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What does an LP look for in a venture capital fund manager?

Sixth in a series of weekly posts by myself and Nicholas Lovell of Gamesbrief which answer the fifty questions you should ask before raising venture capital.  We expect the series to run for a year after which we will collate the posts into a book.  You can find the rationale behind the series here, and the list of questions here.  We welcome your comments on any and every aspect of what we are doing.

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ScreenShot051 Let me start by explaining two terms in the question. 

‘LP’ is a generic term for an investor in a venture capital fund. Typically they are pension funds or insurance companies (otherwise known as ‘institutional investors’), but they can also be corporates, wealthy individuals or governments looking to stimulate the startup ecosystem.  LP is short for Limited Partner, a reference to the legal status of investors in venture capital funds – technically they are partners in the fund with limited rights and obligations.  I covered this in a little more detail when I answered the question Where do VCs get their money from?

A ‘venture capital fund manager’ or sometimes ‘venture capitalist’ is the team of people that decide which companies to invest in and then manage them to exit, they are often known as the ‘GP’ or ‘general partner’.  A GP can have multiple funds under management at any one time and they are compensated according to the terms of the GP agreement for each fund which determines the fees and profit share they receive.  I covered this in a little more detail when I answered the question What is venture capital?

Turning to the question du jour, the first thing that an LP looks for in a venture capital fund manager is track record.  In venture capital past success is a very good indicator of future success, unlike many other asset classes.  Entrepreneurs like to work with investors who have shown an ability to make money and hence VCs with a good track record stand a better than average chance of getting into the best deals and therefore making more money.  Additionally VCs who have had good success have typically built strong networks on the back of that success and are more able to help their companies with introductions to customers and partners.

The next thing an LP will look for is to see that the team has worked together before.  Ideally they have all worked together in the same manager and developed a good track record together.  Alternatively, if the individuals have worked together in past lives then that might be enough to get the LP comfortable.

After that the LP will look to the fund structure/strategy – how many investments of what size and in which geographies and sectors the fund manager intends to make.  There are some basics that have to be got right – e.g. the team needs to be large enough to make the planned number of investments when taking into account their commitments to earlier funds, the fees need to be sufficient to cover the planned expenses of the manager.  Some other elements are more subjective and will appeal differently to different LPs – e.g. which sectors the GP intends to invest in (cleantech, internet etc.).

Finally, if the LP is comfortable on the three items above they will start to look to the terms of the venture fund of which the most important by far are the fees (typically 1.5-2.5% of funds under management) and the profit share or carried interest (typically 15-25% of profits, often after a basic return has been delivered).  LPs look through these percentages to see how much money the partners in the GP will get and as a result larger funds are usually nearer the bottom of the ranges given, whilst smaller funds are able to get nearer the top.  More successful funds are able to command higher fees and carry.

The first three items (track record, team history, strategy) are typically go or no-go gating items whereas the terms are more of a negotiation. 

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  • http://www.gamesbrief.com Nicholas Lovell

    The “good VCs get better deals” is an interesting angle when it comes to luck. In other words, you could say that the secret to being a good VC is to get lucky once, because once you have a reputation for being lucky, LPs and entrepreneurs want to talk to you.

    Of course, I don’t believe in luck, or rather, I believe luck happens and lucky people are those who find ways to be open to lucky situations. So VCs, more than most, need to open to the possibility of Black Swans, and be ready to capitalise on that success.

  • http://www.alanodea.com alanodea

    Guys great work so far my one comment about this recent post is simplay to ask is this not a bit high level for a focus on the games industry and a book.

    Not all games industry guys get VC that got to be like 1-5% of all games companies raise form Institutions.

    Moreover I think it’s a bit high level to be talking about where VC’s get their money and the value chain of the VC industry.

    It might be more valuable to focus on what sort of funding levels VCs look to invest at and what sort of returns and equity splits their looking at i.e. more tactical and less strategic VC value chain issues.

    As a games company owner looking for funding I don’t need to know where VC’s money comes from I am much more interested in their measures and criteria from investment.

  • http://www.alanodea.com alanodea

    Hey guys great series and articles so far my comment is about relevance for this post if the series is fifty questions you should ask before raising venture capital.

    It might be more valuable to focus on what sort of questions to ask your potential VC partner i.e. more tactical advice and less strategic and VC value chain issues.

    As a company owner looking for funding I don’t care where my VC money comes. I’ve never had had my board members, investors, co-founders or managers ask me about what a LP is and how a VC raises its money.

    Nor am I going to be sitting down over tea talking to VC partners about their own fund raising struggles, strategies and hardships :) I wouldn’t expect my VC to share that information with me or any other company or company owner looking to raise money with them.

    If it is fifty question you should ask before raining venture capital

    The next questions in the series to my mind are filling in more detail on what a VC is looking for and what does it involve for a company owner when and if they decide to chase and secure VC funding.

    So questions such as
    • How much do they invest?
    • What are the typical format and criteria for investment?
    • What returns and timeframes do they expect a company to deliver?
    • How will they work with the company i.e. does investment require board positions, special share privileges and voting right?
    • What is the general process of getting VC investment?
    • How long will it take?

    Beyond that if you think it’s really important to focus on LP’s and talk about the fact that VC’s manage their own investors funds then a further output of this post might be some questions a company owner should ask when performing diligence on their potential VC investor?

    • Has the VC currently got a viable fund under management?
    • Can they invest?
    • What will they invest in?
    • How much of that fund is current invested and not invested?
    • When does the current fund end?
    • When are they expecting to see returns on that fund for their own investors?
    • What terms and RoI are they supposed to deliver to their investors?
    • What other companies have they invested in for that fund?
    • How many failures, successes and exits have they achieved so far with their fund?
    • Can I talk to owners of other companies in the fund and have you got contacts for them

    A good VC should have all of this information on hand and a good entrepreneur founder should have these questions lined up if their getting to a term sheet with a VC.

  • http://www.theequitykicker.com brisbourne

    Luck begets success and success begets success, so you are right. As a VC you don’t get that many chances to be lucky though, so you have to maximise your chances of being fortunate by a) being smart and getting into places where you are more likely to be lucky, and b) working hard and being busy – so you are in more of those places

  • http://www.theequitykicker.com brisbourne

    Thanks for the feedback Alan. We will endeavour to keep our posts more relevant to entrepreneurs.

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  • http://www.techfrill.com/ Paras Sharma

    In coming years the industry is likely to mature very fast and have an industry model that is more or less apparent. this will somewhat change the way the venture capitalist invests. But the fundamental needs might remain the same. a great team capable of having open communication,up holding a deep vision. and a ready market.

  • http://www.theequitykicker.com brisbourne

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