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How a VC works behind the scenes

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Learning how a VC firm works behind the scenes is a good way to gain important strategic insights on becoming a more attractive investment. But understanding the ins and outs of a VC firm can be easier said than done, even for entrepreneurs who spend a lot of time speaking to investors.

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How a VC works behind the scenes

  1. 1. Inside Venture Capital Firms Christian Lassonde - @classonde Pauline Brunel - @paulinejbrunel 16th October, 2018
  2. 2. AGENDA Impression Ventures - Who we are VC investing - Venture Capital specificities Structure Business model Economics What else can impact the maths Q&A
  3. 3. IMPRESSION VENTURES - WHO WE ARE Fintech focused VC Firm with offices in Toronto and Montreal Lead late Seed / early Series A rounds Partners and Advisors have significant experience as entrepreneurs, software engineers, product managers and financial services executives. Usual cheque size: $1.5M - $2.5M, with the ability to follow-on. Deals size $2M - $5M Our portfolio includes . . .
  4. 4. AGENDA Impression Ventures - Who we are VC investing - Venture Capital specificities Structure Business model Economics What else can impact the maths Q&A
  5. 5. VC INVESTING - VENTURE CAPITAL SPECIFICITIES You Idea stage Co-founder stage Friends & Family stage Seed stage Series A Series B,C,D... IPO Co-founder Accelerators Business Angels Venture Capital & Debt PE funds & Debt (Banks) Anyone Friends & Family
  6. 6. VC INVESTING - VENTURE CAPITAL SPECIFICITIES Risk / Return High Medium Low Pre-seed Seed Series A Series B Series C Series D
  7. 7. VC INVESTING - VENTURE CAPITAL SPECIFICITIES Professional investor - VC’s invest other people’s money VC is a business of risk adjusted returns ~10% is the average return for the S&P 500 since its inception back in 1928. Adjusted for inflation the "real return" is more like 7% - VCs need to beat that Who are Venture Capitalists Product/service with evidence that there is a big and growing market and capital will accelerate growth VC’s invest in hyper-growth, technology just happens to be an excellent enabler of hyper-growth What do they invest in
  8. 8. AGENDA Impression Ventures - Who we are VC investing - Venture Capital specificities Structure Business model Economics What else can impact the maths Q&A
  9. 9. STRUCTURE - SIMPLE General Partner Venture Capital Fund Co #1 Co #2 Co #3 Co #4 Co #... Limited Partners Limited Partnership AgreementManagement Fees ReturnFunds
  10. 10. STRUCTURE - TYPICAL General Partner Venture Capital Fund Co #1 Co #2 Co #3 Co #4 Co #... Limited Partners Limited Partnership AgreementFund management & GP ownership Management fees ReturnFunds Management Company Parallel Venture Capital Fund Carried interest Funds Return
  11. 11. STRUCTURE - ARGH!! General Partner #1 VC Fund #1 Co 1A Co 2A Co 3A Co #... Limited Partners Management Company Parallel VC Fund #1 Co 1B Co 2B Co 3B Co #... General Partner #2 VC Fund #2 Limited Partners 2 Parallel VC Fund #2
  12. 12. Limited Partnership Agreement Called “LPA” Clearly sets out the terms of the partnership: - investment strategy - fees - duration - responsibilities of both GP and LPs Common to all LPAs: GP’s fiduciary responsibility to act in the best interest of the LPs, which is legally binding. Variations across partnerships: some funds have stricter an investment mandate than others, and specify: - investment stages - industry focus Private document, but VCs tend to disclose the fund’s mandate on their website or discuss it with founders. As a founder, understanding a VC’s mandate can save you significant amounts of time
  13. 13. Management Company and General Partner Management Company - Controls the GP(s) - Owns the fund brand and exists beyond a single fund - Usually responsible for operating expenses such as salaries, office lease, conferences… - Investment expenses (auditors, board meeting attendance,... ) are typically out of the pocket of the fund General Partner - GPs are separate corporate entities - holds all the liability for the partnership - Exists only for the life of the fund - Gives full control of the fund management and investment decisions, within investment parameters, to the management company - The GP must manage the fund in accordance with the Limited Partnership Agreement (LPA) - GP can go to the Limited Partner Advisory Committee (LPAC) for decisions outside the rules - GP ownership is typically nominal, but the individuals who are the named partners (what we think of as the GPs) should at a minimum have 1%
  14. 14. Limited Partners Institutional Individual Insurance companies Banks Family offices Fund of funds Sovereign funds Foundations and endowments Pension funds Corporates High net worth individuals Partners of the fund Family offices Advisors Limited Partner - Investors in the fund - Their legal liability in the funds activities are limited. - Their return of capital is categorized as capital gains.
  15. 15. Limited Partners As a founder, understanding the LP base of a fund is key LPs represent a substantial value add proposition for VCs as they can assist and advise their portfolio companies. Ideally LPs have relevant: - entrepreneurial experience - industry specific knowledge - broad networks In addition, know who is on your cap table is also important as they will usually have co-investment rights and are likely to take up the pro rata rights in later funding rounds. GP ownership: In order to increase their exposure, Partners can either increase the 1% GP ownership or invest their own money in the fund and be involved as LPs as well as GP. -> Reinforces the alignment of interest and mitigates the principal-agent problem
