High-growth, early-stage startups have long-relied on checks from venture capital (VC) firms to grow, expand, and eventually exit. But no checks would be written if not for a venture firm’s most valauble asset—its cash.
In this article, we will explore the concept of venture capital investable cash, its significance, and factors that influence the fund’s capital allocation decisions.
What is Investable Cash?
Investable cash refers to the amount of capital that a venture fund is able to invest, but has not yet deployed. In that sense, it represents funds that will be invested at some point in the future, but that has not been delegated to a commitment or a fund’s expenses.
Though most investable cash will end up in the hands of promising startups or entrepreneurial ventures, it also can generate near-term value for venture firms in some cases.
Why is Investable Cash important in Venture Capital?
Investable cash is the fuel that allows VC firms to make investments in high-potential startups, support their growth, and generate returns for the fund’s limited partners (LPs). The availability of investable cash determines the fund’s ability to seize on investment opportunities and participate in the entrepreneurial ecosystem.
How is Investable Cash determined?
The amount of investable cash in a venture capital fund is influenced by several factors. These include…
- Capital Calls: Venture capital funds may not immediately deploy the entire committed capital from LPs. Instead, they call for capital on an as-needed basis, depending on the timing and availability of investment opportunities. The capital called from LPs becomes part of the investable cash pool.
- Fund Size: Unsurprisingly, the size of the fund will have a big impact on the amount of investable cash. A larger fund typically has more investable cash available, assuming other expenses and commitments remain constant.
- Management Fees and Expenses: VC funds deduct management fees and expenses from the committed capital, which reduces the pool of investable cash. These fees cover operational costs, due diligence expenses, salaries, and other overhead expenses associated with running the fund.
- Reserves: VC funds may set aside a portion of the committed capital as reserves. These reserves serve multiple purposes, such as follow-on investments in portfolio companies or bridging funding gaps. Reserves reduce the investable cash available for initial investments. In most emerging funds all investable capital is deployed and not held for reserves.
How do VC funds manage their Investable Cash?
VC funds employ careful portfolio management strategies to effectively allocate their investable cash. These strategies include:
- Deal Sourcing and Due Diligence: VC firms actively source investment opportunities and conduct due diligence to identify high-potential startups. These ‘filters’ ensure that investable cash is directed into companies that align with the fund’s investment thesis and growth objectives.
- Investment Prioritization: Funds prioritize investments based on various criteria, such as industry sectors, growth potential, market dynamics, and team quality. This helps allocate the investable cash to the most promising opportunities within the fund’s investment strategy.
- Portfolio Diversification: Depending on the strategy of a VC fund, they can aim to build a diversified portfolio by allocating the investable cash across a range of companies, sectors, and stages of investment. Diversification mitigates risk and enhances the potential for returns.
- Reserve Management: As we alluded to earlier, investable cash can help venture firms generate near-term value and plan for future deployments. Many larger and more established VC funds use reserve management to strike a balance between deploying capital now, reserving capital for follow-on investing, and generating current value from investable cash through interest or bonds.
What are the risks associated with Investable Cash?
You can never have too much of a good thing, but having a large amount of investable Cash carries certain risks that VC firms need to be aware of.
Here are some risks associated with venture capital investable cash:
- Capital Deployment Risk: The primary risk is the ability to effectively deploy the investable cash into suitable investment opportunities. VC firms may struggle with how to handle their dry powder: they might deploy too quickly or too slowly, either because of challenges with finding high-quality startups or with identifying startups that have synergy with the fund’s thesis. This risk can negatively impact fund performance.
- Timing Risk: Venture capital funds operate over a time horizon which typically spans several years. The timing of investments is crucial, as market conditions and the availability of attractive opportunities can fluctuate. If the fund fails to deploy investable cash within the desired time frame, it may result in missed investment opportunities and potentially lower returns for the fund and its investors.
- Concentration Risk: Allocating a significant portion of the investable cash to a small number of investments can create concentration risk. While this wouldn’t be a problem if every startup was a winner, the reality is that many will fail—and poor diversification can mean that a few losers can have a disproportionate impact on the overall fund returns. Diversification helps mitigate this risk by spreading the investable cash across multiple investments and sectors.
- Market Risk: The performance of venture capital investments is often influenced by broader market conditions. Economic downturns, industry-specific challenges, or changes in investor sentiment can impact the value and viability of portfolio companies. A decline in the market can affect the valuation of investments and potentially lead to lower returns or losses on investable cash.
- Liquidity Risk: Venture capital investments typically have a longer time horizon and limited liquidity compared to other asset classes. It can take years for startups to mature, reach profitability, or have a successful exit. In the meantime, the investable cash remains tied up, and the fund may face challenges in meeting its capital obligations or returning capital to LPs in a timely manner.
