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The Ideal Number of Limited Partners in a VC Fund

Many new fund managers ask us, “What is the optimal number of LPs in a VC fund?” Having powered the launch of over 100 VC firms worldwide, we’ve gathered valuable insights into the ideal number of investors for new funds, which we believe to range from 20-30 LPs. Intuitively, one might think that having a vast LP base is always advantageous. However, this may not always be the case, as this article will explore.

We’ve seen a tendency from new fund managers to aim for an extensive base of investors. Unfortunately, this can sometimes work against the GPs and cause burdensome operational and administrative challenges. On the other end of the spectrum, having too few LPs can lead to those investors potentially having unhealthy influence and authority within the fund.

Table of Content

Opportunity Costs

When fundraising, it can be beneficial for new managers to set forth a clear plan of who they will target and understand the profile of investors they would like within the fund. For more information, refer to VC Lab’s ‘Ultimate Guide to Get LPs,’ which provides helpful suggestions for fundraising.

Too often, new fund managers focus on large institutional investors, which typically do not invest in new GPs or the relatively small funds they manage. At times, new fund managers also concentrate and spend time on investors who wish to invest relatively negligible amounts of capital which causes them to end up with an unnecessarily large LP base.

Combined, both can lead to an inefficient campaign and result in the fund failing to gain traction in its fundraising efforts. As capital allocators, fund managers can also garner an appreciation for the concept of ‘opportunity cost‘ in fundraising. Time spent on the discussed avenues of financing may lead to expending scarce resources and time in an un-optimal manner. Therefore, setting an appropriate ticket threshold can serve to benefit your time and help you focus on the right investors.

It can be provident for new fund managers to brush up on the decrees set forth by local regulators in their jurisdictions. This is because these institutions can often place limitations on the number of LPs funds can have without registering with authorities. Fund managers can strategize their fundraising efforts and develop a thought-out approach using this information. For example, some jurisdictions such as Luxembourg require extensive KYC and AML checks for LPs if they own more than 10% of the Limited Partnership. This can sometimes be a deal-breaker for some LPs as such processes require intrusive background and financial checks.

In the US, the Securities and Exchange Commission (SEC) requires VC funds that seek exemption from registration to follow specific guidelines, including avoiding general solicitation and the following portions within the Investment Company Act of 1940, which venture capital funds typically fall under. Consequently, having a large base of LPs may result in VC funds not gaining exemptions under the following sections in the US:

Section 3(c)(1) 

Fund managers that seek exemption from registration via section 3(c)(1) must ensure that the limited partnership consists of less than 100 limited partners for funds over $25m. Recently, the SEC changed regulations regarding the number of investors funds below $10m can have and increased the number to 250 limited partners. 

Under this exemption, limited partners must qualify as “accredited investors,” and fund managers must take reasonable steps to ascertain their accreditation status by conducting diligence on each investor. Accredited investor definitions vary with jurisdictions and local regulators; therefore, fund managers should check local decrees. In the US, the SEC, under Rule 501 of Section D, defines accredited investors as persons with a net worth of over $1m (excluding the value of the persons” primary residence) or have a gross income of $200k, or joint spousal gross income of $300k for at least two years in a row. More on accreditation requirements here.

Section 3(c)(7) 

To gain SEC registration exemption using Section 3(c)(7), funds must be comprised of “2,000 or fewerqualified purchasers, where each investor must own $5M or more in investments. Again, fund managers “must” take reasonable steps to ensure each investor’s status as a qualified purchaser.

Administrative Challenges

Taking into consideration the aforementioned regulations, fund managers who have an extensive LP base that exceeds the stated limits will be required to conduct individual diligence on the accreditation status of each investor. As you can imagine this can prove to be an operational challenge, especially when the focus of the fund manager is needed in other critical areas. Upon completing checks, fund managers will also require signatures from every investor to close the fund. Once again a broad LP base can cause friction for GP, who need to orchestrate an efficient process to co-ordinate with all of the LPs. 

Operational challenges

After closing, fund managers typically seek to keep investors informed by reporting the portfolio’s performance. Often they also have to manage individual queries regarding the fund and nurture long-term relationships with LPs by reporting on the performance of the investments.

Again, a more extensive LP base may mean that fund managers spend an un-optimal amount of time fulfilling their duties and accommodating LPs. There can be an opportunity cost in these scenarios as managers may not have enough time to evaluate startups, keep up to date with the ecosystem, and write checks on behalf of their investors. The bookkeeping tasks also increase with the LP base and should be taken into consideration by the GPs in the fund.

Summary

In the US, having a large base of LPs that exceeds SEC requirements can mean that such funds must register with the SEC. Typically, fund managers avoid registration as it can be a lengthy and complex endeavor. Additionally, fund managers must spend an exuberant amount of time navigating SEC regulations and conducting diligence on each investor with both of these registration exemptions. Consequently, fund managers should aim to have 20 – 30 LPs in their funds to run an efficient fundraising campaign.

