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VCs consistently put entrepreneurs under the microscope when looking at investing in startups. This week, we turn the tables and look at how VCs themselves are also subject to due diligence by their own investors (commonly referred to as Limited Partners or “LPs”).
This is a great process for VCs to go through. It gives them a sliver of the lens and experience that entrepreneurs have. I say sliver because comparing the two is not really fair. The stakes are much higher for entrepreneurs, and they can risk everything in order to get their companies properly funded. VCs are typically not subject to the same level of downside. That being said, I still consider it a great exercise for VCs to go through to gain empathy for the entrepreneurial journey of the founders they invest in.
LPs of VC funds vary widely but are typically made up of organizations such as pension funds, foundations, endowments, insurance companies, government bodies and family offices.
For founders, knowing about the VC fundraising process and their LPs is valuable information.
For startup founders and entrepreneurs, knowing about the VC fundraising process and their LPs is valuable information. It can help you pick which VC firm you want to work with and give you great insight into how they are structured and how they might operate once they do invest. The more you know about your investors, the better.
VC firms typically actively raise new funds every two to five years. If successful, this provides the firm with a bucket of money that they can, in turn, invest into your startup. The truth is, like the best entrepreneurs, the best VCs never really stop raising money. Fundraising is always top of mind.
To help us with more insight on this topic, we called upon Nagar Rahmani, principal at Kensington Capital Partners. Nagar is well known in the startup ecosystem, and is an enthusiastic supporter of entrepreneurs and the people that fund them. Kensington Capital is a leading Canadian alternative asset management firm with $1.2 billion in assets under management. Their investment platform includes diversified funds focused on private equity, venture capital, infrastructure assets, and hedge funds.
The first thing LPs look for is track record. As with entrepreneurs, past success is a good indicator of future success. VC firms which have a history of generating cash-on-cash, realized returns (in addition to marked up valuations on paper), are typically viewed favourably by investors. The thinking here goes that the firm has developed a good ability to “pick winners” and that they have the networks and insights in place to help their portfolio companies scale to a good outcome.
LPs are recognizing the importance of gender and race diversity in the makeup of a GP team.
It is important that the deals a VC lists as their track record are fully attributable to the firm and the individual partner who is claiming responsibility for it. The partner should have sourced the deal and added value to the investment by doing things like sitting on their board, adding operational value, and helping with the exit – all in ways that can be checked in reference calls with the founders and/or CEO of the company.
After track record, LPs like to see a team of individuals that have a history of working together. Just like entrepreneurial founding teams, LPs tend to prefer teams of VC managers as opposed to single managers. Ideally, the team has been at the same (or similar) firm together in the past, and achieved a good collective track record.
Individual makeup of the team is also very important. Typically, investors want to see a group of managers who have complimentary skill sets. One partner might be a seasoned investor, the other a seasoned entrepreneur, while another might be a more junior partner who is showing promise of trending towards becoming a more senior partner soon, and so on.
Each partner will be scrutinized for their network and ability to manage an investment on their own (important, because typically entrepreneurs will work directly with primarily one individual partner of a VC firm). However, it is important that they have complimentary partners and networks around them to optimize decision-making in the firm and extend their ability to help their portfolio companies.
It is also important that the team has great connections to other important startup markets such as Silicon Valley or New York. Their networks into these other markets can really help attract new investors, strategic partners, and even buyers when the company is ready to be sold.
Beyond team and track record, investors will heavily scrutinize the strategy of the proposed fund. It has to be a strategy that the VC firm can use to persuade investors that they will generate strong returns to their LPs. VC is a hyper competitive game, and a firm needs to have a unique value proposition in order to work with the best entrepreneurs and fund the best companies — and to attract the best LPs.
For example, some LPs like to see differentiation in the fund’s strategy relative to competitors. Historically, differentiation has been achieved through a focus on a given geography (“we only do deals in Toronto-Waterloo”), sector (“we only invest in mobile technologies or we only invest in cleantech”), or stage (“we only invest at the Series B or beyond stage”). These are examples of the kind of strategic focus that can help the VC get the best deals.
Platforms provide portfolio companies with more than just an investment partner or venture capitalist.
LPs are also recognizing the importance of gender and race diversity in the makeup of a GP team. This is increasingly becoming an important source of differentiation for VCs, as a more diverse team may cast a wider net and get access to a broader set of deal flow opportunities. A homogenous VC team has the danger of thinking the same way and chasing the same types of deals or entrepreneurs.
Having a team with different genders, backgrounds, and experiences permits a more differentiated lens when searching for the most promising startups, which can lead to higher returns for the GP team and their LPs.
These days, we are also seeing other interesting areas of differentiation. Some firms are starting to build up platforms as opposed to just funds. Platforms that provide portfolio companies with more than just an investment partner or venture capitalist. Firms such as Andreessen Horowitz and Georgian Partners are staffed with people who are not just traditional VCs. Rather, they include executives and staff that can help companies with specific functional activities such as sales, technology strategy, product management, human resources and staffing etc. Having a value-add platform can be an edge for firms as they court entrepreneurs and as they help scale their portfolio companies after they invest.
Beyond differentiation, investors will also look to the proposed structure the firm will follow. The capital they are raising has to be sufficient enough to build up a diversified portfolio of companies. The team needs to be large enough to manage the proposed number of investee companies, taking into account any prior fund portfolio companies that still need coverage. And so on.
Once an investor is comfortable with the track record, team, strategy, and structure, they will turn their attention to the terms of the fund. Here, the most important details are usually the management fee (the amount of capital each year paid to the fund managers to cover salaries and expenses) and the carried interest pool (the incentive paid out to managers upon good performance of the fund). Investors want to see a healthy return (typically three times for a venture fund) on their money and want VCs who are hungry enough to achieve these returns by generating performance fees when they generate profits for their LPs.
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