This is part of a series that I’ve been working on called Understanding Venture Capital.
In one of the posts I spoke about how the size and vintage of funds might affect you when you’re raising money. This led Roy Rodenstein (whose company Going.com was sold to AOL) and others to discuss, what happens when VC’s need to invest across multiple funds. Specifically Roy commented
“your company may go long enough that its vintage fund gets cramped and you may get painted into a corner for followons. Even more complicated, VCs often invest from multiple funds or sub-funds into a single deal. So as an entrepreneur it’s hard to navigate those waters over time. As usual the rule is, if you’re doing well, they’ll find the money for your next round.”
Everything that Roy mentions is true. And VC’s don’t like to invest across multiple funds. I thought I’d do a quick post on why VC’s don’t like to cross funds so entrepreneurs can better understand the situation and how to talk with their investors about it.
As a reminder, VC funds are comprised of money from LP’s (Limited Partners) that include university endowments, pension funds, high-net-worth individuals, insurance companies and large corporations. In a single fund of $100 million you might have 30 difference LPs. So if a fund was raised in 2006 and the next fund was raised in 2010 it’s possible that they have two funds that “cross over” at the same time.
It’s technically possible that the VC still has a couple of new investments left from their old fund or even more likely it’s possible that they invested in your company from the end of Fund 1 and subsequently raised Fund 2. In a perfect world they “reserved” enough money from Fund 1 in order to continue to invest in your company from just one fund. But it’s possible that they have to “cross over.”
Why does the cross-over matter? As it turns out some of the LPs in Fund 1 might not have “re-upped” (e.g. invested again) in Fund 2. It’s also possible that some new investors joined Fund 2 that weren’t in Fund 1. So there isn’t a 100% correlation of investors across funds.
So if Fund 1 invested in your first round and Fund 2 invested in your second round, you can imagine the following scenarios:
– An investor who is only in Fund 2 wonders why the VC invested again in your company. Is their money being used to “protect” the investment that was made from Fund 1?
– Conversely, let’s say there is an investor in Fund 1 who didn’t “re-up” for Fund 2. He might be thinking, “whoa, you’ve got this killer portfolio company where my money was used to invest in this startup and now my money isn’t being used to follow on the previous round so I’m owning less of the company than I should.”
– Now, let’s get more ominous. Let’s say that the first round of investment in a startup was done at a $50 million pre-money valuation from Fund 1 but the company has severely underperformed. A totally new VC is willing to invest in the company but at a $15 million pre-money valuation. A condition of their investment is that the initial VC continue investing alongside them. And let’s say that VC now needs to invest from Fund 2. In this case the second fund might actually be used to “crush” the money from the first fund.
Given all of the conflicts you can see why investors would want to avoid crossing over funds.
How do they deal with these types of situations? First, VC’s have “advisory committees” that consist of a sub-segment of their LPs. These groups meet regularly to discuss fund issues such as “how to value the portfolio companies” and to get input on issues like “whether the VC is investing outside of its normal scope.” If it’s a simple cross-over issue the VC might bring the issue to a special advisory committee meeting.
For issues that are more complicated (such as the last scenario above) VC’s have something called a “conflict committee” that is designed specifically for issues that might be perceived as conflicts of interests. You can see clearly how this could be the case in scenario three. The conflict committee will help the VC decide what to do.
But here’s the thing. Most VCs like to raise their next fund from existing investors. It’s less risk and makes fund raising much easier since the LPs already know your firm. So VCs avoid these types of scenarios any time possible.
So how should you deal with this issue? Just make sure to know how big your VC’s fund is, what vintage it is, how many investments they have left in their fund, how much they’re “reserving” for follow on investment in your company and when they’ll be raising a new fund. You can’t just blurt out these questions because they’re sensitive topics. But when a fund offers you a term sheet and is interested in investing you can politely and cautiously approach some or all of these topics.
And if the VC is “at the end of their fund” and about to close a new one I would strongly recommend you talk to them about the “reserves” they have for your company and how they would deal with the issue of investing across funds if it were ever required. Hopefully it won’t be.
Note: I don’t have experience in dealing with these issues in 100’s of funds so it’s possible that other VCs have slightly different points-of-view. If anybody has any more information or thinks about these issues differently please feel free to add in the comments section.