Beyond FUNDraising: a GP perspective
Why is it harder to raise capital for a Venture Capital Fund than for a startup?
Would it be possible to develop the innovation and entrepreneurship ecosystem without Venture Capital funds? In 2019 alone, slightly more than 700 VC funds raised over USD$90bn globally, amount that will be deployed in startups over the next 5 years. This is equivalent to 60 times the cost of the Burj Khalifa, the tallest building in the world, in Dubai. However, this amount is only a little more than a third of the amount raised by startups in the same period, which yields to approximately USD$250bn distributed between 15,000 and 20,000 startups.
The complexity of raising a VC fund is greater than the development of a startup. Below are listed the main reasons why:
1. The investor profile is different
Both, startups and VC funds raise capital continuously. Usually, VC fund investors are experienced institutional investors, committing capital in funds from multiple geographies and industries. An early-stage startup can raise capital from friends and family, or from unsophisticated and unexperienced angel investors.
Therefore, VC fund managers, mainly those who are raising a first-time fund, should study the Limited Partners ecosystem, build long-term relationships with them, taking into consideration the cultural aspects of each of them. There are different categories of LP’s, each with different investment strategies, such as: Family Offices, Multi-family Offices, Corporates, Funds of Funds, Pension Funds, Foundations, Sovereign Funds and Multilateral Institutions.
In the end, regardless of whether you’re raising capital for a VC fund, or for a startup, reputation will be your most valuable asset to have a successful process.
2. Value of a proven track record
Early-stage startups usually base their fundraising on the strength of their team, business idea and their execution ability. Unlike startups, VC fund managers need to have proven track record and experience in investments to facilitate their capital raising. According to Pitchbook and NVCA, in the last 5 years, the number of funded first-time managers in the US, as a percentage of total VC fundraising, accounted for between 10% and 20% only.
VC fund managers should leverage their track record, team experience, internal processes, and network scope to reflect their competitive edge when looking for investors.
3. Fund and ticket size
When launching a startup, raising just USD$100k to USD$500k may be sufficient capital; and actually, if the startup reaches its break-even point early in its lifetime, it probably won’t need to raise additional capital in the future. The average amount of capital raised in a Series A in the U.S. is USD$8mm — USD$15mm. On the other side, a first-time fund raises on average USD$50mm in the U.S., and the typical experienced VC fund manages on average USD$300mm. In addition, the money raised by the fund is committed for at least 10 years.
When raising capital for a VC fund, you should first define the size of it. According to studies, smaller funds (<USD$100mm) perform better than mega-funds. It is also important to establish a first closing (determined usually at the time half of the target size is reached), so that the fund can start operating, and that simultaneously can continue with the capital raising.
4. Investor recurrence
As the startup grows in revenues, the type of investor from which it raises capital will change significantly, moving from angels to VC funds to PE funds. However, the business of VC funds is to raise multiple funds on a recurring basis over the years, so if their portfolio performance builds confidence for current investors, raising future funds will become an easier and more efficient task. VC fund managers must create closer links and consolidate the relationship with their LPs throughout the years.
As a recommendation, at the beginning of the life of a VC fund, the managers can launch Special Purpose Vehicles (SPV’s) or parallel vehicles for different investors in order to generate trust and lasting relationships. It is also advisable to make strategic alliances with advisors, corporate or investors in order to launch a first-time VC fund.
5. Alignment of risk-return expectations
Every entrepreneur’s goal is to develop their business model, expand it and grow it significantly. However, the investors only have one chance with the startups to generate return on their investments, hence there are only 2 possible outcomes: to succeed or fail. In contrast, the objective of VC funds is to build an investment portfolio that generates a financial return appropriate to the risk and expectations of their investors. At the time of raising capital, they must indicate the distribution of yield returns from their previous portfolios, as well as successful exits and losses on their previous startup investments.
In addition, VC fund managers, as they prove to be successful, may establish other investment vehicles with different theses; for example, an opportunity fund to track successful investments, growth funds, debt funds, funds of funds, or expand to new verticals (health, fintech, cybersecurity, energy).
6. Relevance of corporate governance
In the early stages of launching a startup, it is possible to convince investors with a simple idea or a prototype, without the need to be a formally established company with corporate governance. In contrast, Venture Capital funds, since their inception, must clearly define their investment processes, governance structure, and decision-making procedures, all of its accompanied with its correspondent legal documentation. In addition, they must define the terms of the fund and investor rights, such as the commitment of the General Partners, the management fees and the distribution waterfall.
Capital raising for both a startup and a fund is a complex and time-requiring task. The skills required to build a startup are different from those required to manage a VC fund. Undoubtedly, the first capital raising is the most complicated event. But despite being so different, both tasks are rewarding and have a significant impact on the innovation and entrepreneurship ecosystem.
Written by:
Hector Shibata. Director of Investments & Portfolio at ACV a global Corporate Venture Capital (CVC) fund and Adjunct Professor for Entrepreneurial Finance.
Gonzalo Soriano. Investment analyst at ACV.
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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