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How to Scale a Venture Capital (or Private Equity) Fund

English: Metropolitan Life Bldg., Manhattan, N...

Managers of VC funds typically want to grow their business aggressively, just like the founders we back.  But, we normally have a clear ceiling on how high we can grow AUM, before hitting practical limits to deploying capital within the traditional VC model.  

My Partners at HOF Capital are younger than I am, which means that we have a half-century horizon for the franchise we are building.  So we think about scaling a lot.  I suggest there are a number of ways to scale a VC fund.  I’ve listed them below in *very* roughly descending order of efficiency, measured by increased dollars one can put to work, divided by the operational dollars required to implement each strategy.  

Templatize the entrepreneurial process, by providing checklists, standardized agreements and other reusable code.  Among the sites we have found most helpful with practical guides for founders: Biztree, First Search, Foundersuite, Goodwin Founders Workbench, Guides.co, Inc.com, and StartupRocket.  

Encourage founders to turn to other founders and their broader community as resources, not just the VC’s own staff.  This evolves the VC from a server to a router.  First Round Capital’s forum for portfolio executives is a powerful example of a scaleable resource.

Build out low-cost force multipliers such as scouts, Advisors, Entrepreneurs in Residence, Venture Partners, and so on.  Sophisticated VC and private equity funds have a wide array of options for leveraging outside operating executives.  Typically these outside resources are paid only on a success basis, so the marginal cost is low.  

Create a franchise and license access to it, e.g., the Draper Venture Network.  This is a clever way for Tim Draper to leverage his brand and experience.  

Coinvest nearly exclusively, without leading rounds or taking board seats.  This is a model used in at least one case by China’s third-largest private equity firm, China Science & Merchants Investment Management Group ($12 billion+ AUM), which funded in 2015 CSC Upshot, a $400m seed fund through AngelList.  Another example is Correlation Ventures ($300M+ AUM), a VC firm which co-invests in financings with at least one other new outside VC.  The firm attracts deal flow by promising a decision (positive or negative) in under 2 weeks, with minimal paperwork and without repeating due diligence.  Some other companies with variations of this model include Alpha Venture Partners, Connectivity Ventures Fund, Crowdfunder, and Proof.VC .  Coinvestors need to figure out ways to prioritize themselves in a VC’s preference stack for syndicating opportunities.

Syndicate Special Purpose Vehicles (“SPVs”) for specific opportunities.  VCs can do this entirely themselves and/or use companies such as AngelList, CircleUp, FundersClub, OurCrowd, and SeedInvest to create a SPV.  Some of the VC fund’s own limited partners will typically invest in a SPV, plus the platform’s members can contribute additional capital.   

Raise an “opportunity” fund  (a.k.a., “sidecar”, “overlay”, “bolt-on”), which selectively invests in later rounds of earlier portfolio companies, typically at lower management fees than the primary fund.  This allows a VC to put more capital to work in their past portfolio companies with relatively little extra effort. Accel Partners, Andreessen Horowitz, Battery, Foundry Group, Greycroft, and Union Square Ventures all have created opportunity funds.  (These are a different creature than “annex” funds, which are typically used to support existing portfolio companies after the VC has run out of capital in its core fund to do so.)

All of the strategies above have very modest fixed cost.  I’ve listed a few more below which require meaningful startup and ongoing costs.  This requires a real financial sacrifice. VC is a “get rich slow” business, because most VC Partners will not see a carry check for 5-10 years, after waiting for both liquidity events and for LPs to be paid first.  The job of a VC is to invest in unprofitable businesses in anticipation of creating long term value. We all do that with our portfolio companies, but many VCs are not comfortable taking the short-term compensation hit by doing it internally within their management company.

Hire more non-Partner staff.  USC Marshall Professor Noam Wasserman observes in Upside-Down Venture Capitalists and the Transition Toward Pyramidal Firms: Inevitable Progression, or Failed Experiment?: “The early-stage VC industry was [historically] dominated by small firms composed primarily of senior staff members and only a few junior members. In this, they resembled many other professional services firms. In the late 1990s, a number of VC firms (following other professional services firms) adopted pyramidal structures and new internal procedures, relying on a larger number of junior staff, and becoming more institutional and professional.”  Noam observes that the accounting, investment banking, and law firm industries all started off with non-pyramidal structures but now are hard to envision without their current pyramidal model.  13 years after Noam’s paper, the VC industry is still noteable in lacking the traditional pyramidal structure of professional services firms.

