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August 3, 2011

Should You Care About Your VC’s Investors?

I recently chimed in on this question in Quora: Do venture capitalists need approval from their investors before making an investment in a company?

Then
I thought about what my answer would be from a portfolio company
standpoint. Should a company care about the profile of the limited
partners in the VC’s fund?  The answer is … not really.

First, let’s start with the fundamentals. Venture capital firms
are comprised of a series of funds. Each fund is, to a large degree,
independent of the others and must live on its own when it comes to the
companies in its portfolio.  So one company that receives funding from
Fund I will be subject to different dynamics compared to another
company that received funding from Fund II.  Funds within one firm vary
in size from another, with the earlier funds typically being smaller
than the later funds (unless the VC firm is running into challenges and
has had to shrink its fund size).

The larger the change in fund
size over that time, the bigger the change in the investment profile of
the firm.  For example, larger funds equal larger investments in
larger companies. Big funds that focus on early stage businesses have
to either over-fund their companies (the need to write big checks) or
spread the money over a large number of companies (the Pray-and-Spray
strategy).  The ideal situation is to have a fund that’s sized to the
stage of companies (e.g., “Our fund is on the smaller side of a
mid-sized VC fund because we focus on expansion stage companies.”)

Funds
are primarily funded by investors who are referred to as limited
partners (LPs). These investors can range from wealthy individuals to
pension funds to estate funds to funds of funds, and so on. Each type
of LP has his or her own investment parameters and expectations.  Once
an LP makes a commitment to one of a VC firm’s funds, they are expected
to continue participating in subsequent funds. Unless the strategy of
the VC deviates significantly from that of the LP, which may compel the
LP to pass on the next fund.

LPs pay their VC funds in two ways. One is the management fee (typically 1.5-2.5% of the fund size annually) to pay for the day-to-day operations of the firm. Second is the profit share,
or carry (typically 20-25% of the profits generated to the overall
fund).  One of the big issues with VC compensation is how much the
management fees go to make the VC partners wealthy versus the carry.
Ideally for the LP, the VC partners wealth would only be generated
through the carry.

So what would the nature of the LPs of a VC firm tell you about that firm?

VC firm credibility: The quality of a VC can often be judged by the quality of its LPs. High-quality LPs invest in high-quality VCs.

VC firm stability
Is the LP base stable, or is there significant turnover in LPs from
fund to fund?  Is there LP concentration, which would increase the risk
of turnover? Are the LP funds stable enough to continue funding the VC
over time?

Exit Pressure: Are the LPs
pressuring the VC for exits? What is the hold period that LPs are
pushing for and how does it vary from the VCs period? How does either
period differ from yours?

Overall, you should not have any
worries about your VCs investors. Ultimately, your focus should be on
the VCs investment model and how fund it aligned with it.

Key elements you should be concerned about:

  1. Investment strategy:
    What is it, and does your company fit within it?  Does the VC invest
    in companies at your stage or are you too early/late for them? Is the
    amount of funding you need too little/much in matching the size of the
    overall fund?  What is the average hold time the VC aims for and does
    that meet with your aspirations?
  2. Value: Every
    VC will claim to bring value. What specifically does the VC do to
    deliver that value? What are specific examples of initiatives that the
    VC delivered on for other portfolio companies?
  3. Domain expertise: Does the VC have domain expertise in your sector? Does that matter?
  4. Cultural fit:
    Perhaps the most important element. Do you and the other board members
    see yourselves getting along with the VC partner? Is there good
    chemistry?

For more on raising money, check out these posts on the trick to raising VC money and if you should syndicate an investment.

Firas Raouf is a Venture Partner with OpenView Venture Partners.  You may find this post, as well as additional content on OpenView's blog located here.  You can also follow Firas on Twitter (@fraouf) by clicking here