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In recent weeks, we have heard a lot about founders being forced to change gears completely. So there's a lot of this going around…

The starting model


I think there's a lack of transparency in how the VC business is understood so I want to talk a little about how the pandemic can create certain situations for VCs – even regardless of how well their portfolio companies are doing.

Today's topic is to help founders understand "reserve management", i.e. how their investors think about making future capital allocation decisions – and how this could be affected in times of uncertainty.

I will be making a lot of generalizations because decision-making varies wildly based on where VCs are in the lifecycle of a certain fund.

Typically, funds have a 10-year life-cycle:
  • Years 1-3 for making fresh investments.
  • Reinvesting in existing companies until year 6.
  • And aiming to exit all investments by Year 10.

A firm that raises a fund in 2014, will aim to raise another in 2017 ("Vintage 2017"), and so on.
Each fund has a slightly different underlying investor base so, to mitigate conflicts of interests, each vintage of a fund invests in a discrete set of companies. This means VCs need to have strong views across certain fronts – here are a select few:

  • Portfolio construction
    "How many companies do I want to spread my capital across?"
    This can vary depending on the strengths of each firm – e.g. sector-specialised firms bias towards a lower number, but the typical target is about 30 companies.

     
  • First cheque vs. follow-on (reserves)
    "What share of the fund will make new investments? And how much will be reserved for reinvestment?" 

    Funds which allocate a large portion of capital to first-cheques sacrifice the ability to participate in companies that break out. 
    Firms often allocate around 60% capital to new investments and reserve 40% for follow-on.
     
  • Pacing
    In order to meet these numbers, firms need to manage their pace of deployment. 

    While relatively easier to manage for first-cheques, I find it's more reliable to rely on the opportunities in the market rather than the models on Excel. 
    If a portfolio company outperforms unexpectedly early, this can present difficult decisions. Should investors wait to see how some more of their portfolio performs or should they start doubling-down and tapping into reserves early?
The above allows funds to build a model of how they will allocate capital that plays to their strengths.

So let's take a hypothetical baseline: assume I'm targeting a $50mn seed-focused fund.

This gives me about $40mn of investable capital (after admin costs & management fees). I want to concentrate Series A's into ~60% of original bets, and Series B's into half of the Series A's.

Note: I have not used real numbers so round sizes don't map to reality in this model.

Here's how the strategy comes together:
Great, so that's the starting model.

While many things could go wrong with the portfolio, I'm going to focus on something a little simpler to model…

Unlike companies, funds often raise their capital over a period of time. A fund targeting a final size of $50mn may start investing as soon as they have 25% of that committed from investors, with the expectation that they will raise the remainder over the next 12-18 months.

So let's assume I've raised $25mn so far and, 6 months in, made this progress investing in line with my plan above:

And then, coronavirus strikes.

Any potential LPs (people & institutions that invest in funds) become suddenly bogged down with managing the other 95% of their portfolio that they don't want to invest in any new funds.

So now I'm stuck with half the target fund, of which half is already invested. On the fly, I've got to remodel my deployment strategy.

Maybe I decide something like this:

I don't have enough to do Series B's so that's the first to go. I would like to do enough Series A's but I have to ensure the Fund has enough companies (perhaps 25) so I'm not overexposed in one place.

This forces me to over-allocate first cheques, but with lower cheque sizes across the board to ensure I come out of this thing alive.
While most funds today are focused on existing portfolio, this is the kind of knock-on effect that can hit round sizes and, as it cascades, valuations.

As such, we may be seeing a lot more of this:
So for founders, it's important to have this conversation early, get a pulse of investor sentiment and calibrate a new strategy.

This is one of many things that can happen. Every situation is unique and I'm happy to share inputs – just hit reply.


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