Hire more Partners.  For a VC fund to be actively engaged in a large number of investments, it needs to hire more Partners to sit on more boards.  However, beyond a certain number of Partners, VCs historically have not been manageable; it’s too hard to herd the cats, who are often each former CEOs.  Even the largest VC funds rarely have more than a dozen partners. Andreessen Horowitz’s compromise: they have a half-dozen “board partners” who serve on the boards of their portfolio companies, representing A16Z, but who are not full-time employees of A16Z.  If you’re thinking of hiring a Partner, I suggest see How to Negotiate a Partner Role at a Venture Capital or Private Equity Firm.

Provide hands-on operational support for portfolio companies.  HOF Capital provides hands-on support through our in-house team, plus a network of outside mentors who work with portfolio companies on an as-needed basis.  We particularly help companies in winning revenue from our LP network and raising capital for subsequent rounds from top-tier late-stage investors.  I see a small number of other VCs at our stage pursuing a similar, expensive strategy.  

Launch a “venture studio” or “foundry”.  (I’m distinguishing these from incubators and accelerators.)  Venture studios work as co-founders with a founding team, with the larger ones assigning dedicated internal teams for each startup idea (e.g., engineers, designers, business developers).  Typically they get cofounder common equity, in addition to the preferred stock that a conventional VC gets. Examples include Betaworks, Expa, Efounders, FJLabs, Idealab, Juxtapose, Science, Inc., Prehype, Rocket Internet, and numerous others . For more, see the Startup Studio Playbook.

Launch a venture capital fund of funds. Foundry Group recently launched Foundry Group Next, which will further strengthen their already impressive level of connectivity in the ecosystem.

Semi-automate the investing decision, by using analytics on large data sets to generate idea flow and inform investing decisions.  Among the VCs who are pursuing variations of this model are Correlation Ventures, HOF Capital, Google Ventures,  Ironstone Group, Signalfire, and Venture Science.  For more on this, see The 9 Steps of Using Technology to Improve Investing in Private Companies.

Go public.  There are a few examples of publicly-traded investors in tech companies  in the US, notably Alphabet Inc. (GOOG); Actua Corporation (ACTA, formerly Internet Capital Group); GSV Capital (GSVC); Harris & Harris Group, Inc. (TINY); and Safeguard Scientifics, Inc. (SFE).  There are many more public US entities which invest in almost any category of private company (typically taking majority or 100% stake), including my former client Icahn Enterprises L.P. (IEP); Fortress Investment Group LLC (FIG); MCG Capital Corporation (MCGC); Apollo Investment Corporation (Nasdaq: AINV); The Blackstone Group LP (BX); Ares Capital Corporation (Nasdaq: ARCC); Berkshire Hathaway Inc. (BRK-A); and Prospect Capital Corp. (PSEC).  Prominent investor Chamath Palihapitiya recently announced he is launching a blank-check public VC fund, hoping to raise $500 million in an IPO.

Unlike the modal VC, US public VCs typically find it difficult to take small minority stakes in companies as their core business, because of their regulatory regime.  There are significant challenges to being a US publicly-traded VC, including compliance with the ’40 Act; the negative tax implications of being a public VC; and unpredictability of revenues.  That said, Europe is different: Draper Esprit (LON: GROW) is a British VC which recently IPO’d, joining a number of public VC firms in Europe, e.g., Imperial Innovations plc, IP Group plc, BGF Ventures, Eight Roads, Octopus Ventures, and Partners Group.

Disclosure: I have a financial interest in Foundersuite, a ff Venture Capital portfolio company.

Previously posted on PEHub

Photo: English: Metropolitan Life Bldg., Manhattan, New York City, in 1911. (Photo credit: Wikipedia)

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