VC Lab runs Genesis, the four-month accelerator for venture capital firms and venture builders.

Cohort 6 starts in February and will help participants from around the world close on capital and start investing by June of 2022.

Learn more and apply here

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The Ultimate Guide to Get Limited Partners

Integral to the success of launching an enduring VC firm is the ability to fundraise from LPs effectively. At VC Lab, we’ve created a set of free resources for aspiring fund managers to use. These resources are designed to provide clear insights and help GPs source, reach out and pitch limited partners. This article encapsulates all of the information fund managers need to run an effective fundraising campaign and get to a quick first close.

Note: Each jurisdiction has its own rules regarding general solicitation, and fund managers should make efforts to understand them when communicating with potential LPs and fundraising. Refer to VC Lab’s ‘Tips to Avoid General Solicitation‘ for more information. 

Table of Contents

Planning to fundraise

Fundraising is the single most misunderstood thing in VC

Adeo Ressi

Adeo Ressi, CEO of VC Lab, suggests that fund managers may want to consolidate fundraising to as short a period as possible, ideally three months or less. In running a focused and efficient fundraising campaign, it can be important to lay out a plan prior to fundraising. To do this, you might want to identify all of the relevant target LPs and engage with connectors in your network to get warm introductions. Refer to VC Lab’s set of resources on ‘Leveraging your Network’ for more information.

This involves gaining a good understanding of the LP landscape. As explained in our guide on ‘The Best LPs for New VC Firms.’ large institutional investors may not always be the best source of capital for new firms, and fund managers can be better served focusing on HNWIs. In your planning, you can also start warehousing deals to bring into the fund in preparation to showcase LPs. Read VC Lab’s guide to ‘Warehousing Deals‘ for more information.’  

Setting a fund size

At times, new managers look to raise larger funds to incite change in their domains which can sometimes work against them as they’re considerably more challenging to close. When starting a new fund, even experienced GPs who have managed vast funds opt to start small since they can close quickly and scale their fund size in due time. 

Typically, fund managers must get from 10%-20% of the fund for a first close. As you might imagine, it can be much more challenging to close 20% of a $50M fund compared to a $10M fund. As Paul Bragiel, experienced fund manager and mentor at VC Lab says, it can be prudent to establish a ‘Minimum Viable Fund.’ Refer to VC Lab’s free resource on ‘Evaluating your Network’ to calculate your ideal fund size. 

Some LPs also do not look favorably at large audacious first fund sizes either. In an interview with VC Lab, when asked about an ‘LPs advice to VCs,’ Court Lorenzini, LP in over 15 funds, stated that it could be a point of concern to see new fund managers raise too large a first fund. 

1st close strategy 

Importantly, you may want to approach each of your closings with varying strategies. For your first close, it can be beneficial to target HNWIs who are more likely to invest. 

You can start with smaller check sizes in your first close while highlighting your track record of success to gain traction. This is because larger LPs often wait for the fund to operationalize before committing capital. Therefore, by raising a large fund focused on large institutional investors, you may find yourself in a conundrum. This strategy often does not yield a successful outcome as GPs cannot gain momentum in their fundraising efforts when speaking with LPs. Refer to VC Lab’s guide for more information on ‘How to Pitch LPs.’

You may want to take time to consider the minimum ticket size for your first close relative to the ideal number of LPs in your fund, which is ideally around 30 to 50. Below is a guideline for ticket sizes for each of your closes.

Min Ticket Threshold 1
Guidelines for minimum ticket sizes

Gaining traction 

Fundraising is a momentum game

Adeo Ressi

Often, successful fund managers leverage a first close to gain momentum for their 2nd and successive closes. This can be an essential concept in fundraising as it can contribute to helping new managers to get traction and efficiently close their first funds. 

Upon a first close, you can start operationalizing your fund and deploying capital to construct a portfolio. When doing so, it can be beneficial to invest in high-profile companies that can generate a quick markup in valuation, preferably in time for your second close. By displaying markups, you can demonstrate two things from the viewpoint of LPs. Firstly, you de-risk the fund as your LPs can take advantage of the markups. Secondly, you can exhibit your ability to get great deal flow and pick outstanding startups. To gain a more in-depth understanding of the viewpoint of LPs, refer to Adeo’s insightful conversation with Court Lorenzini on ‘The LP’s Perspective’.

As mentioned in your second close, you may want to adapt your fundraising strategy and shift your focus to more prominent investors, such as family offices. As shown in our minimum investment guidelines, you can increase your ticket thresholds with each consecutive close.

VC Lab runs Genesis, the four-month accelerator for venture capital firms and venture builders.

Cohort 6 starts in February and will help participants from around the world close on capital and start investing by June of 2022.

Learn more and apply here

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Insights Limited Partners

Interview: Court Lorenzini of DocuSign on being a LP

Watch the interview with Court Lorenzini, co-founder and former CEO of DocuSign, and LP in 15 funds with over 60 additional investments in early-stage companies across the world.

