1. Identify a fund with a compelling thesis
A thesis is a unique vision for the future of a market, technology or business model with a clear strategy to capture future value in the market. Investors and limited partners in venture capital have the option to invest in different funds with varying strategies.
Research what type of technology companies you would like to have in your portfolio and listen to the views of fund managers with different areas of focus. For example, some VC funds exclusively invest in a certain sector at a certain stage of development, in certain geographies while others are global multistage generalists.
The thesis and type of company also determine the risk, duration of the fund and other factors. For example, deep-tech companies are typically riskier and take longer to develop than most companies, but may result in above-average returns in some cases. You should predetermine the fund strategy that best fits you and what sectors you want exposure to.
Additional Resources: VC Investment Thesis, Selecting a VC Firm Focus, Determining VC Fund Size
2. Diligence the manager
Venture capital is often compared to marriage. However, while the average marriage in the US is 8 years, the most common closed-end fund duration is 10 years, so relationships between fund managers and the limited partners (investors in the fund) are really important. Speak with many managers and get a sense of their theses and the markets they’re focused on.
When speaking with managers, find out the ticket and fund size. Larger funds can make more investments and have a diversified portfolio, though the ticket sizes are typically higher.
You should dive deeper into the manager’s thesis and strategy and find out if you are both aligned. It’s also important to get a grasp on how the manager will get quality deal-flow and access to high-grade companies. Conducting diligence on this matter is prudent. Find out if entrepreneurs actively seek out the manager and if they have an amazing network of entrepreneurs and experts.
A manager’s track record and past performance are some of the best indicators of future performance in VC. The power law applies in venture capital funding too, and some exceptional managers vastly outperform the rest. For example, the average returns for VC over the last 10 years are 13.2%, however, in that time some fund managers achieve a considerably much higher IRR.
3. Review and understand the fund documents
Once you’ve found a fund manager with a compelling thesis, it is recommended you review the economic terms in the fund’s Limited Partnership Agreement (LPA) or equivalent governance document. The LPA sets forth the terms and conditions of the fund and serves as the operating manual for the venture fund and delineates your rights as an investor. Terms such as carried interest, fund duration, capital commitments, management fees …etc will be clearly defined here.
For example, the Management Fee can be structured as a flat 2% fee per year or cascading down from 3.5% per year to average out to 2% overall. The Maximum Portfolio Investment Percentage will dictate how much can be invested into a single company as a percentage of the fund. Other terms such as GP Commitment Percentage will set forth how much capital the General Partners will put into the fund. LPs typically ask this to be set at 1%.
Brush up on all of these terms before subscribing to a fund. You can read more in VC Lab’s very own Cornerstone LPA which has simplified the legal jargon and complexity for fund managers and investors.
Additional Resources: How to use the Cornerstone LPA
4. Sign the fund documents
The fund manager will communicate with you that they are planning to close the fundraising. You should be prepared to finalise the closing package, which typically depends on the firm, but will include documents such as the ‘accredited investor form’. If you are unsure of the terms at any point then ask a GP for further clarification.
Once you are happy with the terms and conditions of the fund, consider using a fund lawyer when signing the agreement. Be prepared to submit said package in a timely manner, which is about a week. Beware that failure to produce said documents in an efficient manner may result in you missing the closing, especially if the fund is oversubscribed.
Upon signing the documents you may not receive immediate confirmation. This is because the fund manager needs time to gather all the signatures from the LPs and finalize the closing.
Note that you are committing capital to the fund by signing this agreement and should have enough liquid capital on hand to remit funds when the fund calls capital from you.
5. Contribute capital
To start investing in startups, GPs will typically ‘call capital’ from investors. Capital calls are legally binding requests for you to wire capital that has previously been committed to the fund.
Capital calls usually do not happen immediately after signing the documents, but after the fund is ready to invest in startups. Typically, fund managers will not call your entire capital commitment at once but initially will call somewhere between 25% – 40% over a period of time depending on the fund.
They will use these funds to invest in companies during the fund’s investment period. Fund managers will then back the winners in the portfolio over time and call capital from yourself and other LPs when necessary.
6. Receive returns as portfolio exits occur
You will receive your portion of the returns as the companies in the portfolio mature and start exiting and being acquired. This can take longer than the lifetime of the fund, especially if the fund has considerably large winners. At times, the fund may be extended for a pre-defined period of time outlined in the LPA, to look for secondary sale opportunities and to maximise the returns on the assets held by the fund.
Some companies in the portfolio will break even and return modest earnings, though typically most of the returns will come from a few companies while a majority will fail. So it is important to note that your earnings will not be equally distributed.