Thursday, July 9, 2009

How to Invest in a VC Fund

So you always wanted to be a partner in a venture capital fund? Well, here's how it works.

The following is Part 3 of my five-part series on how to invest in early stage technology companies as an angel investor or through an investment in a venture capital fund. Privately held companies in emerging technology sectors--such as nanotech, clean tech, biotech, info tech and new media--frequently have exciting upside potential that can only be fully harnessed by investing in them when they're in their infancy.

In Part 1, I gave a general overview of the playing field and in Part 2, I examined the stages of an emerging growth company’s lifecycle and the types of investment that it hopes to obtain at each relevant stage.

Here, I'm going to explain how you can invest as a limited partner in a venture capital fund.

When you invest in a venture capital fund, your role in the early stage company will be completely “hands off.” You're investing in the vision and/or track record of the venture capitalist and will rely on the venture capitalist to make and manage your investment decisions. It's crucial that you match your investment goals with venture capitalists sharing similar goals. For example, an investor that wants to maximize exposure to nanotech and its commercialization would not want to invest with a generalist venture capitalist or a venture capitalist focused on the Web 2.0, SaaS or cloud computing sectors.

Before you invest in a venture capital fund, there are several things to consider which I detail below the fold.

1. An investment in a limited partnership in a venture capital fund is long term and illiquid. Long term in this case typically means it will be 10 years before all of the fund's investments will be liquidated, sometimes even longer. Money will only be distributed to you as the venture capital fund liquidates these individual investments. There's no easy way for you to get your money back and there's typically no market for you to sell your limited partnership interest.

2. You'll be required to qualify as an “accredited investor.” For an individual, this means you must either have a net worth (or joint net worth with your spouse) in excess of $1,000,000; or have income exceeding $200,000 in each of the two most recent years; or joint income with your spouse exceeding $300,000 for those years; and a reasonable expectation of the same income level in the current year. Some funds have even higher net worth thresholds. If you're unable to meet the fund's investment criteria, they won't accept your investment.

3. The fund will require you to make a sizable upfront investment coupled with a substantial commitment for future investment. Most funds require, at a minimum, a $100,000 up-front investment with a minimum commitment in the $500,000 to $1,000,000 range. These numbers vary greatly depending on the size of the fund and the experience of the venture capitalist, however, they very rarely fall below these thresholds. The remaining bulk of your commitment will be tapped by the venture capital fund over a period of four to six years known as the "drawdown" period.

4. Investing in emerging technology companies is exceptionally risky and there's a strong possibility that a number of the venture capital fund's investments will be worthless and that none of these investments will see significant returns. The risk of losing all of your investment is higher when investing in a venture capital fund than when investing in public equities. However, it's probably lower than if you invest directly in companies as an angel or angel syndicate. The reason for this is twofold: You'll have exposure to a larger number of potential and actual investments through a venture capital fund; and the venture capitalists are theoretically better at identifying emerging trends and companies that are good bets than angels or angel syndicates.

Now, if you meet these criteria, can afford to have your capital locked in for a long period of time, and don’t mind the risk of substantial losses, the potential benefits are substantial--annual returns can often reach up to 30 percent for successful venture capital funds.

If you decide to pursue investing in a VC fund, you'll be given a private placement memorandum that describes the fund's objectives, the experience of the venture capitalists and the terms of your investment. It also includes a comprehensive “risk factors” outline that provides extensive detail on the various risks that you'll be assuming. You're also given the subscription agreement you must complete to make your investment and a copy of the limited partnership agreement that will govern the legal terms of the fund.

Familiarize yourself with these legal terms and consult with your attorney and other professional advisors before you pull the trigger. Bear in mind, the terms of the limited partnership agreement are typically not negotiable. This makes a certain amount of sense since the venture capitalist fund will usually have 20 to 30 different investors and may talk to hundreds of potential investors. These investors commit at different times and commit different amounts of money, so it would be extremely time-consuming and arduous to negotiate separately with all of them.

Now, if you were going to commit for a substantial percentage to the fund, then you'll have more latitude on terms and conditions. However, the typical individual investor is investing a relatively small amount when compared to the public pension funds and other large institutions investing and, consequently, he/she has relatively little bargaining power.

Fortunately, the terms of venture capital funds don't vary much from “market” rates that have evolved over the last 20 to 30 years. This can make it easier for you because you can simply check to see if the terms you're being offered are in the market range.

A few of the most common economic terms are the management fee, the carry, and reinvestment rights. Typically, governance rights for limited partners in venture capital funds are minimal.

The management fee is the lifeblood of a venture capitalist. This is the money that they live off of from day to day. Usually, the management fee will be a percentage of committed capital. That is, the total capital that everyone has committed to the fund, not the capital the fund has actually drawn down.

Traditionally, this fee has been 2 percent but anything from 1.5 to 2.5 percent is common, depending upon the size of the fund. With a larger fund, the percentage may be lower and vice versa for a smaller fund. This fee is taken annually and can add up relatively quickly. For example, if the fee is 2 percent, on a $200,000,000 venture capital fund, the venture capitalists collect $4,000,000 a year for 10 years-–or $40,000,000. And this is completely independent of whether they make good investments. Occasionally, the management fee will be capped at actual budgeted expenses or will scale downwards to reflect the fact that more work is required during the funds early years; however, a flat percentage is the norm.

The carry is the second form of compensation for venture capitalists. However, unlike the management fee, the carry is directly tied to success. The carry is the percentage of the fund's profits that the venture capitalist gets to keep, typically 20 percent. Often, the investors are guaranteed some ordinary rate of return on their investment (eg, 6 percent or 8 percent) that the fund must first deliver before the carry will kick in.

However, the latter distributions will be tiered up so that the venture capitalist ends up with 20 percent of all profits. Occasionally, there may be some deviation from the 20 percent figure, but this is rare. One thing to look for is whether the fund looks at the profits of the fund as a whole or on the profits from each individual investment. If the former, there's often a “clawback,” so that if an early portfolio company has a home run but all the rest are losers, you'll be able to take back the excess profits that are distributed to the venture capitalist.

Reinvestment rights are the right of your venture capitalist to take profits from early successes and reinvest them into new investments rather than pay them out to you and the other limited partners. This may be a good thing for you because it means you have more capital at work and, in a sense, this is free to you since the management fee doesn't apply to reinvested money. On the other hand, it may be a good idea to take some money off the table. Some form of reinvestment right, at least for the first few years, is relatively common. Just make sure you understand what it means to you.

The next part of this series will look in detail at angel investing and its important characteristics, including typical legal and business terms.
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Dividends and Preferences by Hank Heyming is licensed under a Creative Commons Attribution 3.0 United States License.