I recently chimed in on this question in Quora: Do venture capitalists need approval from their investors before making an investment in a company?
Then I thought about what my answer would be from a portfolio company standpoint. Should a company care about the profile of the limited partners in the VC’s fund? The answer is … not really.
First, let’s start with the fundamentals. Venture capital firms are comprised of a series of funds. Each fund is, to a large degree, independent of the others and must live on its own when it comes to the companies in its portfolio. So one company that receives funding from Fund I will be subject to different dynamics compared to another company that received funding from Fund II. Funds within one firm vary in size from another, with the earlier funds typically being smaller than the later funds (unless the VC firm is running into challenges and has had to shrink its fund size).
The larger the change in fund size over that time, the bigger the change in the investment profile of the firm. For example, larger funds equal larger investments in larger companies. Big funds that focus on early stage businesses have to either over-fund their companies (the need to write big checks) or spread the money over a large number of companies (the Pray-and-Spray strategy). The ideal situation is to have a fund that’s sized to the stage of companies (e.g., “Our fund is on the smaller side of a mid-sized VC fund because we focus on expansion stage companies.”)
Funds are primarily funded by investors who are referred to as limited partners (LPs). These investors can range from wealthy individuals to pension funds to estate funds to funds of funds, and so on. Each type of LP has his or her own investment parameters and expectations. Once an LP makes a commitment to one of a VC firm’s funds, they are expected to continue participating in subsequent funds. Unless the strategy of the VC deviates significantly from that of the LP, which may compel the LP to pass on the next fund.
LPs pay their VC funds in two ways. One is the management fee (typically 1.5-2.5% of the fund size annually) to pay for the day-to-day operations of the firm. Second is the profit share, or carry (typically 20-25% of the profits generated to the overall fund). One of the big issues with VC compensation is how much the management fees go to make the VC partners wealthy versus the carry. Ideally for the LP, the VC partners wealth would only be generated through the carry.
So what would the nature of the LPs of a VC firm tell you about that firm?
1. VC firm credibility: The quality of a VC can often be judged by the quality of its LPs. High-quality LPs invest in high-quality VCs.
2. VC firm stability: Is the LP base stable, or is there significant turnover in LPs from fund to fund? Is there LP concentration, which would increase the risk of turnover? Are the LP funds stable enough to continue funding the VC over time?
3. Exit Pressure: Are the LPs pressuring the VC for exits? What is the hold period that LPs are pushing for and how does it vary from the VCs period? How does either period differ from yours?
Overall, you should not have any worries about your VCs investors. Ultimately, your focus should be on the VCs investment model and how fund it aligned with it.
Key elements you should be concerned about:
1. Investment strategy: What is it, and does your company fit within it? Does the VC invest in companies at your stage or are you too early/late for them? Is the amount of funding you need too little/much in matching the size of the overall fund? What is the average hold time the VC aims for and does that meet with your aspirations?
2. Value: Every VC will claim to bring value. What specifically does the VC do to deliver that value? What are specific examples of initiatives that the VC delivered on for other portfolio companies?
3. Domain expertise: Does the VC have domain expertise in your sector? Does that matter?
4. Cultural fit: Perhaps the most important element. Do you and the other board members see yourselves getting along with the VC partner? Is there good chemistry?