Direct investment alongside a venture capital firm
- Will the venture capital firm (VC) stay in business and have money to invest in future?
Corporate venturers (CVs) need to make sure the VC that brings you a deal can support future rounds to the portfolio companies through exit, self-sustainability or profitability, as someone dropping out can send a bad signal. A shortfall of enough capital to reach a significant inflection milestone frequently dooms the portfolio company to failure.
While some CVs mistakenly believe all VCs have an unending flow of capital from limited partners (LPs) there are predictions the number of independent VC fund managers – called general partners (GPs) – will contract by between 25% and 50%.
I also think there is still too much capital in VC. At the height of the last bubble around the millennium more than $100bn was raised in the asset class in a single year. Today, the amount committed to VC funds is just over $15bn, which is still too much as there has been a five to 10-times capital efficiency increase in the money needed to start a business.
What it took to build an information technology company in 2000 takes far less capital today due to a start-up’s ability to use outsourcing, cloud computing, mechanical Turks and open-source software. $500,000 now goes as far as $5m did 10 years ago.
Too much capital affects the success of the ecosystem. This excess of capital causes premiums to be paid – effectively valuing the company too highly too early in its life, investments into incremental rather than disruptive innovation and too many copycat companies occupying the same space.
This ultimately reduces the return on investment that traditional LPs can expect, or have received, from a long-duration, risky asset class such as venture capital.
With a negative annual rate of return on US VC funds over the past decade (the average VC has lost money), few VC firms have generated the risk-adjusted returns institutional investors are looking for and so capital is moving away from venture capital as an asset class, leading to the inability of many VC firms to raise future funds.
Secondaries firm Coller Capital’s Global Private Equity Barometer Winter 2010-11 of 120 LPs found two-thirds (64%) said only a small number of VCs worldwide would show "consistently strong returns over the next decade". A fifth (22%) said "no venture capital firms will be able to deliver consistently strong returns", Coller’s barometer added.
If this is the case, why would an LP invest in the area? The answer is it would not, as evidenced by the recent speed-dating of investors to VCs in the US that revealed more than 50% of LPs said they had no desire to meet a VC.
Given this slow decline in fundraising and consolidation of the industry, many VCs will lack sufficient reserves to support future investments. This is just one of the many reasons the best technology does not always win.
Some of the most important questions a corporate venturer should ask are:
- What is the size and vintage year (when it was raised) of the fund you will invest from?
- How much capital has been drawn (invested in deals) and how much is held in reserves?
- For this investment in a company, how much capital are you holding in reserve for a follow-on investment?
These three questions will reveal how much dry powder, or money, a VC has and how long it can support the investment from a fund, although the next question can affect this.
- Do you typically do cross-fund investing?
This question asks if the fund invests monies from one fund in the beginning and then another fund in future rounds. This can identify whether it is likely to have a neverending flow of capital, but it is quite rare the LPs like this – it can cause conflicts of interest between two different funds within the same VC. If the firm has set a precedent of doing such crossover investing in the past, then it is likely its LP base has approved of this.
This dry powder argument, however, is only a piece of the puzzle, since the people in a GP can change over time and the personal dynamics of who does which deal can be important.
Support, clout and control for a deal come from a VC’s investment committee, or sometimes one founding managing partner.
- Who is on the fund’s investment committee?
- Who on that committee supports the investment in X?
- Who is the most reluctant?
- Who has the most reservations?
This is key to getting to know your syndicate partner’s fund dynamics. Can the person proposing the deal influence his partners and what kind of push-back does he currently get from people on the investment committee? Partnerships easily discontinue support for an investment in a poor cycle, especially if they did not like it in the first place. Understand your contact’s authority in his firm and the support his firm gives your shared investment.
- What other VCs do you feel are experts in this space and who do you think is an expert like yourself?
Understanding who are the sector experts in the VC industry will help you in the due diligence process. Creating relationships and networks with other VCs in that particular space is helpful in obtaining historical data, as this is a close-knit circle of people with plenty of overlap in reviewing deals. Most likely this is not a proprietary deal and someone has looked at it before.
Get to know those other VCs in this space as they may know a lot about the firm with which you are going to coinvest and may have insights into the partnership that you do not have. These relationships could tell you more about the partnership, board and portfolio companies and makes a more thorough diligence process.
Indirect investing as an LP in a VC fund
Direct investing can be tricky, and those without a network, a track record or previous knowledge of the industry are easily taken advantage of and are perceived as "dumb money" even if CVs themselves think their brand is valuable.
