arijit bhattacharya

Raising capital as a first-time venture capital manager (or "VC") is always challenging

Raising capital as a first-time venture capital manager (or "VC") is always challenging – primarily due to a lack of track record and performance coupled with not knowing or having access to prospective limited partners (those entities or individuals who invest in venture funds or "LPs"). This dichotomy can become more pronounced and exacerbated when capital becomes tighter, and events or other in person means for meeting people go virtual, further limiting access, for example, during the COVID-19 pandemic.

Fund size is determined by the portfolio construction and capital needs to maintain fund ownership. Fund size is also determined by target sectors—life sciences, especially, tend to be capital intensive. Institutional investors, especially those managing multibillion dollars, prefer to invest in funds than are at least $100 million in size. This allows them to maintain efficiency and manage relationships appropriately.
Portfolio construction design factors in the size and timing of investments with the view to balancing cash flows and minimizing risk. Portfolio construction design involves the following:


Total number of companies, typically a range, say 8 to 12. For technology funds, this range tends to be higher, at 20 to 30 companies.
Average total investment amount per company, typically no more than 10 percent of the fund.
Average investment amount at the point of entry. Typically, this would be one-third of the average total investment per company. Capital is reserved for future rounds of investment.
Average target ownership at time of exit, and target exit values leading to target internal rate of return (IRR) estimates.
Stage of investment—seed, early, or growth. These stages require different amounts ...

Choosing your initial strategy The first thing you need to do is layout your initial portfolio construction. As I'll explain in the next section this should not be the construction you end up with but it's still very important to have a solid starting point to iterate off of.

Number of initial investments
The most common mistake that is seen here for new seed managers is having too few portfolio companies. For example many preseed funds that are targeting 15–18 portfolio companies in their fund. This sounds reasonable but in practice is not a good idea. Even at a solid conversion rate of 60% between preseed→seed, seed→A and A→B, that fund ends up with a post series B portfolio of 3 companies. Hopefully it goes without saying that very few institutional LP's would sign up for a B focused fund whose strategy was to only invest in 3 companies. In practice we think you want in the neighborhood of 20–25 post series A or 10–12 series B companies. Given venture returns generally follow a distribution similar to the power law this gives you a good number of "shots on goal" for exits that can be fund returners. From there you can work your way back to the stage where you plan to enter using an estimated conversion rate.

Pacing/initial investment period
Pacing is a hard thing to project but you'll still want to layout over how many quarters you'll make your initial investments. You need to think deeply about the quality of your deal flow as well as how many investment processes and new portfolio companies your team can manage. Our pacing is to do 35 new investments over 3.5 years. That initial investment period is quite a bit longer than average for a seed fund but we don't feel comfortable doing more than about 10 investments per year across 4 GP given our level of involvement with our portfolio companies and as I explained above we feel strongly in having a relatively broad initial portfolio at the seed stage. We'll get into recycling below but one thing to note is the longer period you spread your initial investments, the more time you'll have to get liquidity for recycling.

Average size of initial investments
The classic mistake here is new managers pick an amount like 250K or 750K when they should be pegging initial checks to a target ownership. At the end of the day, the percentage you own of a portfolio company when it exits is what's important, not the amount you put in. Pick a target ownership percentage you'll try to stay close to. Then based on the average terms you project investing at, approximate the average allocation you'll need to invest to buy that ownership. As an example for our 4th fund, which is $100M, our target average ownership is 12.5% (all are 10%-15%) which for our investments equates to an average initial check of $1.25M. Part of the rationale for this ownership range is that if we maintain ownership in the 10% range when the company is worth $1B, an exit at that time can return the whole fund. Every successful VC fund you will hear of has at least one company return at least the entire fund (remember the power law) so you want to make sure you're well aware of what that will take.

The size of your initial checks will have a strong impact on your strategy. At $1.25M we pretty much always have to lead or colead, which we're built to do. In today's seed environment you can probably do preseed checks up to around $300K and seed checks of up to $600K on average as a follower. Above that and you'll likely need to start leading. Unless you feel confident you're ready to lead and take the responsibilities involved with doing that (be the primary fund to drive diligence, negotiate terms, drive legal, be the hands-on investor of record, often take a board seat, be the first one founders look to if an extension is needed, etc), it's probably best to set your ownership targets (and analogous initial check size) to a level where you'll be able to get allocations as a follower.