- Regulatory and Compliance Risk: VC firms need to adhere to regulatory requirements and compliance obligations. Non-compliance with regulations governing investments, reporting, or fiduciary responsibilities can lead to legal and reputational risks. Failure to manage these risks can impact the fund’s investable cash and its ability to attract and retain LPs.
- Currency Risk: In the case of cross-border investments, venture capital funds may face currency risk. Fluctuations in exchange rates between the fund’s currency and the currency of the investment can impact the value of the investable cash and the returns generated.
- Fundraising Risk: The ability to raise additional capital for subsequent funds is crucial for VC firms’ long-term sustainability. If the fund’s performance or market conditions are unfavorable, it may face challenges in raising new capital. This can limit the availability of investable cash for future investments and hinder the growth and expansion of the fund.
To mitigate these risks, VC firms should employ rigorous due diligence, diversification strategies, ongoing portfolio monitoring, and risk management practices. Additionally, maintaining a strong network, market intelligence, and adapting to changing market conditions can help mitigate risks associated with venture capital investable cash.
What are some best practices for Investable Cash?
When it comes to managing venture capital investable cash, there are several best practices that VC firms can follow to optimize their capital deployment and mitigate associated risks.
Here are some best practices you should consider:
- Investment Strategy Alignment: Align the investment strategy with the fund’s objectives and LPs’ expectations. This involves defining the fund’s investment thesis, sector preferences, and stage focus. By establishing a clear investment strategy, VC firms can ensure that the investable cash is deployed in line with the fund’s mandate and target returns.
- Robust Deal Sourcing: Implement a proactive and disciplined deal sourcing process to identify a broad pipeline of potential investment opportunities. This can include building relationships with entrepreneurs, attending industry events, leveraging networks, and staying up-to-date with emerging trends. Some VCs even build venture studios to incubate potential portfolio companies. All-in-all, high-quality deal flow increases the likelihood of finding high-quality investment targets.
- Rigorous Due Diligence: Conduct thorough due diligence on potential investments to assess their viability, growth potential, market fit, and management team. Comprehensive due diligence helps identify risks and opportunities, enabling informed investment decisions and minimizing the chances of misallocation of investable cash.
- Diversification: Diversify the investment portfolio to spread risk and maximize potential returns. Allocate investable cash across different sectors, stages of investment, and geographies. Diversification helps reduce concentration risk and enhances the fund’s ability to navigate market fluctuations.
- Active Portfolio Management: Implement active portfolio management practices to monitor and support portfolio companies effectively. This includes providing strategic guidance, facilitating introductions to industry contacts, and actively participating in board meetings. Active involvement increases the likelihood of successful outcomes and enhances the value generated from the investable cash.
- Continuous Monitoring: Regularly monitor the performance of portfolio companies to identify early warning signs and make informed decisions about capital allocation. Stay updated on key metrics, milestones, and market dynamics. Monitoring ensures that investable cash is deployed optimally and enables timely adjustments to investment strategies, if necessary.
- Reserve Management: Effectively manage reserves to support follow-on investments in promising portfolio companies. Reserve management should balance the need for additional capital with the requirement to maintain sufficient investable cash for new investment opportunities. Regularly assess the performance and capital needs of portfolio companies to determine appropriate allocation of reserves.
- Market and Competitive Intelligence: Stay informed about market trends, competitive landscapes, and emerging technologies to make strategic investment decisions. Continuous market intelligence enhances the ability to identify promising sectors, understand industry dynamics, and anticipate potential risks or disruptions.
- Risk Management: Implement risk management practices to identify, assess, and mitigate potential risks associated with investments. This includes analyzing market risks, operational risks, and regulatory risks. Maintain a robust risk management framework to safeguard investable cash and protect the interests of LPs.
- Transparency and Communication: Foster transparency and open communication with LPs regarding the management of investable cash. Provide regular updates on portfolio performance, investment decisions, and overall fund activities. Clear and transparent communication helps build trust and maintain strong relationships with LPs.
By following these best practices, VC firms can effectively manage their investable cash, optimize capital deployment, and increase the potential for successful investment outcomes. These practices contribute to the overall success and sustainability of the venture capital fund.
Conclusion
Investable Cash is a critical component of a VC fund’s ability to support startups and generate returns for its investors. Understanding the factors that influence investable cash—and the strategies employed by VC firms to manage it—is essential for both investors and entrepreneurs seeking funding. By effectively allocating its investable cash, VC funds can drive innovation, foster entrepreneurship, and contribute to the growth of the startup ecosystem.