Notes from Venture Deals (Brad Feld, Jason Mendelson) – Part II

Part I is here.  In a hurry? Italics in the post represent key dos and don’ts for founders.

How VC firms work

  • One management company (franchise) – this is the name of the VC firm you hear.
  • Under them are several “general partnerships” (no longer a “general partner” i.e. single person, this is a separate legal entity of its own ). Each “general partnership” has different funds – LPs (limited partnerships) under it.
  • Interest of VC firm != interest of the GP/LP always, particularly when new people join or MDs leave.
  • How VCs raise money
    • LPA – limited partnership agreement
    • Fund amount is not actually with the VCs. A capital call is made each they want to invest in a startup, and the LPs are obligated to respond to the capital call in two weeks.
  • Capital calls can fail or result in lower funding than expected .2008-like situations: LPs include HNIs who may be struggling with illiquidity themselves, banks who, like in 2008, may be dissolving themselves, endowments/pension funds etc who are facing capital crunch due to general market conditions.
  • Average total fee over a 10 year period: 15% of the fund. VCs are expected to make capital gains and recycle those gains to cover up for the fees.
  • Partners see base compensation with every additional fund raised.
  • “It takes 10 years to kill a venture fund.” – additional funds / rounds can be raised while the performance of the first few isn’t clear.
  • Carry: VCs get a 20% of the profit cut, which is known as “carry”. This can be reinvested (and is expected to be reinvested, at least till it covers the management fees).
  • Friction within a VC firm – Firms don’t equal allocation between partners- seniority matters. An individual partner can make X times the amount allotted, but still get no carry because of allocation style and poor performance of the overall firm or fund.
  • GP Commitment: LPs want VCs to invest a cut as well – 99% money comes from LPs, 1% from the VCs. Has gone up to 5%.
  • Clawback: VCs can pocket the carry in the middle of the fund (say 20% of 50 mn in profit) and then the overall fund turns out to not do so well. VCs have taken more than the deserved carry and LPs demanding for this back is ‘clawback’.  Harder to pull off across multiple partners.. (e.g. one partner got divorced, paid half to spouse. All partners paid taxes on the carry).
  • Time impact of fund activity
    • If you are raising with a VC fund that closers to closing, higher pressure for an exit.
  • Wary of ‘zombie’ VC firms (no new funds to raise, carrying on their existing funds). Just ask when their last investment was.
  • Wary of ‘secondary sale’ – VC can sell their entire portfolio to someone in a secondary sale.
  • VCs close to end of the fund can also redistribute the portfolio to LPs – hassle for founder if there are too many LPs.
  • Reserves – VC have a fraction of the fund (30-50%) in ‘reserve’ i.e. for future investments with their portfolio companies. Ask upfront for details on this.
  • Cashflow – how does the VC maintain their cashflow? Are they recycling the carry appropriately to make up for the management fees? ([KR]: How does this affect the founder?)
  • Cross-fund investing – bad idea, since there are multiple sets of LPs and multiple kinds of terms involved.
  • Figure out what happens if and when the partner who invested in you departs – does it trip a ‘key-man clause’? (LP can ask for recall of funds).
  • Understand your VC’s fiduciary duties – they are serving you/your board, the VC firm, their own GP/LP and a bunch of other people. Not all VCs are direct about what they have on their plate, making their behavior confusing.
  • Understand your investors motives and financial incentives. Have an open, if difficult conversation about it now, to avoid surprise and trauma later.

Read More »

Notes from Venture Deals (Brad Feld, Jason Mendelson) – Part I

In a hurry? Just skim over the italics in this post – they represent key dos and don’ts for founders. Part II of the post is here.

Resources

Term Sheet

  • Typically 8-ish pages (~2012).
  • Two key aspects, everything else is secondary, don’t waste too much time on other terms:
    • Economics terms
    • Control terms.
  • Signs of the VC not being entrepreneur friendly appear during the term-sheet negotiations.

VC History

  • Early VC example: AR&D:  70k for 78% of the company. Post-money valuation becomes 90k.
  • Individual VCs today own less than 50%, no effective voting control. They negotiate provisions that give them control over the major decisions made by the company.
  • VCs investing at different stages in the company => different ownership percentages, varying rights, diverging motivations.
  • Founders should direct and control the process of financing – leave as little as possible outsourced for the lawyer.
  • Capitalization-table (Cap Table): spreadsheet that defines the economics of the deal.

VC hierarchy

  1. MD/GP: Managing Director or General Partner. They make the final decisions and sit on the boards of the companies they invest in. Prefixes “executive” or “founding” may be applied to indicate seniority.
  2. Principal/Directors: Have deal responsibility, need a MD involved to take the final decision. These are junior partners making their way up to MD.
  3. Associates: Not deal partners, they work for the partners. They do: scout new deals, due diligence on existing deals, write internal memos about prospective investments. Associates likely spend the most time with the cap table.
    – Many VC firms have a 2 year associate program – after that, the associate leaves to go to B-school, work for a portfolio company or start up her own company. Star associates may go on to become principals.
  4. Analysts: Bottom of the ladder, crunch numbers and write memos.
  5. Other people involved in VC:
    1. Venture partners/Operating Partners: Experienced entrepreneurs who have a part-time relationship with the VC firm. May take an active role in managing the investment as chairman or board member.
    2. EIR (Entrepreneur in residence): Experience entrepreneurs who park themselves at a VC firm while figuring out their next company. Help the VC with intros/networking and due diligence. Last 3-12 months typically. Some VCs pay the EIR , some just offer office space and an implicit agreement to fund the next company.

Read More »

Notes from The Power of Positive Thinking

Caveat Emptor: Great book, but throws in way too much Christianity/religion in the face of the reader. IMHO, it is much easier for humans to place absolute confidence and faith in an abstract higher power, than it is to place faith in their innate prowess. Substitute “prayer” and “God” in this book summary for something similar that works for you.

  • Six point action plan to stop fuming and fretting:
    1.  Get in a relaxed physical position.
    2. Visualize: Your mind is the surface of a lake, tossed by waves and in tumult. But when the waves subside, the surface of the lake is placid and unruffled. This imagery should help you calm down.
    3. Spend two-three minutes thinking about the most beautiful and calming nature scenes you’ve witnessed.
    4. Repeat, slowly to yourself, words along the lines of “tranquillity”, “serenity”, “peace” and let the effect of them sink in.
    5. Make a list of times in your life when you were worried and anxious, and things turned out fine (for the more religious, “God took care of everything”).
    6. Rely on a higher power to take charge of the situation and fix it.

Read More »