CVs beware – this is not automatically the case.
Don’t get fooled about that brand value, as valuable as it may seen to everyone internally at your firm. There is a reason VCs are typically reluctant to have CVs in earlier rounds.
Inexperience and the cyclical nature of CV plans almost always require them to pay a premium to invest in a VC’s portfolio company, if they can get a seat at the table in the first place.
But VCs are, depending on terms, conditions and sector, more open to a CV if it brings insight to customer needs, pilot testing, revenue as a customer, a distribution partnership or potential as an acquirer – especially if the entrepreneur is likely to need plenty of funding, as in the clean-tech sector (see Rachel Sheinbein’s article in October’s Global Corporate Venturing on why clean-tech start-ups need to partner big companies).
Another option to add value and get a seat at the deal table is to write a bigger cheque, through being an LP in the VC’s fund. CVs can also learn a lot about VC investing by committing to a VC fund before they starting investing directly in entrepreneurs themselves.
My former employer, parcel delivery company UPS, committed to VC funds in the early days of its CV unit in order to understand the business and obtain dealflow.
These commitments allowed for deal access, information rights, onsite working relationships, as well as a transfer of knowledge. It is also valuable when you are region or specific sector focused, since there are many international and sector-specific funds available. Though this may be true, there is definitely a price to pay, which leads me to my next questions.
- What is your fund’s investment minimum?
- When are you going to raise your next fund and would you be interested in us becoming an LP?
- Does your LP base include any corporate – off the balance sheet and not pension – strategic monies? Can you describe that relationship and can I talk to them?
This should be music to most VCs’ ears, particularly since fundraising is very hard at the moment.
The price tag for entry into VC funds is usually a $5m to $10m commitment for regular institutional LPs, such as pension funds, life assurers and funds of funds, yet might be more for a CV if it wants more than quarterly reports on a set of blind pool assets – investments decided by the GP that may be of no strategic interest to the CV. If the VC has a sectorspecific focus this may not be as big a problem, but sectors can include a wide range of deals.
Understanding the VC’s industry, its network, and how it underwrites deals is valuable information when getting off the ground as a CV. It is not unreasonable to ask for office space at a firm for a $10m to $20m investment directly into a VC fund or to attend the Monday morning partner meetings to obtain access to all its dealflow and analysis.
Even the deals they turn down might be interesting to you. This is a smart option for groups just getting into the CV business and a good opportunity for a firm to support someone spending the first six months after commitment working from inside the VC firm.
If a CV can convince the private equity portfolio manager at your parent’s employee pension plan to give you information and guidance in diligence for various managers that, too, could help. The pension plan’s private equity portfolio manager can offer you access to databases which benchmark and track VC performance.
They can also give you valuable guidance during the due diligence process. I would personally be a bit reluctant if your pension group uses a fund of funds or a consultant for its fund picking as these groups have very little understanding of a CV’s motivations. Seek out the individual in the pension group who has several years’ experience of investing in VC funds.
However, due to regulations governing corporate pension plans there are limitations to the transfer of information.
But if the pension group finds the VC fund interesting it might invest an additional $10m to $50m alongside the commitment from the CV, thereby putting you very high on that VC’s priority list.
With few VCs generating significant returns, a thoughtful CV can be particular in selecting the right firm or even the right individual to back. An individual might make money while his firm does not, which, if you then want to make selected direct deals, can provide valuable insights.
This lesson I learned from my move from UPS’s CV unit to its pension group. This leads me to my next question.
- May I obtain your firm’s updated historical – inception to date – deal attribution broken down by partner, sector, geography and portfolio company?
- Do you have a due diligence questionnaire (DDQ) you supply to LPs?
These questions are critical and rarely asked unless the investment in the fund is significant. There are some exceptions with regard to the couple of successful firms that are consistently oversubscribed. They have a takeit- or-leave-it attitude to their LP/GP contract – the limited partnership agreement.
The deal attribution process and review of their DDQ is indicative of sophisticated pension investors, and can give you insights far exceeding even what other VCs could get.
I was shocked to find out that there are some high-profile VCs that have not generated a return of principal back to their investors over their entire venture career. Find those that have returns, not just great personal brands.
I hope these questions are helpful. They are just the first of many questions that CVs rarely ask, but will get you going in the right direction. Do not hesitate to contact me – erik@cmea.com – if you agree, disagree or want to chat further.
CV is a passion of mine and a smart way for corporations to get access and insights in the technology space.