Can VC’s Invest Across Two Funds?

Posted on Apr 3, 2010 | 23 comments


Man JumpingThis 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.

  • http://www.5o9inc.com/ Peter Cranstone

    Mark,

    These really are a great set of posts, and help the Entrepreneur understand the workings of the VC business. However I would like to add something for the Entrepreneur here. VC's are not our customers and while it's important to understand how the business works, it's far more important to understand the customer problem you're solving. As they say, sales solves all problems.

    Secondly Entrepreneurs really need to understand that VC capital is both emotional and very subjective. I've seen (and I'm sure you've seen it) VC's invest in things that leave us (entrepreneurs) scratching our heads.

    It's ultimately their “Gold” and it's up to them how they invest it. Our goal should always be twofold – solve a real customer problem and drive to measurable, sustainable profitable revenue from volume. If we stay focused on that then funding becomes nothing more than a milestone vs. a goal.

  • http://david.ulevitch.com/ davidu

    Mark,

    There are funds like those at Sutter Hill Ventures that evergreen annually and never close. This helps to avoid the issues you describe.

  • http://bothsidesofthetable.com msuster

    Hey, Peter. I agree that being an entrepreneur is 95% about solving a customer problem. But I also feel it is important to understand how other facets of your business work and for many growth companies that includes VC. To me it's the equivalent thing as saying (in the US), I'm just going to put my money in the bank and not worry about that pesky FDIC insurance limit thing – or – having debt and not worrying about what those covenants mean. Capital is a part of growing a company and the better you understand how the capital flows the easier a time you'll have focusing on the customer.

    My goal in cranking out this set of posts was to have a repository for first-time CEO's who are going through the funding process so they'll better understand what they're dealing with. When I was raising money over a decade ago I certainly didn't know better.

    That said, you obviously understand that side of the equation. You're right that VC investing can be both emotional and subjective.

  • http://bothsidesofthetable.com msuster

    Ah … thank you for the addition. I forgot to talk about “evergreen” funds. These are funds that reinvest their profits on more companies rather than distribute all of their earnings back to shareholders. Some of these are even publicly traded. It's the minority in the VC business but it does exist.

  • http://www.5o9inc.com/ Peter Cranstone

    We're in violent agreement :) The posts are wonderful. They “illuminate” a somewhat mysterious process for the newcomers which is a great thing. It's simply amazing what's available for the first timer now. When I started understanding a term sheet was akin to CDO's. Now you can download them!

  • http://www.5o9inc.com/ Peter Cranstone

    Mark,

    These really are a great set of posts, and help the Entrepreneur understand the workings of the VC business. However I would like to add something for the Entrepreneur here. VC's are not our customers and while it's important to understand how the business works, it's far more important to understand the customer problem you're solving. As they say, sales solves all problems.

    Secondly Entrepreneurs really need to understand that VC capital is both emotional and very subjective. I've seen (and I'm sure you've seen it) VC's invest in things that leave us (entrepreneurs) scratching our heads.

    It's ultimately their “Gold” and it's up to them how they invest it. Our goal should always be twofold – solve a real customer problem and drive to measurable, sustainable profitable revenue from volume. If we stay focused on that then funding becomes nothing more than a milestone vs. a goal.

  • http://david.ulevitch.com/ davidu

    Mark,

    There are funds like those at Sutter Hill Ventures that evergreen annually and never close. This helps to avoid the issues you describe.

  • http://bothsidesofthetable.com msuster

    Hey, Peter. I agree that being an entrepreneur is 95% about solving a customer problem. But I also feel it is important to understand how other facets of your business work and for many growth companies that includes VC. To me it's the equivalent thing as saying (in the US), I'm just going to put my money in the bank and not worry about that pesky FDIC insurance limit thing – or – having debt and not worrying about what those covenants mean. Capital is a part of growing a company and the better you understand how the capital flows the easier a time you'll have focusing on the customer.

    My goal in cranking out this set of posts was to have a repository for first-time CEO's who are going through the funding process so they'll better understand what they're dealing with. When I was raising money over a decade ago I certainly didn't know better.

    That said, you obviously understand that side of the equation. You're right that VC investing can be both emotional and subjective.

  • http://bothsidesofthetable.com msuster

    Ah … thank you for the addition. I forgot to talk about “evergreen” funds. These are funds that reinvest their profits on more companies rather than distribute all of their earnings back to shareholders. Some of these are even publicly traded. It's the minority in the VC business but it does exist.

  • http://www.5o9inc.com/ Peter Cranstone

    We're in violent agreement :) The posts are wonderful. They “illuminate” a somewhat mysterious process for the newcomers which is a great thing. It's simply amazing what's available for the first timer now. When I started understanding a term sheet was akin to CDO's. Now you can download them!