On the VC Asset Class

VC typically performs equally or better than other less risky assets

If you look at the asset class of private equity and sub-segment that down into startups you are looking across the ecosystem and saying “Where is this performing relative to other assets in my portfolio?”.

I’ve got many options to put capital to work and as an asset class even though this one is riskier it typically performs equally or better than what others would classify as less risky. To me, it’s a combination of asset allocation performance but also when you find managers who are outperforming they are generally radically outperforming. So you tend to pile up on those and that’s fun to watch and help those managers.

On VC Asset Allocation

I don’t have a specific number and I’m not aiming for a target amount with respect to my overall portfolio

This for me is a community with which I’m very comfortable. So as an asset class, I walk into this with my eyes wide open and I understand the risks, metrics and value. That being said, my portfolio to some might feel over-allocated to VC. I’ve probably got around 25% allocation in this class. 

But I’m not looking at the percentage. If I have a huge win in the portfolio I’m not really going to slow down my allocation to this asset class. I’m constantly looking at where my currently illiquid assets are and I have a bet that they’re going to become liquid at some point, or some portion of them will. So I’m not strict about that, to be honest.

On Evaluating New Fund Managers

I get very worried if I see a first-time manager saying they’re going to raise a giant sum of money

How much money I put into new fund managers really depends on many factors. I usually invest anywhere between $300k – $500k the first time out, depending on the extent of the manager’s track record. This gives me a feel of what this person will be like. Over the long term, I can put in around seven figures.

In evaluating a manager in the early stage, I firstly look at their deal warehouse, if they have any. I look at what those companies look like and talk with a few founders to see what really attracted them to this particular manager. I want to see if they have access to deal-flow that I want but am currently not exposed to. 

Importantly, I also look at the size of the fund they’re planning to raise and how they plan to allocate that. If a new fund manager says they’re raising a very large sum of money, that’s usually a red flag for me. To both raise and deploy large sums of capital is not a great thing for new managers. I also look at the size of the partnership, relative to the amount of capital being raised. I want to determine how many firms they can actually invest in or what they plan to invest in. Additionally, I look at how much time they’re willing to spend on each investment.

On Follow Up Investments

At this point, I can assess the fund’s performance

I have a couple of managers in the portfolio that have come back for second funds. I will say that in most cases I have re-upped with a bigger number in the second fund as generationally the funds get larger. 

I will put a certain amount of capital to work in the first fund and then wait to see how that performs. And then when they’re back in the fundraising mode I assess again and ask some questions. How do they pick? What are those companies looking like right now? Have they had any exits? Have they had any follow on investments? What do those look like? What are the things that they’re doing that make them stand out amongst fund managers?

On Sector Focus

I stick to markets in my experience base which is B2B Enterprise Software

One thing I check is if we are sector-aligned. I tend to know the sectors that I’m most comfortable in and can make a reasonable assessment. I tend to stick to my knitting in the sense that I’ll invest with folks that are going to build funds in areas that I probably have a deeper level of understanding.  

For example, there are some terrific pickers in the healthcare space and they’re successful as hell out there. However, because it’s not in my experience base it’s hard for me to initially judge whether they’re good or not. And so I tend to remain on the sidelines. 

There are lots of LPs who come from that space who are better suited. Flip that around and say enterprise software and consumer-facing companies, I know that space quite well. I’m very comfortable there and even climate, greentech as well as fintech, I can get comfortable with. So there’s a lot of spaces I’m okay with and there are a few sectors that I know I need to probably stay away from.

On Terms and Economics

Co-investment rights are very important to me

I have one other strong request that I make of all fund managers. I want to support the fund I want to be there and put a big chunk of money to work. But I also am very specific that when I make that investment, I also want co-investment rights when those opportunities present themselves. 

If the fund is looking for other people to jump in and add more money to the company it’s my expectation that I’m acting more like another venture investor than an adjunct to the fund in that context. So in such situations, I want no fees or carry on those co-investments as I’m in the fund already

On Being an LP

When they call I respond

I’m very active in the funds I’m an LP in. Again, part of my ethos is to operate in a way that not only provides capital but also my layers of experience to portfolio companies in the moments they need it. I’m always offering myself up to all the funds that I participate in as a resource and I’m extremely active in those funds.

As an LP, I want to economically grow the basket and put capital out where the entrepreneurs are, as opposed to pushing them into 5-10 economic centers. I think that model is tapped out. So as a significant backer of VC Lab, it’s important to me to back fund managers that are focused on undercapitalized and underserved markets. This is really important, however, these businesses must make economic sense. The deal still has to pencil out as that cannot be the only vector you judge.

One of our prime theses for myself and my wife is backing people from diverse backgrounds. We have a family foundation that my wife runs and we also have a for-profit entity that I run. In both of those, we look to deploy more than our fair share of capital to minorities and women investors, who themselves are investing in that sphere.

In Part 2 Court looks at the world of Venture Capital through the lens of an LP and shares his insights and advice for new fund managers.

Click here to continue reading.