Venture capital involves numerous processes. This article offers an overview of key procedures, such as creating an investment Thesis, forming a team, managing a fund, and others. Each procedure is critical in a venture fund’s lifecycle. This article serves as an introduction to these essential venture capital operations.
Writing the Thesis
A Thesis gives a fund its strategic direction. The Managing Partners, who are normally the founders of the firm, typically crafts the Thesis. A clear, concise Thesis is crucial for guiding a fund’s investment choices and attracting potential investors.
- Define the geographic focus of investments
- Identify the sectors or market companies the fund will target
- Highlight the unique strategy or “secret sauce” of the fund
- Determine the stage of venture fund
- Set a target for the amount of capital to be raised
- Identify the fund’s name
- NOTE: Completing a fund Thesis is an interactive process that can take four to six weeks.
“Purple Ventures is launching a $5 MM angel fund in Brussels to back European government technology startups that leverage the partner’s experience running a network of 1,600 startups and 12 unicorns in the space after holding various political roles across the EU.”
Forming a Team
The core venture team of Managing Partners and partners makes all of the key investment decisions. Forging the ideal team is the role of the Managing Partners. An optimized team is able to execute on the Thesis and secure top decile returns for limited partners.
- Identify potential partners that who are known by the team for years
- Develop a target list with those that are a fit with the Thesis
- Organize a series of brainstorming sessions with the targets
- Evaluate if a target is a partner or venture partner candidate
- Determine target’s commitment to the fund’s goals and values
- Discuss an offer with the target to gauge interest
- Test the target for a month or two
- Make the official offer after the fund is formed
NOTE: New managers are advised to only work with partners that they have known for five years or longer in a meaningful relationship.
A new manager forming a FinTech fund in Africa approaches two of his best friends to work with her as partners, both of whom have different and relevant domain expertise. One agreed to join with a 45% share of the carry, and the other became a venture partner with a 5% share of the carry.
Completing Fund Formation
Fund formation sets up the legal and financial structure of the fund. The Managing Partners oversee this process, which normally involves specialized fund formation attorneys and back office professionals. A properly formed fund ensures legal compliance and smooth operation.
- Ensure at least 10% of the fund is hard circled
- Choose a domicile for the fund, such as Delaware
- Select appropriate vendors for the fund
- Draft necessary agreements with fund foundation counsel
- Review agreements with potential Limited Partners (LPs)
- Officially form the venture capital firm and fund entities
- Set up a bank account for the fund
NOTE: Formation normality takes two to six months, depending on the domicile, and the bank can often be one of the slowest things to set up.
After a $5 MM micro fund in the US secured $1.5 MM hard circled, they hired Decile Launch to create a firm in Delaware, which took two months to set up and close on the fund.
Pitching Limited Partners
This process involves securing capital commitments from potential investors, called limited partners. The Managing Partners typically lead the pitching process, although all members of the firm assist with fundraising when needed. Securing commitments from limited partners is critical as it provides the capital that the fund needs to invest in companies.
- Define one or more archetypes for the ideal Limited Partner (LP)
- Test whether LPs in each archetype respond favorably to the fund’s Thesis
- Build target lists of potential LPs in the target archetypes
- Work with Connectors to arrange meetings with key LPs
- Conduct meetings and presentations to pitch the fund
- Secure a PACT, a commitment letter to invest, when a LP expresses interest
- Send investment materials and an LPA to sign when preparing to close
A venture capital firm might pitch to wealthy individuals, family offices, corporates, pension funds, and other institutional investors.
Closing a Deal
Closing a deal secures an investment in a startup. This process is managed by the fund’s Partners and assisted by the Venture Partners, Principals, Associates, and Analysts. Successful deal closing translates into portfolio growth and potential returns for the fund.
- Source a series of investment opportunities with the Thesis
- Develop conviction to invest in one opportunity
- Present the opportunity to the team or investment committee
- Conduct due diligence on the potential investment
- Negotiate the terms of the investment
- Execute the investment agreements
- Wire the money to conclude the investment
- Store the investment agreements in the document storage
- Set a schedule to get regular updates and to assist the company
A partner at a firm focused on SaaS software finds an online tool to manage your house, which matches the background of the partner, and she secures support from the other partners to invest $500K into a pre-seed SAFE note.
Preparing the Annual Report
Annual reports provide detailed updates on the fund’s activities and performance. The entire fund team collects data and analysis for the Managing Partners to review and draft a final version. Regular reporting maintains transparency with limited partners and keeps them informed about their investments.
- Collect news on the target industry, sectors, and stage of the fund Thesis
- Maintain a list of news items related to the fund, including press by portfolio companies
- Secure updates on portfolio company fundraising initiatives and business progress
- Gather information on the fund’s recent investment activities
- Compile data on the fund’s performance, including fund financials
- Write a comprehensive report covering all aspects of the fund
- Distribute the report and fund financials to all Limited Partners (LPs)
- Respond to any inquiries from LPs on the activity
NOTE: Some funds send out quarterly updates and also do monthly newsletters to keep their limited partners engaged.