  16. 16. AGENDA Impression Ventures - Who we are VC investing - Venture Capital specificities Structure Business model Economics What else can impact the maths Q&A
  17. 17. BUSINESS MODEL Management fees Carried interest Capital Gains How do VCs make money - Fixed compensation - Annual % of assets under management - Industry average of 2% - To cover for operational expenses - Variable compensation - % of the profit of the fund - Industry average of 20% - It mostly ensures a strong alignment of interests between GP and LPs - Variable compensation - % of the profit at an exit equivalent to an ownership industry average of 1% - It ensures a strong alignment of interests between GP and LPs
  18. 18. BUSINESS MODEL Fee structure is typically kept private and described in the LPA Founders should be aware that: - in bigger funds, the 2% fixed fee represents a significant amount of money and could potentially alter the GP’s behaviour toward risk and lead to a misalignment of interest. - on the other side, an over-reliance on the 20% upside can encourage “cherry picking”, and cause managers to focus intensively on the one or two portfolio companies for which big IPOs are possible.
  19. 19. AGENDA Impression Ventures - Who we are VC investing - Venture Capital specificities Structure Business model Economics What else can impact the maths Q&A
  20. 20. UNDERSTANDING VC RETURNS 1.5 2 3 4 5 6 7 8 9 10 2 22% 41% 73% 100% 124% 145% 165% 183% 200% 216% 3 14% 26% 44% 59% 71% 82% 91% 100% 108% 115% 4 11% 19% 32% 41% 50% 57% 63% 68% 73% 78% 5 8% 15% 25% 32% 38% 43% 48% 52% 55% 58% 6 7% 12% 20% 26% 31% 35% 38% 41% 44% 47% 7 6% 10% 17% 22% 26% 29% 32% 35% 37% 39% 8 5% 9% 15% 19% 22% 25% 28% 30% 32% 33% 9 5% 8% 13% 17% 20% 22% 24% 26% 28% 29% 10 4% 7% 12% 15% 17% 20% 21% 23% 25% 26% Exit multiple Exit year IRR is both a function of time and exit multiple
  21. 21. UNDERSTANDING VC RETURNS Investment horizon The average VC fund has a duration of 8 to 10 years. But it actually holds funds for about 6 years, accounting for: - Investment and divestment periods - VC is not in the business of managing cash. LPs’ committed amounts are called gradually - Stage investment, earlier funds will hold longer, later stage funds will hold shorter Expected return VC is a high risk asset class -> investors need to be fairly compensated for the risk they are taking. The industry common average target is a min. IRR of 20%: - For a $100 million fund -> the fund manager needs to return $300 million to its LPs -> a multiple of 3x. - The truth is: LPs would be happy with this target, but not euphoric, the best VCs do better – but the majority of the funds don’t get anywhere near this target level.
  22. 22. UNDERSTANDING VC RETURNS Historical US Venture Capital IRRs Compiled by Cambridge Associates LLC
  23. 23. UNDERSTANDING VC RETURNS In Venture Capital, Normal Distribution doesn’t apply to returns, the Power Law does Let’s take the example of the $100 million fund investing in 20 companies ($5 million total investment in each): Power Law means that a substantial part of the portfolio will fail and VCs need a home run investment to meet return expectations. Population Exit multiple $ Return 10 (50%) 0 -50 6 (30%) 3 +90 3 (15%) 7 +105 1 (5%) 30 +150 Total +295
  24. 24. UNDERSTANDING VC RETURNS VCs are looking for scale-up potential in the startups - > VCs invest in growth As a founder, you need to show the VCs that there is a path to a +30x exit: - Probabilities may be low and that’s okay - VC’s role, is also to help de-risk the business and increase the probabilities of success Key point for founders: understand that VC type of returns are very difficult to obtain and may not be achievable in some industries or businesses. -> We’ve turned down some companies which we knew would be great businesses and generate excellent outcomes for their founders, but would not meet our return hurdles.
  25. 25. AGENDA Impression Ventures - Who we are VC investing - Venture Capital specificities Structure Business model Economics What else can impact the maths Q&A
  26. 26. WHAT ELSE CAN IMPACT THE MATHS Position on the risk reward curve: - The earlier stage the fund invests, the riskier the investment is, the more likely it will be looking for big exits multiples Fund concentration: - Optionality is common in the VC world - It can impact the ability and the willingness of the fund to follow-on - Which can send a negative signal on your next fundraising event Reserve % for follow ons: - Usually varies from 30-50% Fund size: - Look for current fund size and number of deals left Proactivity in exits: - Some funds will have an hard investment horizon of 5y and look for a secondary market, no matter what
  27. 27. ALTERNATIVE VC MODELS Deal by Deal Funds/Angel Syndicates - Create a GP/LP for each deal - Raise capital for each deal - Economics for GP are amazing - Economics for LPs are only amazing if they better deal pickers then the GP, otherwise worse (aka, almost always worse) Short Duration funds - Deploy all the capital in a short duration (1 year or so) - Follow on investing is not a given - and which LPs follow on is not a given - Attractive model for later stage investing Corporate Funds - A single LP - Performance typical measured not in returns of the fund, but in addition to bottom line of parent company over time Evergreen Funds - Funded once, only re-invests gains from initial investments - Very long duration investment vehicle
  28. 28. AGENDA Impression Ventures - Who we are VC investing - Venture Capital specificities Structure Business model Economics What else can impact the maths Q&A
  29. 29. Q&A Questions?
  30. 30. THANK YOU

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