbacks’, ‘recycling’ and ‘hurdle rates’ affect profits another day.

So, a typical VC fund charges their LPs a 2% management fee and 20% of the profits as carry. If you’ve ever heard the phrase ‘two and twenty’ but were too afraid to ask what it meant, now you know.

Returning profits

Returning profits can be a complex process, but what founders need to know is that VCs can only share profits with their LPs if they have liquidity. Unlike public markets, where you can buy and sell shares in seconds, there’s no easy way to sell shares in early-stage startups on a secondary market. Instead, VCs must rely on liquidity events like acquisitions or IPOs to generate the capital they need to return to LPs.

For founders, it’s critical to understand where a fund is in their lifecycle, as VCs’ behaviour will change as their incentives do.

In the first three to four years of a ten-year fund, VCs are largely focused on finding investments and deploying capital, but as years five and six swing by, VCs will increasingly feel the pressure to return capital to LPs. And like it or not, that pressure will probably find its way to you.

If the rest of a fund’s portfolio isn’t performing well and you receive an acquisition offer, the VC may be more inclined to push you to accept the deal. The GP of the fund may have a board seat and have a formal vote in whether or not to take the offer, but even if not, many investors have special voting rights when it comes to acquisitions.

If, during a pitch, the VC hasn’t mentioned when they started the fund, make sure to ask them. If it’s less than four years old, you’ll probably face less pressure to take an early exit compared to a fund later in its lifecycle.

However, companies are now staying private for longer, which delays liquidity events. The median age of US tech companies IPOing in 2018 was 11 years, compared to 4 years in 1999 (though the madness of the dot-com era probably played its part there.) Airbnb stayed private for 12 years before their IPO in 2020, and Palantir for 17 years (though to be fair it’s not a typical startup.)

To counter this trend, VCs may negotiate extensions to their fund’s lifecycle, LPs may sell their stake in a fund to secondary buyers, or both parties may explore non-traditional liquidity options like dividends or share buybacks so they can recoup some of their investment without a full exit.

As a result, founders should be aware that investors are likely to be in their lives for more than a decade if things go well, and take that into consideration when deciding who to take money from.

In a nutshell: The incentives behind VC behaviour

Now we know where VCs get their money: institutional investors called Limited Partners who typically pay VCs a ‘two and twenty’ management fee and carry to outperform market indices. To do that, VCs need to invest in high-risk startups with huge potential upside if they succeed. The age of a fund can also play a big part in creating incentives and influencing VCs’ behaviour.

If you want to go deeper into the LP-VC relationship or understand VC better, get yourself a copy of Secrets of Sand Hill Road, which is the best book I’ve read so far on the topic.

As I mentioned above, I’m looking for a handful of founders to provide me with feedback on how I can make the best fundraising resource for entrepreneurs looking to raise early-stage capital (anything before Series A).

I’m looking for founders who:

• Are looking to raise capital in the next six months.

• Have previously raised VC successfully.

• Are prepared to spend roughly 1-2 hours per month giving me thoughtful feedback.

In return for your help, you’ll have access to any resource or course I create on fundraising for free, forever, as well as a tonne of advice I normally charge for as part of my consultancy and advisory services. Hopefully, you’ll also get to meet some more founder friends too - always nice in such a lonely domain!

To make sure founders in the group are engaged and committed to providing feedback to myself and each other, I’ll be charging a nominal fee of $15 per month to participate.

You can sign up here or hit reply to ask me any questions. I’ll send joining details to founders that commit to this first thing on Monday morning, if not before.

Hope you enjoyed this week’s edition and speak soon,

Nelson