Investment funds are often the lifeblood for entrepreneurs to scale an early venture into a proper company. But besides the independently wealthy, the pathways to becoming a startup investor of any type are often a complete enigma, even to those already steeped in the wider startup and tech culture and communities. Like the complexities of starting any new business, there are obviously unique challenges associated with launching a new investment fund. So where does one get started to become an early-stage startup investor? And how does one even consider raising an investment fund? We explore.
We all know that raising venture capital funding is increasingly common practice for entrepreneurs. Even for successfully bootstrapped businesses, there often comes a time when a push for rapid growth often makes sense—and to accomplish this, organizations typically need outside investment to add fuel to their fire. Regardless of when entrepreneurs seek funding, the pool of venture dollars, as well as the investment demand coming from founders, are both growing larger with each passing year.
If you are looking to start a new venture capital fund, check out our Guides on How to Start a Venture Capital Firm, including:
To get an idea for the growth in venture capital, this PitchBook report shows that the industry invested just under $131 billion in U.S. based companies in 2018, up from a previous all-time high set back in 2000’s dot-com frenzy. Some notable takeaways from the report are that the median VC fund size reached nearly $82 million, while those funds raised over $55 billion across 256 vehicles in 2018, the highest total capital raise ever recorded in a single year.
So the overall market is growing—and many in the startup world would argue we are in a new era of capital abundance. While for some founders it is indeed true that capital is increasingly cheap, other minority founders’ access to venture capital remains shockingly inequitable. So even for a maturing VC industry, there is certainly room for new funds and managers with different (e.g. more inclusive) visions for investment portfolio makeups and deal flow strategy.
The Pitchbook report also illustrates that in 2018, there were just shy of 9,000 VC deals inked—and according to this TechCrunch report, startups’ total pre-series A capital averaged a total of ~$5.6 million in funding in 2018, up from just $1.3 million as recently as 2010. Series A rounds in 2018, on the other hand, averaged $15.7 million per round. So while later-stage deals continue to account for an outsized portion of the overall investment, among the nearly 9k VC deals set, thousands were seed or Series A rounds. According to Pitchbook,
Angel & seed and early stage dealmaking posted strong momentum in 2018, experiencing 15.0% and 22.9% increases in median deal size, respectively.
Fortunately, there is no shortage in demand for VC dollars, especially at the seed and early stages. Looking in from the outside however, the process for how exactly to go about getting started as an early-stage startup investor can seem quite impenetrable.
In this Breaking into VC series, we explain some of the common ideas and processes for how average investors of modest wealth can go about laying the career groundwork towards eventually becoming independent fund managers and startup investors.
Defining the Vision & Strategy
Successful ventures start with planning—and to launch a successful venture fund, you will need a solid investment strategy to act as your foundation. Next, in the very simplest of terms, you will need the following:
That’s mostly it. Just like entrepreneurs seeking to raise funding, the only way to fundraise successfully is to very deliberately go after the folks who have the free capital to allocate. Once your fund has investors, everything else is a matter of legal work, reporting and communicating, and following through on your predefined investment strategy. You legalize your investment vehicles, you source your deal flow to find great startups to invest in, and then you close the deals. Post-raise, the goal of your fund is to hit a unicorn-level return from at least one of the startup investments you make, and return a huge multiplier to the fund and your LP investors.
So, how do you get investors to join your fund? In short: they really, really need to believe in you personally, and your vision for the fund’s execution—and to convince them to give you their money, you will need to articulate a well-defined strategy.
At a high-level, your investment strategy should answer the following:
- Capital is cheap. What differentiates you from the competition?
- This is hard-earned money. How are you going to make investment decisions?
- What kinds of investments will you make? Why? Why now?
Differentiating your fund from the competition
Some funds are highly specialized to focus on specific industry niches, while others are industry agnostic but stage specific, and still others prefer to focus only on companies in certain geographic regions. Regardless of the choice, having a coherent and consistent investment plan makes external messaging, internal focus, and ultimately, who invests in the fund, all more clear for everyone from the outset.
And money aside, why you? Why this fund? What other value will you deliver besides just capital? While each investment will be different, there should be clear consistencies that define your fund.
