How To Raise a Venture Capital Fund
Over the last 4 years, I have raised around $400M across different vehicles from many different types of investors. Today I am going to break down the early stages of how to raise a venture capital fund and then stay tuned for a follow-up to this where we will break down a fundraising deck for a fund, what to do, what not to do etc. But to the first element.
Your Fund Size is Your Strategy:
The most important decision you will make is the size of fund you raise. So much of your strategy and approach will change according to your fund size target (LP type, messaging, documentation, structure etc). Remember, your fund size is your strategy. If you are raising a $10M Fund, you are likely writing collaborative checks alongside a follower, if you are raising a $75M fund, you will likely be leading early-stage seed rounds. These are very different strategies and ways of investing.
MISTAKE: The single biggest mistake I see fund managers make is they go out to fundraise with too high a target fundraise. One of the most important elements in raising for a fund is creating the feeling of momentum in your raise. The more of the fund you have raised and the speed with which you have raised those funds dictate that momentum. So the smaller the fund, the easier it is to create that heat and momentum in your raise.
LESSON: Figure out your minimum viable fund size (MVFS). Do this by examining your portfolio construction. In other words, how many investments you want to make in the fund (the level of diversification) and then alongside that, the average check size you would like to invest in each company. Many people forget to discount the fees when doing this math and so the traditional fund will charge 2% fees per year and so across the life of the fund (usually 10 years), that is 20% of the fund allocated to fees.
We are raising a $10M Fund.
20% is allocated to fees for the manager and so we are left with $8M of investable capital.
A good level of diversification for an early-stage fund is 30 companies and so with this fund size, I would recommend 32 investments with an average of $250K per company. That is the $8M in invested capital. Big tip, I often see managers raising a seed fund and are only planning to make 15 investments, this is simply not enough. You have to have enough diversification in the portfolio if you are at the seed stage. No one is that good a picker. Likewise, I sometimes see 100 or even 200 investments per fund, this is the spray-and-pray approach, and although works for some, your upside is inherently capped when you run the maths on fund sizes with this many investments.
A big element to point out in this example is we have left no allocation for reserves. For those that do not know, reserves are the dollars you set aside to re-invest in existing portfolio companies. Different funds reserve different amounts, on the low end there is 0% reserves and on the high end some even have 70% of the fund reserved for follow-on rounds.
In this example, given the size of the fund being $10M with a seed focus, I would recommend we have a no-reserves policy. Any breakout companies you can take to LPs and create SPVs to concentrate further capital into the company. This is also better for you as the manager as you then have deal by deal carry on the SPVs that are not tied to the performance of the entire fund.
So now we know we know $10M is our MVFS as we want to make at least 30 investments and we want to invest at least $250K per company. Great, next step.
Set a target that is on the lower end, you can always have a hard cap that is significantly higher but you do not want the target to be too far away that LPs question whether you will be able to raise the fund at all. This is one of the biggest reasons why many do not invest in a first time fund, they are unsure whether the fund will be raised at all.
Alongside the size of the fund, the team composition is everything, simply put, LPs like managers who have invested in the stage you are wanting to invest in moving forward. They like to see track record.
IMPORTANT: I see so many angels write checks into breakout Series B companies and then go out and try and raise a seed fund with this as their track record. Do not do this, this does not prove you are a good seed investor but merely shows you have access at the Series B. These are very different things.
With regards to track record, in the past, TVPI or paper mark-ups were enough, now there is a much greater focus on DPI (returned capital to investors). LPs want to see that you have invested before at that stage and they also want to see that the team has worked together before. You want to remove the barriers to no. If you have not worked with the partners you are raising with before, LPs will have this as a red flag, and as team risk, it is that simple.
Navigating the World of LPs (Limited Partners)
The size of the fund you are raising will massively dictate the type of LPs that will invest in your fund.
MISTAKE: You have to change your messaging and product marketing with each type of LP you are selling to. A large endowment fund will want a very different product to a Fund of Funds.
Example: If you are a large endowment, you will invest in early funds but you want the manager to show you a pathway to them, in the future, being able to take not a $10M check but a $50M check from the endowment. Whereas the Fund of Funds will likely want you to stay small with each fund. So when discussing fund plans, it is crucial to keep these different desires in mind.
If you are raising a $10M fund, you will be too small for institutional LPs and will raise from individuals and family offices. An LP will never want to be more than 20% of the LP dollars in a fund and so the size at which an institutional LP (really the smallest fund of funds) would be interested is when you raise $25M+ and they can invest $5M. Generalisation but a good rule of thumb to have.
LP Composition of Your Fund:
Speaking of one LP being 20% of the fund dollars, it is helpful to consider the LP composition you would like to have for your fund. The most important element; you want to have a diversified LP base. A diversified LP base is important in two different forms:
We will see the death of many mico-funds ($10M and below). Why? The majority raised their funds from GPs at larger funds and from public company founders. With the changing market environment, most GPs are no longer writing LP checks and most public market founders have had their net worths cut in half by the value of their company in the public market and so likewise, are no longer writing LP checks. In this case, the next funds for these funds will be in trouble as their core LP base is no longer as active as they used to be. We are seeing this today.
