Building Blocks: VC Fund Size and Portfolio Construction
“Know what you own, and know why you own it.” — Peter Lynch, American Investor
VC fund managers are expected to raise enough capital to invest and receive financial remuneration that allows them to meet their day-to-day expenses and retirement plans. A first-time fund who raises approximately USD$100mm in the United States, would expect to receive a 2% management fee, that means it would have USD$2mm to pay the fund’s salaries and operating expenses annually.
By contrast, a giant VC firm such as a16z, who raised USD$4.5bn in 2020 in 2 different funds, assuming a management fee of 2%, would receive USD$90mm annually over the life of both vehicles to cover the fund’s salaries and operating expenses.
Definitively fund size is a major topic in Venture Capital, but how do Venture Capital firms determine the size of funds and how does this impact the construction of their portfolios?
Here’s our reverse engineering method for portfolio construction:
First define the size of the fund, for them consider your experience at Venture Capital and the likelihood that you will raise this amount of money. If you have previously raised capital, this vehicle should be the continuation of your investment thesis, and you should perhaps be looking for a fund larger than the previous one.
The capital available to invest is the result of the total amount raised minus the management fees you will receive annually throughout the fund’s life. For example, if you raise USD$100mm and have a 2% management fee for 10 years of the fund’s life, your investable capital will be USD$80mm.
Then consider what percentage of the fund you will allocate for the first investment tickets and for subsequent investments. If you consider 50% (USD$40mm) for initial investments and pretend to have a portfolio of 21 companies, then the average initial investment ticket should be USD$1.9mm. Consider that you can have an investment range of USD$1mm — 3mm, which would position you in Seed — Series A type of investments.
To build a portfolio with 21 startups you will have to determine your origination channels and keep in mind that Venture Capital is a game of numbers. You have to evaluate at least 2,000 companies to be able to invest in 1% of the opportunities with the greatest growth potential. The more companies you see, the more robust your investment process will be. Remember that 75% of Venture Capital’s investments in startups fail (Shikhar Ghosh, HBR).
The remaining 50% (USD$40mm) will go to follow-up investments, bound to support the winning companies in your portfolio. Uses the one third rule; that is, 1/3 of the companies in your portfolio will probably fail, in 1/3 you could invest additional capital to keep your pro-rata (anti-dilution), and in 1/3 you could invest not only your pro-rat but additional capital (double-dip). Considering this example, your average investment ticket for follow-on investments would be in the range of approximately USD$3mm.
To validate the investment stage in startups, study the percentage of shareholding you would like to have in each of your portfolio companies. For example, if you invest USD$1mm for a 20% shareholding within the round, the startup should raise USD$5mm (Seed and Pre-Series A); on the contrary, if you are looking for a 5% participation of the round with the same ticket, you expect to enter a round of USD$20mm (Series A and Series B). That results in different stages of investment that you could focus on.
Your investment decision will also depend on whether you’re the structuring leader of the round or just participating in the syndicate. Similarly, this relates to the investor rights you’re looking to obtain. If your goal is to have a more active role within the startups in your portfolio, you can access a board member seat or be an observer only. Also, if you have a significant percentage you will have additional mayor investor rights, for example, pro-rata, liquidation preference, information rights, anti-dilution, among others.
There are certain conditions that will also affect the construction of your portfolio from the moment you raise capital from your Limited Partners. For example, consider that you will not be able to invest more than 10–20% of the total fund size in a single startup (regardless of its potential); also take in mind that you should establish a first closing of the total fund’s size when fundraising, meaning that from that point in time you can begin the capital deployment ; you will need to define a period of time to invest (usually the first 3–5 years); and you will not be able to raise additional capital to the established hard cap (maximum fund size). In addition, consider that you can only raise a new fund once you have invested aprox. 80% of the current one.
In the end, the most important thing to achieve in the construction of your portfolio, even if you are a firm specialized in a single vertical, is to build a diversified portfolio with investments in different sub-verticals and if it is possible, in different geographies.
Venture Capital funds are constantly searching for the unicorn, but not everyone is fortunate enough to find it. To achieve this, you’ll need to build a robust and promising portfolio to increase your chances of success.
Hector Shibata. Director of Investments & Portfolio at ACV a global Corporate Venture Capital (CVC) fund and Adjunct Professor for Entrepreneurial Finance.
Ana Maury Aguilar. VC Investor at ACV.
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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