How are your investment decisions going to be made? Not all investments follow an exacting formula. The wide variation of possibilities ranges from slotting the exact same amount of dollars into each startup, to tiered investments based on stage and industry, to only working with certain investment vehicles (e.g. SAFE notes), to retaining some portion of funds for re-upping seed investments in future capital rounds.
Then, you set how many investments you want to make over what period of time. By stretching it over at least two years, that gives more wiggle room for investment deal flow to come through. The most common fund cycles distribute the capital over the first two or three years, with follow-on investments within the first five years, and returns delivered back to investors within 10 years.
Choosing aligned Investors
Seek to align your investors vision with your own to the greatest extent possible. If you are in a major tech hub, finding wealthy entrepreneurs may be less of a struggle, but the reality is that most funds will have a diverse set of sources. These investors range from pension and endowment funds, to institutional fund managers, to certain foundations, angels, high net-worth individuals, or family investment offices.
With an initial investment strategy and fund vision in place, messaging consistency will help to source your relevant funders more easily. Developing the investment firm marketing awareness early is very advantageouis, and email newsletter campaigns can readily be crafted keep all relevant stakeholders up-to-date and engaged.
Developing a Business Plan for the Fund
As a new fund, there will be pros and cons working for and against you. By developing a plan, you reduce risks through clearer vision, and draw in both the right investors and the right startups at the right time. Consider the following elements as part of the fund’s business plan:
- Define your messaging
- Define what kinds of startups or entrepreneurs you will invest in
- Set a timeline for when and how many investments will be made
- Estimate when all investments need to be drawn into the fund
- Establish an advisory board
- Establish auditing and financial tracking processes
- Identify how much, if any, management fees will come from the fund
- Set size of investments to be made and if you’ll have carry over investments
- Find a law firm, especially one that can differ costs until the fund closes
- Develop a prospectus for investors
Raising Capital and Starting to Invest
Even with a plan in place and everything legally setup, the most important questions are: when can you start raising capital, and when can you start investing? The simple answer is that you should start seeking capital immediately, as the process will take time. Use initial asks to act as feedback loops to improve, and only once you feel the business case and messaging have been honed tightly, go after the key investors you are looking to court.
Create a list of at least 100 target investors, and search for 2nd and 3rd degree network connections to ask for introductions to all 100. Make the ask for initial meetings all at once, and try to setup as many meetings as you can within a few week period. Creating an abundance of meetings helps you shift into a confident fundraising mindset, so that momentum is always looking forward for the ‘right investor’ who really gets it. As for achieving the final amount of your fund, be sure that it’s attainable for a first time fund, or this could put off some when making the ask for investment.
When it comes time to make investments, it’s easiest to work backwards when thinking about executing on your strategy. If within the first year you plan to invest in 20-30 startups, that will take a great deal of lead-time, conversations, and due diligence—so the process can start before the fundraising round is even fully closed. Checks typically don’t start going out until a certain minimum amount of funding has been committed, and that doesn’t happen right out of the gate.
With investors starting to come onboard, this is also the perfect opportunity to bring some of them on as advisors for the advisory board. Reach out to people with whom you have connections. If you don’t yet have the personal connections to form an advisory board, that’s likely a good hint that you may not have the required connections to secure LPs and build a strong fund.
Once a board is in place, find a law firm that specializes in venture capital funds and startups. In some cases, these firms will allow you to differ the cost of their work until the round closes, which puts less stress on your team while building out the foundation.
Early Fund Advantage Mindset
Large, established funds will have most startups clawing their way to get a piece of their pie, there is no arguing this. However, for smaller funds, especially newly created ones, startups know there is more risk to be taken. According to the Kauffman Foundation, the largest funds have been notably light on delivering market-beating returns, which makes younger funds potentially more appealing to investors. Being exclusive is a fundraising mindset, picking the winners through seeking alignment.
* * *
These resources are provided by VC Lab, a 14 week intensive program to help New Managers start accelerators, pre-seed, seed or Series A venture capital firms globally.
VC Lab is a free VC Accelerator program run by the Founder Institute, the world's largest pre-seed startup accelerator. The Founder Institute has over 5,000 portfolio companies worth an estimated $30B in value.
Learn more about the Founder Institute at FI.co or VC Lab at FI.co/vc.