Rules of the VC Game, Part 2: The Size of the Fund Matters

This is the second article in a series of posts intended to provide entrepreneurs and startups with background knowledge about venture capital financing.

Many entrepreneurs and startups nowadays are very skeptical about taking VC money, and with good reason.  Not only do you have to worry about the terms of the specific deal, but also your company’s short and long term goals and how well they align, or don’t, with the VC’s financial interests.  Most of the time, there is no alignment whatsoever.   That doesn’t mean you don’t seek VC money, but instead it means that you have to proceed cautiously when you decide to accept this form of investment.  Specifically, when determining whether a particular VC is a good fit, look at and carefully scrutinize the size of the VC fund from which you will be receiving money.  This is very important for two reasons:  Management fees and growth tension.

Management Fees. Venture capitalists make their money in two ways – management fees for the assets that they have under management (typically a 2% fee paid quarterly or annually directly out of the fund) and through profit sharing called preferred profit participation, or “PPP,” usually equal to 20% of the profits of the fund.  When a VC raises a fund, they typically outline their goals, such as what type of investment they anticipate making.  If the goal of a fund is to invest in startups, then they will be making seed or Series A investments that are typically far less than those funds that invest in later stage deals.  As soon as the VC invests the money, that money becomes “assets under management” (AUM) for which the VC begins to earn a management fee.  The more money invested, the larger the fee.  This leads to misalignment between how much money you believe you need to fuel your growth and the amount of money that the VC would like to give you, the latter typically being more.  Once again, the more AUM, the more fees generated for the VC.

Growth Tension. When determining whether you want to accept a VC’s money, it is equally important to look at the size of the fund so as not to create any added tension between your goals, as you have mapped them, and the goals that the VC may have for your business.  In some cases, these may be perfectly aligned.  In many cases, they will be diametrically opposed.  For example, a larger fund will not only push to make a larger investment than you might like but they will also push you to grow in ways that you may not want, such as through new product investments, international expansion, or acquisitions of competitors.  This type of growth may not be what you had in mind when you accepted the VC’s investment which will lead to a stress between you and the VC.  If you also gave away control of the company in order to accept the investment, which is typical, you and your cofounders could find yourselves out of a job since the VC will most likely want to replace you with someone who will grow the company much more aggressively.  As you read articles in magazines and online about founders leaving their startups, take note of how often the founder indicates that the separation is as a result of misaligned growth goals.  It is fairly common.

Venture capital can be a very good thing for many founders looking to get over the hump and propel their companies to the next level.  That does not mean it’s the right thing for your company or that the VC willing to invest in your business is of the right size.  As you do your due diligence on a prospective investor, make sure to ask lots of questions about the size of the fund itself to make sure that they invest in companies like yours.  If you don’t, you may soon find yourself bitter about your VC experience and out of a job.