Category: Fund Terms
Fred Wilson has a spectacular post up on how VC funds should think about reserves. It’s even more valuable to entrepreneurs so they can understand how the best VCs think about reserves, giving the entrepreneurs ammunition to ask their investors how they are thinking about reserves.
I only noticed one thing missing from Fred’s post which is a statement about cashflow which I commented on.
“Fred – phenomenal. The only thing I noticed missing was a comment on fund cash flow. To recycle, you have to have the cash flow. If you don’t have the exits to generate funds to recycle, you can hit a cash flow wall where your reserve model breaks (since you don’t have the cash to fund the reserves.) There are several solutions to this, including recalling capital, having an annex fund, and suspending management fees, but the best is having the cash in the first place …”
In addition to the post being great, the comments have a lot of rich stuff in them as well.
Q: What is the best path to take if a VC which has invested in my company closes down, but we have not exited and are still operating profitably ? What happens to the LLC entity that was formed at the time of investment? Do we ask the VC for our shares back or buy them back at a discount?
A (Brad): First, you need to understand what actually happened to your VC firm. There are lots of specific points in time to consider. Let’s start with two magic milestones – year 5 and year 10.
1. The VC is outside their five year investment period. Most VC funds have a five year investment period. This is the time frame in which they can make investments in new companies (those that they haven’t already invested in.) However, most funds last 10+ years and can be extended for many more years. In this case, even if a fund is outside of its investment period, it can still make follow on investments in your company.
2. The VC is outside their ten year fund period. As mentioned above, most funds last for 10 years. However, they often have two, one-year automatic extensions, resulting in a 12 year life. Beyond 12 years, the fund can continue to be extended to operate with approval from the fund’s investors (the LPs). Many funds end up operating for 15 – 20 years.
Now, in each of these cases, you’ll have two situations – the VC firm has raised a new fund or it’s hasn’t. If it has, then the firm itself is still “in business” even if the fund that has invested in your company is getting older. If the firm has raised a new fund in either case, then you have nothing to worry about. However, if the firm hasn’t raised a new fund by year ten, it’s like to be considered a zombie firm.
Now, these zombie firms may still be operating, managing their existing investments, but not making new ones. As time passes, and a firm clearly is not going to raise another fund, most of the partners move on to other things. And this can go on for a long time as long as there is at least one partner from the VC firm still engaged in managing it.
Ultimately, we come back to your question. What if the firm actually shuts down, either because the LPs won’t continue to support additional extensions, or the remaining partner doesn’t feel like continuing to manage things. There are a few different options.
1. Distribution of shares to a liquidating trust: In this case, the equity in your company held by the VC fund now belongs to a completely passive entity that is simply going to exist until the shares become liquid, either through a sale or an IPO.
2. Distribution of the shares to the LPs: Similar to #1, but you now pick up a whole bunch of new shareholders in your company, who were there LPs of the VC fund. No one really likes this option – LPs don’t want private company shares, the companies don’t want all the new shareholders, and the VCs likely have no upside after the distribution.
3. Managed liquidity of each company: In this case, the VC will sell off each company in whatever manner he can at the point of time, either via a secondary sale to another investor, or a sale of the shares back to the company. By this point, VC funds typically have two kinds of companies in them – ones that are worth something and ones that are worth nothing. The graceful VC knows the difference and behaves appropriately. The non-graceful VC tried to squeeze blood out of rocks.
Regardless of the situation or outcome, there isn’t a simple, straightforward one. This is compounded by the complexity of VC / LP relationships, private company dynamics, and the optimism of many investors that “something good will come in the future”, more formally known as “maintaining option value.”
Today, our friends at Techstars posted their model forms of seed financing documents.
There are five primary documents in the set:
Of course, these are just example documents so all legal disclaimers about usage apply (e.g. “do with them what you want, but we take no responsibility for your actions.”) That said, I think these are a great starting point for anyone doing an early stage financing.
Q: My client is looking for a 5 million dollar investment from a VC firm. What can he do to protect himself if he is worried that the VCs will acquire the rights to his product and then try to fire him and keep those rights? Does this happen often?
In addition, he anticipates that the new entity will generate tax losses in the early years and wants to share them with the VC. What can he do here? Finally, he would like to be able to force the venture to buy back his shares if after 5 years the company is still private. Can any of these things be done?
