When investing in a VC fund, investors are relying on the investment firm that manages the fund (commonly known as the fund manager or sponsor) to pick successful startups on their behalf. As a result, the criteria for evaluating a fund investment are different from those applicable when evaluating an investment in a single business, and there are specific factors to consider. These include the relevant investment firm’s investment thesis, reputation, team, and the fund’s investment terms and structure.
We’ve created a short guide to help investors learn more about VC fund investment opportunities.
Most VC funds have a clearly defined investment strategy and thesis. A fund’s investment thesis is the strategy that the fund commits to following to generate returns for its investors. The thesis will typically identify the sector, stage, and geography of target investments.
Sector: Is the fund sector specific or generalist?
Normally this information will be clearly highlighted on a fund manager’s campaign page and website, as managers are keen to attract inbound deals from startups that are a fit for their investment thesis. For example, JamJar Investments focuses on funding consumer startups, and SuperSeed focuses on investments into B2B Saas businesses.
Stage: At what stage in a company’s lifecycle does the fund invest?
Some funds may exclusively invest in the seed rounds of investee companies, others are exclusively later stage, and some make investments across multiple funding rounds (commonly known as stage agnostic). The stage at which a fund invests impacts the risk profile of investments, and the timeline to exit.
However, even funds whose investment strategies state that they invest at seed stage (or later) will often invest in the later funding rounds of their best performing portfolio companies. This allows the fund to double down on its commitment and ensure that its equity stakes are not diluted by later stage investors (see the ‘‘Follow-on/reserves’’ section below).
Some funds are limited to individual countries or regions, for a number of reasons. EIS and SEIS funds, for example, are limited to investing in UK companies in order to ensure that their investors qualify for tax relief. To learn more about tax relief, take a look at this article.
Cheque sizes: What are the average ticket sizes the fund’s investments?
This typically varies depending on the fund stage and size. SFC Capital’s Angel Fund XII SEIS invests tickets from £10k at the earliest possible stage, whereas EQT Ventures’ minimum investment is €1m.
Portfolio size: What is their target portfolio size?
This will impact the overall diversification of the fund. If the fund is planning to invest in 10 companies, investors’ capital will only be diversified across 10 investments. A fund of the same size investing in 50 businesses will be better diversified, but have less of a stake in each business.
The number of investments a venture capital fund intends to make matters because a significant proportion of the early stage companies a venture capital fund invests in will fail or will only be exited for a modest return. Funds rely on a handful of highly successful investments to generate most of the fund’s returns to its investors. The more investments a fund can make, the higher the chance it has of picking a winner!
Follow on/reserves: Does the fund reserve some capital for follow on investments or prefer to build a larger portfolio?
Many funds like to reserve capital to allow for follow on investments. This means that if a business is doing well and raises further financing at an increased valuation, the fund can defend its stake from dilution and double down on its winners.
Investors should ask themselves ‘does the strategy align with my risk profile, time horizons and portfolio construction?’
Investment firms that manage VC funds can come in many shapes and sizes. Some firms launching their first fund may be run by one partner with relevant experience. More established firms with multiple active funds can have hundreds of employees across investment, BD, admin, finance, and all other functions you’d expect at a business of that size.
Experience: What is the experience of the fund manager?
It’s important to check the experience of the fund manager’s team to feel confident in their ability to find the best startups, evaluate and invest in those startups, and help their investments succeed. Some managers will be exited founders, former startup operators, or perhaps investors with sector expertise.
Deal origination: How are team originating quality deal flow?
Some funds rely on well networked partners with a wealth of experience and connections to get access to the best deals. Other funds have large teams of associates attending conferences and other events, actively scouring the market for the best deals. The strength of a fund manager’s brand presence and network within the startup ecosystems of its target geographies will be key to its ability to source investments in high growth companies that are likely to produce outsized returns for the fund.
Advisers: Does the team have advisers or an entrepreneur in residence working with them with additional sector expertise?
If funds feel their team is lacking key sector expertise, they may hire advisors with the relevant knowledge.
Fund series: i.e. Are they first time fund managers or is this fund V.?
Whilst past results are not a reliable indicator of future performance, experienced managers will have gone through the cycle of fundraising, investing, managing portfolio companies, exiting and returning funds to investors before.
First time managers don’t need to be ignored – every successful manager was a first time manager once!
Performance metrics: Have they published performance metrics for previous funds such as MOIC or IRR?
Funds can deliver performance and track record in a number of ways and via a number of metrics:
- Internal Rate of Return (IRR): The internal rate of return (IRR) shows the annualized percent return an investor’s portfolio company or fund has earned (or expects to earn).
- Multiple on Invested Capital (MOIC) – Also known as Gross MOIC, Book Value on Invested Capital, and Multiple on Money (MOM), MOIC compares the value of your current investment to the amount of money you put into it.
First time managers may also incorporate performance of angel investments previously made, as they don’t have a track record for their fund performance.
Value add: what specific value do the funds promise founders?
