How do VCs raise their funds?

What is an LP? A GP?

On the one hand, as VCs, we are on the vanguard of innovation. We invest in exciting technologies that can and will change the world.  However, from a different perspective, we are money managers who cling to conventions and are very, very slow to change. Raising money is the old school part of venture capital that hasn’t changed fundamentally since the industry got started over a half century ago.

This is no surprise if we look upstream and see where the money is coming from. Pension funds and insurance companies are not exactly big risk takers. Hence, VCs set up our funds just like private equity funds were doing back in the 1950’s. VC funds are limited liability partnerships in which the VCs are the GPs (general partners) and the pension funds, banks, endowments and other investors are the LPs (limited partners).

As the title implies, the LPs have a limited role. They will have no active participation in our partnership and will have no liability beyond the cash they’ve invested. All they do is supply cash and get cash in return.

Fundraising Strategy

It can be surprising to learn that, as VCs, we (I’m using “we” since we’re learning how to be VCs), we pitch to our investors in much the same way as startups pitch to us. Just as startups must put together a fundraising strategy and pitch to numerous investors, we also go on a roadshow to present our firm as an investment opportunity for institutions.

Both VCs and startups present a specific amount being raised and a strategy for the use of funds. While startups are presenting a series of milestones on the way to a successful exit, we pitch a particular fund size and strategy that should match the competencies of our partners.

The main variables that determine the size of the fund are the number of partners, the number of deals each partner can handle and the stage of financing that the firm will target. Earlier stage generally will need less capital. Later stage needs more.

Let’s say, for example, that we have three partners and we would like to invest in early stage startups, say $5-7M per startup. If we believe that each partner can handle one new deal per year for a five-year investment period, we’d be looking at a total of 15 startups in our portfolio. At $7M/startup, we’d need to raise about a $100M fund for this strategy, excluding management fees, which we’ll discuss shortly.

If we choose to alter our strategy to be a little bit later stage, which would require more capital per startup, say $12-15M per investment, we might need to raise a $175M fund. Add a partner, and we may be able to increase our portfolio size by 1/3, up to 20 startups. Now we might be looking at a $250M raise.

As GPs, we are constantly working our LP network to gauge the temperature of the fundraising market. That is, we are asking our LPs and prospective LPs what they’d want to see. Just as startups create an MVP (minimum viable product) and test it with early customers, we will start floating the idea of our new fund to LPs to gauge interest. We’ll iterate our fundraising strategy based on their feedback…

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This is the first page of a 13 page chapter. Also covered in this chapter:

  • Capital Calls
  • 10-year Fund Life
  • Early Peek at Return Potential
  • Multiple Funds
  • Mega Funds
  • Fee Structure
  • Corporate VC