A: (Jason) Reputable VCs don’t engage in this type of behavior – funding and then stealing a company. For one, it’s not a repeatable model. If a VC acted this way, they wouldn’t have any deal flow to consummate future deals. More importantly, VCs invest in folks to run companies – we have no interest in running your company for you, as we have other investments that we monitor.
Also remember that VCs don’t acquire any rights to your product, they simply invest in the company that owns the rights, presumably. So the corporate entity is what controls the rights, not any particular person. If you question is how many CEOs leave the employ the company that they’ve created and raised money for, it’s a relatively small number. More interestingly, the vast majority of CEOs that leave companies do it by their election, not that of the VCs. Many CEOs are serial entrepreneurs and prefer starting companies, not running them after they become larger and more successful.
To answer your other couple of questions, neither of these will work. Since you will have to incorporate your entity as a c-corp, these loses won’t flow through to the VCs and even if they did, VCs can’t use these types of loses. As for the VC buy back – forget about it. That’s a non-starter. If I fund a company and can’t get liquidity, the founder certainly doesn’t have the right to get me to put even more money in to buy him/her out.
Q: Why don’t VCs invest in real estate? I have a great idea but I can’t get past the sentence where I mention it’s a real estate deal.
A: (Jason). We don’t invest in real estate because we don’t know what we are doing in that market. Okay, that was a little glib, but it’s true. VCs don’t / shouldn’t invest in sectors and themes that they don’t understand. Outside of some folks that I know who made some shrewd residential moves with their personal properties, I’d not want to trust my money to a VC doing a pure-play real estate deal.
Our investors don’t want us in that arena either, as evidenced that most of us have a charter of what types of deals we can and cannot invest in. For instance, a VC’s partnership agreements might say that they can “invest in the domestic technology industry in companies that do not require government approvals for the sale of their products.”
In this example, the VC could invest in U.S.-based technology companies, but not in any industry where the government would have to okay the sale of their portfolio companies products. Translation: this VC can’t invest in biotech (FDA approval) and better be careful about some media deals (FCC approval), etc. The VC would, however, be able to invest in a technology company that provides solutions to the real estate industry (think Zillow.com).
There are plenty of real estate development corporations out there who can much more effectively play in this space.
Question: I’ve always been curious, what are standard GP terms for venture funds? What carry percentages are there? How much do GPs actually put into funds?
Our Take: There is a range, but in terms of general economic terms:
– Management Fees: 1-3% of capital commitment. Smaller funds usually have a higher percentage. The norm is usually 2-2.5%. Note that after the first five years (when the period for making new investments normally ends), the percentage usually decreases.
– Carry: 15-35%. Mid-case is 20%. Some newer funds have lower percentages and some of the large top-tier funds have 30% and higher. Some funds have a scale whereby if they meet certain profit hurdles, their percentage increases.
– GP commitment: 1-5%. The trend over time is for the percentage to increase. This is both because investors want the GPs to have more skin in the game, but also because it’s a tax efficient way for GPs to receive compensation assuming they are successful.
Question: I understand that each fund has a time limit (5 to 10 years). What are the dynamics of the funds? Does a fund nearing the end of its term tend to try getting as many exits as possible (at any price)? What happens with portfolio companies after the end of the fund’s term? Is it true that they turn worthless, even “thrown to the dogs?”
Or is it the opposite? Does a fund with money nearing the end of its life-term tend to become “easier” or even desperate to find deals?
Our Take: VC funds have finite terms of life. Generally, funds have 5 years to make investments in new companies and have an aggregate of 10 years to harvest the fund. In addition, most funds have a provision which allows the fund managers to unilaterally exercise 2 one-year options to extend the life of the fund if necessary to maximize investor returns. In other words, think about a fund having two “lives.” The first “life” is the period of time that the fund may invest in new companies. The second “life” the fund may operate to manage its current investments, including follow-on investments.
To specifically answer your questions, a fund nearing the end of its life (10 to 12 years) will try to liquidate its investments in order to return value to its investors. After the fund hits its termination period, it must shut down and either distribute cash or securities to its investors. If the company is private, distributing securities is not feasible; therefore one does see VCs selling the fund assets. This isn’t a fire sale – there are plenty of professional buyers out in the market that purchase these types of assets. That being said, if the company is successful, the fund will have sold out too soon.
With respect to the first life, if the fund has excess cash and is getting near its 5 year cut off for making new investments, we have seen cases where the cash flows a bit looser out the door. Most reputable VCs, however have pretty good control over their cash available for new investments and plenty of deal flow, so normally we don’t see a rush to spend before the time period expires.