Some funds specify what value they add to companies in order to get access to the best possible deals. SuperSeed’s team of ex-operators are focused on helping B2B startups get the all important early revenues, and accelerating seed stage businesses to series A. This commitment attracts startups that are struggling with those particular challenges and are seeking input from experienced industry experts.
Fund team size: How many investors are on the team?
Some funds are run by solo partners (known as GPs – General Partners), others by teams of GPs with analysts and associates supporting deal origination , diligence, and investment decisions.
Investors should ask themselves ‘do I feel confident in the expertise of the team to make the right investments?’
VC Fund structure and terms
VC funds have many different structures, and it’s important to thoroughly review the structure and terms before investing, as these directly affect the timeline to returns for investors.
Lifecycle: what is the fund investment period and exit timeline?
Most funds operate with a finite lifecycle. The fund sets clear parameters during which it will invest all the capital in the fund, and a clear timeline as to when investors should expect to receive returns. The typical total life span of a private fund is typically 8-10 years, during which the fund must return distributions to investors, plus up to two 1 year extensions (at the discretion of the fund manager and/or the investors) to ensure that the fund has sufficient time to achieve the best possible exits from its investments. The first 5 years of the fund’s life will usually comprise the investment period during which the fund is able to make investments (although most funds will allow for an extended period to make follow-on investments in existing portfolio companies).
This does mean that investments in private funds are long term investments and it may take many years before investors begin to receive meaningful distributions from the fund.
Drawdowns: What is the fund drawdown schedule?
When a fund announces that it has raised £100m, it doesn’t necessarily mean that the fund has all of that money in the bank on the day it makes the announcement. Instead, the fund will have signed legally binding commitments from investors totalling £100m . The fund will not typically take all the money from investors on day 1, but will draw down from investors on a pro rata basis as and when it needs money to make investments (payments made by investors under drawdown notices are known as ‘‘contributions’’). This means that investors can hang onto their money until the next scheduled drawdown, rather than investing everything up front. However, please note that through Seedrs drawdowns are usually only available to investors who commit more than £10k.
Fees: What are the management fees?
Different funds charge different fees. For example, a traditional VC fund fee model is known as a “2 and 20”. The 2 refers to the 2% annual management fee, charged annually on the total contributions made to the fund to pay for the running of the firm. The 20 refers to a 20% carry, which is a fee charged on profits that are distributed to investors in the fund. This is just one example. The fees charged for each fund will differ, and it’s important to review these carefully. Please note that on top of the fund’s fees, Seedrs will also charge standard investor fees and carry on profits.
Distribution waterfall: How does the fund distribute returns to investors?
VC funds distribute the proceeds of their investments to investors using what is known as a distribution waterfall, which typically operates as follows:
- Return of capital: First, funds will return the principal amount that investors have contributed to enable the fund to make its investments (after certain fees, costs and expenses have been netted off)
- Preferred Return: After the return of capital to investors some funds then pay the preferred return (sometimes known as a hurdle rate) to investors. The preferred return is effectively a minimum rate of return which the investors will expect to see for their money before the fund manager receives any carried interest. Some funds, particularly US-based VC funds, don’t pay a preferred return. The standard rate is 8%, although this may vary. The preferred return is calculated on the average daily outstanding balance of the Limited Partners (i.e. based on the amount drawn down and not yet returned, when it was drawn down and when it was returned) – similar to an IRR calculation.
- Catch-up: The catch-up stage of the waterfall exists to ensure all profits (i.e. anything exceeding the investors capital) are split between the Limited Partners and the fund manager in accordance with the carried interest percentage (generally 80:20 – see next paragraph).The preferred return is payable to ensure that the fund manager does not receive any carried interest until the investors have received a certain rate of return on their investment. However, assuming investors receive this rate, the fund manager will ‘catch-up’ so that all profits distributed under the preferred return stage and catch-up stage are also split in accordance with the same percentage (i.e. 80:20). This means that all or the majority of all distributions after the preferred return hurdle has been reached will go to the fund manager until it receives its agreed profit share.
- Carried Interest: The final stage in a standard distribution waterfall allows for profits to be split between the fund manager and the Limited Partners in accordance with an agreed percentage. The standard is 80% to Limited Partners and 20% to the fund manager. The element payable to the fund manager is referred to as the carried interest (or carry), and is the main incentive for a fund manager to achieve the highest possible returns on the capital it is investing on behalf of the fund’s investors.
GP commitments: Are partners investing their own capital to give them skin in the game?
The knowledge that the partners controlling the investment decisions are personally invested into the fund can be a great trust builder for investors. Some more established VC fund managers will commit as much as 2% of total commitments to the fund.
Lead investors: Who is backing the fund already?
This could range from, Sovereign wealth funds, quasi-public investors (such as the British Business Bank), institutional investors, strategic investors (e.g corporates), family offices, and high net worth individuals. The number and quality of a fund manager’s institutional investors can be indicative of its reputation in the market and the conviction that its team is able to inspire.
Investors should always complete their own research and diligence beyond what is listed in this article. Investing in venture capital funds is very risky. Only eligible investors can invest. Only ever invest what you are comfortable with losing.
Live fund opportunities are available to eligible investors on Seedrs Private Deal Room.