A fund organizes an annual LP summit around the time of the annual report to present the performance of the fund to limited partners in person and answer any questions in real time.
Assisting Portfolio Companies
This process involves supporting portfolio companies beyond financial investment. The process is often managed by the fund’s partners or venture partners, who have specialized domain expertise to help. Helping portfolio companies succeed can significantly enhance the returns of the fund.
- Develop a value-add proposition to offer as part of the brand of the firm
- Source portfolio companies that benefit from the fund’s assistance
- Identify areas of assistance during the investment process
- Assist potential portfolio companies after the investment closes
- Evaluate if the assistance creates positive change in the portfolio company
- Refine the assistance offering to generate positive results
NOTE: Not all venture capital firms assist portfolio companies, and the industry has a reputation of promising help and not delivering anything besides money.
A partner will introduce a portfolio company to five investors for the next round, two of which decide to invest, filling half of the round in under 45 days.
Helping with an Exit
Portfolio companies exit through an acquisition or initial public offering (IPO), and firms proactively assist in this process. The fund’s partners, venture partners, and wider team help with this process as needed. Successful exits generate returns to limited partners and, if in carry, to the general partners.
- Provide support to the entrepreneur throughout the exit process
- Maintain responsiveness to ensure smooth operations
- Assist in the negotiations for a favorable outcome
- Expedite the signing of exit paperwork by all parties
- Follow up to ensure timely payments and receipt of any stock certificates
In the case where an exit is an acquisition by a public company, the partner helps the company to secure an extra $200 MM in the purchase price, and then quickly completes all of the paperwork to secure the first exit cash payment, which was distributed to LPs in 30 days.
This process returns capital and profits to the fund’s investors. The fund’s financial team, normally a back office provider, typically manages this process with the help of the Managing Partners. Timely and accurate distribution of proceeds ensures investor satisfaction and enhances the fund’s reputation.
- Secure the cash and stock proceeds from an exit in timely manner
- Determine if the exit brings the fund into carry
- Review the distribution amount owed to each limited partner from their capital account
- Consider any fees or carry that needs to be distributed
- Review any special agreements or side letters that affect the distribution
- Write an update about the distribution to the various stakeholders
- Distribute the proceeds within the timeframe from the Limited Partner Agreement
- Respond to any inquiries
A fund has a $150 MM return from an exit in the seventh year, which provides a 15x TVPI on the fund. In celebration, the partners organize a special gift to be sent to each LP to celebrate the success.
The venture capital processes outlined in this article represent high-level summaries of the standard practices within a firm and its fund operations. Each procedure, from forming a team to distributing proceeds, contains numerous intricate sub-processes and tasks. For instance, closing a deal encompasses not just negotiation and paperwork, but also a series of steps like exhaustive due diligence, financial analysis, and legal compliance. Similarly, assisting portfolio companies extends beyond advice or mentoring to strategic guidance, facilitating key introductions, and potentially providing interim management support.
The intention of this article is not to delve into the minutiae of each process but to provide a broad overview of the multitude of tasks that constitute venture capital operations. The real-world execution of these processes is layered with complexity and requires significant expertise and experience. Despite the intricacies involved, each process remains crucial to the successful performance of a venture capital fund. The ultimate objective is to make successful investments, ensuring high returns for the fund’s limited partners, and each of these processes is a stepping stone towards that goal.
Angel Fund: A type of investment fund that focuses on providing early-stage capital to new startups.
Carry: Also known as “carried interest,” it refers to the percentage of profits that the fund’s managers are entitled to.
Top Decile Returns: Refers to the distribution of returns in segments or deciles, with top decile returns representing the top 10% of performance.
Domicile: The legal home of the fund, often chosen for regulatory or tax reasons.
Due Diligence: An exhaustive investigation or audit of a potential investment, including reviewing financial records, operations, legal compliance, etc.
Exit: The process by which an investor sells their stake in a company, either through an acquisition or an initial public offering (IPO).
Hard Circled: A term used to describe committed capital from investors that is considered secure, though not yet legally binding.
Limited Partner Agreement (LPA): A legal document outlining the terms between the general partners (who manage the fund) and the limited partners (who invest in the fund).
PACT: A term used in this context to refer to a commitment letter from a potential investor expressing their intent to invest in the fund.
Principals: Senior professionals in a venture capital firm who are typically involved in making investment decisions.
SAFE Note: A Simple Agreement for Future Equity, a type of financial instrument that allows investors to invest in a startup with the promise of equity at a later date.
Thesis: A set of guidelines that direct the investment strategy of a venture capital fund.
TVPI: Total Value to Paid-In, a ratio used to measure the value of a fund’s investments compared to the amount of capital paid into the fund.
Venture Partners: Individuals who may not be full-time employees but work with a venture capital firm, often bringing specialized expertise or connections.