Follow on strategy
To what extent do you want to follow on in order to maintain your ownership through subsequent rounds? You'll get tons of conflicting advice here between people who say you need to optimize for "doubling down in your winners" and those who say you get the best value early. The optimal answer here depends on the size of your fund. The larger your seed fund, the more likely you'll optimize results by reserving a sizable amount for follow on investments. A common mistake is to save money for follows at the cost of having too few portfolio companies, as discussed above. When you have a small seed fund it's more important to have a broad portfolio than to protect your ownership post initial investment because in our experience, the ownership you buy at seed dwarfs the ownership you buy in later rounds for the portfolio companies that drive strong fund level returns. Like everything, there are exceptions to this but broadly we've seen this hold true. When you do follow on in subsequent rounds, the common practice is to "take your pro rata", which means to maintain your ownership percentage. In the early rounds the allocation size to take your pro rata is often in the neighborhood of your initial check. Some funds have a strategy to do "super pro rata" in subsequent rounds but managers need to understand this strategy is dependent on who leads the following round and may be hard to execute consistently.

As seed funds grow, their optimal strategy is to maintain their ownership deeper into a portfolio company's lifecycle as they need to put that extra money to work. To project this out you'll need to estimate the conversion rates between each round. This can be difficult especially if you don't have much historical data. For example, in Eniac III ($55M) we had a strategy of maintaining our ownership through the series B but our seed→A conversion rate ended up being about 50% higher than we projected, which resulted in that fund only being able to do half of its overall series B prorata.

The end result of laying out your follow on strategy is that you should have projections for how your fund will be allocated over the rounds you expect to participate in.

Over time we've come to appreciate that portfolio construction needs to be optimized throughout a fund's lifecycle as projections are replaced by real data. If you're planning on fully recycling (which almost every sophisticated LP wants to see since it effectively allows you to recycle your fees away) having a dynamic strategy is pivotal. As mentioned before, one way to build your preseed/seed portfolio is to pick a later stage portfolio that gives you a good number of potential fund returners and work backward. To do this you'll project a conversion rate between each round, but these are educated guesses so you'll want to update these as you see real world results.

If your strategy isn't dynamic it can lead to big issues
Take the example below where you're building a seed portfolio with a target of having 12 active portfolio companies post series B. You initially project 75% conversion rate between each round but in practice, you see only 50%. A relatively small change in conversion rate results in a very different portfolio construction strategy.
In this case, if you started seeing this lower conversion rate, you'd want to adjust in order to do more initial investments. In order to do this, you'd take money allocated for follow on rounds and reallocate those funds to doing more new deals. You need more "shots on goal" as having only 4 series B companies is not a well-diversified portfolio and thus very risky. In other words, you need more initial investments to achieve your target portfolio diversification.

One thing almost every seed manager struggles with is recycling. Recycling is especially challenging for seed investors compared to later-stage investors because the average hold time per investment is 2–3 years longer than series A.
The tension here is that you want to invest around 100% of your fund (i.e. fully recycle) but 20% (sometimes more, especially for very small seed funds) is generally earmarked for fees and costs over the life of the fund so you need to get that 20% back in the form of exits in order to fully recycle. Sometimes you get lucky and have a sizable exit early in a fund's lifecycle like we did with Anchor but overall most exits in the first few years tend to be pretty small. Therefore most seed funds invest that 80% of their fund before they get back 20% worth of liquidity. If this happens you'll have to either stop investing (which means possibly missing out on some exciting opportunities) or you can invest funds earmarked for future fees. Since most funds collect fees over a 10 year period you can invest funds earmarked for those later year fees betting on the fact you'll have liquidity before those fees are needed. This is what most sophisticated seed funds do. Having visibility into this bet is where having a strong model is pivotal, which we'll get into more in the next section.