Going back to the question of diversification, my preference and what we have at 20VC, the majority of dollars are concentrated from a small number of investors. Of a $140M fund, we have $100M invested from 5 large institutions. These are a combination of endowments, Family Offices, a High Net Worth Individual and a Fund of Funds. The remaining $40M originates from smaller institutions or individuals, for us we have over 50 making up that final $40M. For me, I really wanted to have a community around 20VC Fund and so we have over 40 unicorn founders invested personally in the fund as LPs.
Bonus Points: The best managers select their LPs to play a certain role or help with a potential weakness the manager has. For example, I was nervous I did not have good coverage of the Australian or LATAM startup market and so I was thrilled to add founders from Atlassian, Linktree, Mercado Libre, Rappi and Nubank as LPs to help in regions where I do not have such an active presence. If you can, structure your LP base to fill gaps you have in your ability.
Status Check In:
Now we know our minimum viable fund size, we know the team composition we are going out to raise with, we know the LP type that we are looking to raise money from and we know how we want our desired fund cap table to look.
Now we are ready to move to the LPs themselves.
Fill Your Restaurant with Friendlies:
As I said, the appearance of your raise having heat and momentum is important.
Mistake: The biggest mistake I see early fund managers make is they go out to large institutional investors that they do not have an existing relationship and spend 3-4 months trying to raise from them. They lose heat, they lose morale and the raise goes nowhere.
Whatever fund size you are raising, do not do this. Fill your restaurant with friendlies first. What does this mean? Go to anyone you know who would be interested in investing in your fund and lock them in to invest. Create the feeling that progress is being made and you have momentum.
BONUS POINTS: The best managers bring their LPs with them for the fundraise journey. With each large or notable investor that invests in your fund, send an email to the LPs that have already committed to let them know about this new notable investor. This will make them feel like you have momentum, they are in a winner and many will then suggest more LP names, wanting to bring in their friends.
MISTAKE: Do not set a minimum check size, some of the most helpful LPs in all of my funds have been the smallest checks. Setting a minimum check size will inhibit many of the friendlies from investing and prevent that early momentum.
The bigger the name the incoming investor has the better. You can use it for social validity when you go out to raise from people you know less well or not at all. Different names carry different weight, one mistake I see many make is they get a big name invested in their fund but it is common knowledge to everyone that this LP has done 200 or 300 fund investments, in which case, it does not carry much weight that they invested in your fund. Be mindful of this as it can show naivety if you place too much weight on a name that has invested in so many funds.
Discovery is Everything:
The world of LPs is very different to the world of venture. 99% of LPs do not tweet, write blogs or go on podcasts. Discovery is everything. When I say discovery I literally mean finding the name of the individual and the name of the organization that is right for you to meet.
This can take the form of several different ways but the most prominent for me are:
Bonus Point: The top 1% of managers raising will already know which LPs are in the network of the LP that has just committed and will ask for those 3 specific intros. They will then send personalized emails to the LP that has just committed. The LP is then able to forward that email to the potential LP you want to meet. You want to minimize the friction on behalf of the introducer and so writing the forwardable email is a great way to do this.
Mistake: Many VCs do not like to introduce other managers to their LPs as they view it as competition. This is moronic. If the manager asking for the intro is really good, they will raise their fund with or without your intro. If they are not good, then you can politely say it would not be a fit for your LP and move on. Do not be too protective of your LPs from other managers.
MISTAKE: LPs invest in lines, not dots. Especially for institutional LPs, it is rare that an institution will meet you and invest in you without an existing relationship and without having followed your work before. A mistake many make is they go to large institutions and expect them to write a check for this fund, it will likely be at best for the fund after this one or most likely the third fund. This does not mean you should not go to them with your first fund but you should not prioritize them and you should not expect them to commit. I would instead go in with the mindset of we are not going to get an investment here, so I want to leave the room understanding what they need to see me do with this first fund, to invest in the next fund. The more detailed you can get them to be the more you can hold them to account for when you come back to them for Fund II.
Example: If they say, we want to see you are able to price and lead seed rounds and we are not sure you can right now. Great. Now when you come back to them in 12 months' time, you can prioritize the fact that you have led 80% of the rounds you invested in, and their core concern there has been de-risked.
In terms of how I think about LP relationship building, I always meet 2 new LPs every week. I ensure with every quarter, I have a check-in with them and ensure they have our quarterly update. This allows them to follow your progress, learn how you like to invest, and communicate with your LPs. It also really serves to build trust. Doing this not in a fundraising process also removes the power imbalance that is inherent within a fundraise and allows a much more natural relationship to be created.