  • http://www.emergingenterprisecenterblog.com/ Dave Broadwin

    Great post. As you point out it is just good business for entrepreneurs to understand the concerns and constraints of their investors. This issue quickly gets beyond the point where any entrepreneur can influence it. For example, investments made after yours can affect reserves. And, strangely enough, triage in the VC portfolio can make money more available (if you survive). Once you are in the B or C round and you have three or four VCs there is little you can do, beyond knowing about the issue.

  • http://how2startup.com/ Roy Rodenstein

    Thanks Mark, was aware of most of these issues but as usual it's great that you throw out 4-5 real-world examples that cover the bases.

    And Peter, agree, I learned most of this stuff at Double-Secret Entrepreneur Wilderness Camp, but I am glad there is more info now and happily help; starting a company is hard enough without the spy games.

  • http://www.emergingenterprisecenterblog.com/ Dave Broadwin

    Great post. As you point out it is just good business for entrepreneurs to understand the concerns and constraints of their investors. This issue quickly gets beyond the point where any entrepreneur can influence it. For example, investments made after yours can affect reserves. And, strangely enough, triage in the VC portfolio can make money more available (if you survive). Once you are in the B or C round and you have three or four VCs there is little you can do, beyond knowing about the issue.

  • http://how2startup.com/ Roy Rodenstein

    Thanks Mark, was aware of most of these issues but as usual it's great that you throw out 4-5 real-world examples that cover the bases.

    And Peter, agree, I learned most of this stuff at Double-Secret Entrepreneur Wilderness Camp, but I am glad there is more info now and happily help; starting a company is hard enough without the spy games.

  • OSU_Matt

    Hey Mark, Great post again, and a good series indeed about demystifying venture capital and some of the intricacies of financing. I have an angle that I would be interested on seeing you comment on here or maybe in a future post (I apologize if this has been addressed in another article which I am unaware of). I'm curious about does it really matter significantly if you “fit” the standard profile of the fund (I guess both in regards to whether you get funding and what it may say to future investors). For example, as an intern for one of the two VC's in Columbus, a good amount of local entrepreneurs and companies stay in touch with our firm. However, say a tech company from Silicon Valley were to one reason or another get in touch with our firm and we were to invest in a Series A round. When they went to raise money at a later date, would you guys at GRP or other West coasts firms think there might be something slightly wrong with the product/leaders/concept etc. since they went from the mecca of tech to middle-america to a smallish VC? This may somewhat apply to the signaling article you completed earlier, but I don't believe you specifically addressed how fitting the criteria of the fund (location, industry etc) affected industry view of the company. Thanks again Mark and hope you and your family had a marvelous weekend, Matt

  • OSU_Matt

    Hey Mark, Great post again, and a good series indeed about demystifying venture capital and some of the intricacies of financing. I have an angle that I would be interested on seeing you comment on here or maybe in a future post (I apologize if this has been addressed in another article which I am unaware of). I'm curious about does it really matter significantly if you “fit” the standard profile of the fund (I guess both in regards to whether you get funding and what it may say to future investors). For example, as an intern for one of the two VC's in Columbus, a good amount of local entrepreneurs and companies stay in touch with our firm. However, say a tech company from Silicon Valley were to one reason or another get in touch with our firm and we were to invest in a Series A round. When they went to raise money at a later date, would you guys at GRP or other West coasts firms think there might be something slightly wrong with the product/leaders/concept etc. since they went from the mecca of tech to middle-america to a smallish VC? This may somewhat apply to the signaling article you completed earlier, but I don't believe you specifically addressed how fitting the criteria of the fund (location, industry etc) affected industry view of the company. Thanks again Mark and hope you and your family had a marvelous weekend, Matt

  • OSU_Matt

    Hey Mark, Great post again, and a good series indeed about demystifying venture capital and some of the intricacies of financing. I have an angle that I would be interested on seeing you comment on here or maybe in a future post (I apologize if this has been addressed in another article which I am unaware of). I'm curious about does it really matter significantly if you “fit” the standard profile of the fund (I guess both in regards to whether you get funding and what it may say to future investors). For example, as an intern for one of the two VC's in Columbus, a good amount of local entrepreneurs and companies stay in touch with our firm. However, say a tech company from Silicon Valley were to one reason or another get in touch with our firm and we were to invest in a Series A round. When they went to raise money at a later date, would you guys at GRP or other West coasts firms think there might be something slightly wrong with the product/leaders/concept etc. since they went from the mecca of tech to middle-america to a smallish VC? This may somewhat apply to the signaling article you completed earlier, but I don't believe you specifically addressed how fitting the criteria of the fund (location, industry etc) affected industry view of the company. Thanks again Mark and hope you and your family had a marvelous weekend, Matt

  • Aditya Kapil

    Where might one get actual data on VCs who have done this?

  • Aditya Kapil

    Where might one get actual data on VCs who have done this?

  • http://bothsidesofthetable.com msuster

    done what?

  • http://bothsidesofthetable.com msuster

    done what?

  • ravibjain

    Can you provide examples of some VCs who invest into the same company across different funds….

  • ravibjain

    Can you provide examples of some VCs who invest into the same company across different funds….