One note, it's really hard to hit 100% right on the nose. Generally, the investments that get you to full recycling are later follow on rounds which can be hard to predict well in advance. Our advice is to aim above full recycling, in the 105%-115% range, to ensure you get over 100%. A lot of great performing seed funds go well over 100%. When you raise your fund you'll want to include provisions that allow for this although most sophisticated LP's will be happy to amend your docs to help make this happen given it is in their best interest.

Driving with a single holistic model is key
For years we used a handful of models to maintain our portfolio construction. Generally at least one to lay out and track the strategy and another to project future cash needs over time. When Kristin joined us from Point72 last fall we finally had some serious modeling experience on the team. She and I worked together (99.9% Kristin, .1% Hadley) to put together this model which does a great job of tying everything together.
However, even a pandemic doesn't stop all new managers from securing capital. Despite the fact that recent fundraising has been dominated by established funds, some capital is still directed to new managers who can prove their value and differentiate themselves to LPs. Looking back further in time, even when limited partner capital was scarce due to economic recessions, first time funds continued to be raised then too.
Sapphire Partners engages with dozens of emerging managers every year, and those most successful in raising capital traditionally follow these four P's of Fundraising.

1. Patience
Fundraising as a first-time manager almost always takes longer than you anticipate, and it's likely to take even longer in a capital-constrained market, where you can't meet LPs in person. Keep this in mind when speaking with LPs about your fundraising timeline, and with entrepreneurs about your ability to invest.
In general, we believe LPs move as slowly as they need to get excited about, and comfortable with a VC. Also, unlike a VC who has a certain time frame to deploy their capital into new portfolio companies, LPs do not typically have the same legal construct obligating them to make new VC relationships. Instead, LPs have the option to continue to invest their capital in their existing portfolio. As a result, fund managers need to have patience and focus on building relationships over a long period of time, anywhere from months to years. This process may be even longer for emerging managers and first-time funds who do not have a track record that helps LPs get excited.
We know that emerging managers are eager to start investing as soon as they can. However, since LPs are looking for a relationship that will last years if not decades, you should view the fundraising process as the dating period before jumping into marriage.

For LPs, it's essential to build trust and understand the character of an emerging manager. Ideally, LPs like to see you in action – observe your strategy and how you perform over a period of time before investing. Further, when an LP invests in a fund they are mentally also assuming they will be with this VC for a number of funds. LPs look to make relationships with VCs that will last decades, this is also different from how a VC invests in a portfolio company. For that reason, LPs often prefer to get to know a VC across cycles. That's one reason so many of your fundraising meetings may be relationship building rather than capital accumulating. That means you have to be patient, but also…

2. Persistence
As an emerging manager, be prepared to hear "no" a lot.
Unless you're a manager coming from an established firm, with a strong, transferable track record, and a following of LPs waiting for you to break out and start your own fund, you will likely have dozens if not hundreds of LP meetings.
While hearing "no" all the time can be demoralizing, it's important to recognize how small the LP world is. LPs talk to each other and run references as part of their diligence process. As an emerging manager, character references are one of the more concrete data points an LP can grasp given the lack of track record. But even if you get a "no" this time around, that does not mean it's a "no" forever. You need to be persistent in building and maintaining those relationships as you develop your reputation. Find opportunities to remain top-of-mind for LPs and think of each touch point as building toward the next fund.
There will be a lot of passes and it will be psychologically discouraging, but you will find LPs become interested at some point in the future. Take advantage of these meetings and use them as an opportunity to receive constructive feedback. Every LP has different preferences and is looking for different attributes in a VC at different points in time. Or in other words, each LP you will speak to will most likely have their own portfolio construction and return objectives which could be very different from the next one with whom you speak. LPs just need to know that you fit their portfolio needs, which is when you need to be…

3. Persuasive
Being persuasive means refining your message to be absolutely convincing in the shortest period of time possible. After all, your years of relationship building may come down to a single 30-minute Zoom call that seals the deal with an LP. The market is overflowing with venture capital firms, and you need to clearly define what differentiates you and why this LP needs to use one of their few bets this year on you.
Your deck needs to be tight – concise and compelling. To minimize the amount of work that you have to do in LP meetings, do the legwork upfront. Make sure your deck is so comprehensive yet succinct that an LP can look over it and know who you are, what you're going to do, your edge, and so on.

Do not waste precious meeting time going through items that are better read in a deck. Make sure all the most crucial points are conveyed in the deck.
Where you want to focus the meeting is your story, the way you pitch the LP, and the ensuing conversation. Present the right details at the right time and reference the supporting evidence in your deck. Manage the pitch to make sure you get through everything you need to. Here are a few things I will want to understand for the single VC starting a fund:

Your background and track record (or lack thereof)
Why you're starting the firm
How are you qualified to manage and run your own fund?
How are you going to find your deal flow?
How are you going to win?
Why would an entrepreneur pick you?
What's your edge over another GP?
What's your approach to portfolio construction?
Are your aspirations and vision for the future great enough for me to be interested, but also grounded in executional potential?

If you're a team of multiple venture investors coming together to form one VC, you'll have a few more questions to answer, especially if you've never worked together:
Why did these people decide to come together to start this firm? How do they know each other? Can these people work together successfully for multiple funds in the future? What do each of them bring to the table? Are they going to break up after this fund?
Is the team capable of seeing a fund through to liquidation?
Identify all the potential risks and find a way to mitigate them for LPs. Don't have your potential LP sit there and wonder how they're supposed to be comfortable with those issues.
All of this should be communicated in that short window of time, keeping in mind that all the traditional qualitative components of diligence — where a fund gets to know the partners and can see the dynamics of the partnership at play — are a bit more complicated in the current virtual environment.
References are even more crucial in times like this. Having a list of LP, VC, and founder references identified and ready to share will help tremendously. If you don't have references or a track record, as many emerging managers don't, focus on what you can control, such as your strategy and fund construction.
As you pitch, you'll naturally become better at refining your message as you get feedback and practice. Focus your efforts on clearly articulating your strategy and differentiators.
Don't be afraid to follow up with LPs and try to move things forward, but don't forget that LPs move at our own pace. You want to be persistent but not pushy, and ultimately, you'll need to be…

4. Pragmatic
Your approach to fundraising and your differentiators need to be pragmatic.
For first-time managers, LPs might want to write smaller checks to reduce their risk. Take the money – the first fund is hardest to raise and LPs tend to be more loyal to existing managers. You want to take that first step, even if it's not as large of a step as you were hoping.
You also need to know when to call a fundraise "done," have a first close and start investing. Know what your 'minimum viable fund size' is to execute your investing strategy and when you hit it – go for it. As an emerging manager, your reputation won't be made during fundraising, it's made with investments, and you want to start doing that as soon as you can.
Finally, remember that your fund size should be contingent on your strategy, and based on fund math rather than vague ambition. Demonstrate that you're not just picking $100 million as your fund size because it sounds great. Showcase the math behind why, and how, you arrived at the number. Simply put: X# of companies with X% ownership to produce $X return.

Applying the Four P's
The current environment has accelerated a number of trends that could make it more challenging for emerging managers to fundraise. Realistically though, the fundamentals of which LPs will invest in shouldn't change too drastically. We don't expect VCs to have a crystal ball that sees into the future, which is why we want to be comfortable and excited about your approach, team and differentiation. Being Patient, Persistent, Persuasive and Pragmatic will help you convince LPs to come on this journey with you.
Cash Flow Model
The Model tab then pulls data from the Portfolio tab into each fiscal quarter, to create a cash flow model based on your investment assumptions. It then subtracts out any management fees and expenses to forecast your available capital and investable capital over the life of the fund. This is then graphed and summarized on the Summary and Assumptions tab under the Summary section. So, as you change variables like check size, frequency of investments, and conversion rates, you can see how it impacts your available capital.
Return Scenarios
One more tool we found helpful is a return scenario model. Instead of modeling expected returns per company, we use the return scenarios to see how long the fund's capital will last depending on its annual return performance. On the Summary and Assumptions tab (beginning in cell C123), there is a table for three different potential scenarios where you can enter returns you might expect in different years. These rates of return are then pulled into the Model tab to model out each scenario. The results are then graphed on the Summary and Assumptions tab with each scenario's expected cash max out date.



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Arijit Bhattacharyya