Starting a VC Fund, Episode 12: Getting to Your First Close

Hi there. I'm Patrick Iwas, the founder and CEO of MindMaven, a executive coaching firm that helps leaders achieve true greatness by focusing on relationships.

And here we have, I'm Charles Hudson, managing partner at Precursor Ventures. We're an early stage venture firm that invests in founders at the earliest stage possible.

All right, and today I'm super excited about the topic we got because we are going to talk about how to get a to the first close of your very first LP fund. And so what are some of the first thoughts you have?

I think one of the things that was hard for me to understand and it's unlike most other things in investing, but let's just be super clear for most, in most cases, there's very little economic incentive to invest early in a venture fund. You, generally speaking, don't get better terms, you don't get a great deal. You're really just helping the GP get their fund off the ground. And so cynically, the best thing you could do as an LP is be the last dollar in because you're probably not going to pay a higher price and you're going to get the benefit of seeing how the fund is unfolded.

And that contributes to making it very hard to get your first fund closed. All right.

So how do you, how do you manage these folks to come in early to actually help you get that momentum you need to succeed?

Well, I will say this, I think there's some savvy LPs who will sometimes ask you for sweeteners or special treatment early on in order to get them to come in earlier and help create momentum. And at some level, I think the two big ones are they'll ask you to buy a portion of the management company, which I would think of as basically adding another part, a forever partner to your fund. Or they might ask you for a portion of the fund's carry or carried interest. The upside you're going to get as the GP based on the performance of the investments.

And should you do this, is this a very normal thing to do or what advice would you have?

I would say the ask is fairly normal. But I think it's important for you as the GP to think about what you're really signing up for. If you sell a portion of the management company. If you think about the way the venture firms operate, the management company is the single entity that receives all of the funds, all the management fees from all the funds you're going to raise in the future. So if you, if you cut someone into your management company, you're Basically in business with them effectively forever and they're going to be a partner who's going to have probably a point of view and a say about how you invest those fees. Excuse me, how often you raise a fund. This is a very difficult relationship to unwind. Oftentimes the only way to unwind that is to create a brand new management company. So it's a very consequential decision. You're unlikely to get out from under in subsequent funds. Selling a portion of your carry, you can get out from under that. You're basically saying, hey, in exchange for giving me an early vote of confidence for my first fund, I'm willing to give you a portion of the upside in this first fund. Now you could make the argument that when you go out to raise fund two or fund three, that maybe you can have a different arrangement with that person. But you know, once you've given it, once you've sort of ceded the moral ground that, hey, we don't give carry to our LPs, so you're going to have to start from position of I've already done this once, at least once for someone.

And so what do you recommend?

I would say if you're going to sell a portion of your management company early on, you better be very sure you have long term alignment with the person to whom you're selling the management company, because that's a very hard thing to unwind when it comes to selling carry. It's not uncommon, but it really does put you in a position where you've done it once. I think it's worth remembering that when people go to look at your next fund, they're going to say, well, what did you do in the previous fund? What side letters did you have? What economic arrangements did you make with your other LPs and like assume anything you agree to in fund one will basically become public to your prospective LPs in fund two.

So basically what I hear you say is try to avoid both of those. But for sure be extremely careful with selling an element of your management company.

Absolutely.

All right, good. What are some of the things that you've seen people do in trying to really push LPs to close that you wouldn't advise or that you just think don't work?

I totally get that. Getting that first close done, it's super stressful. You want to get it done. I think when you're trying to get that first close done, there's this temptation to do whatever it takes to get the first fund closed. And I would say, like don't do whatever it takes. Let's talk about a few things that I've seen people try that I don't think work. One is, I think just completely, totally, arbitrarily made up deadlines that have no teeth. So saying we're closing on this and this and that date, no matter what, and the date's made up, and there's no forcing function. That date may come and go, and if you're not closed by picking that date with no teeth, you've lost all credibility and your ability to maintain.

A deadline.

Okay.

The flip side is I think the no deadline close also doesn't work. People say, when are you closing? Hey, whenever you're ready, we'll have a close. No LP wants to hear that. They didn't want to hear that. Your closing timeline is totally dependent on them. I think you should always. One of my mentors always told me, always have a next close date in mind.

Excuse me. You should always have a next close date in mind.

And I've always believed in that. Like, if someone said, so when's your next close? You're like, hey, we're gonna have a close at the end of next quarter. We have a bunch of people that are in progress, and you should always have a date because the fund with no close date isn't a fund that has any sense of urgency. All right.

What else does? Threats don't work.

Threats. Tell me more.

I've certainly heard people say, we are closing on this date. If you don't have your docs in by then, we're moving on without you, and this is a done deal.

I think that doesn't work. And what I found is that, like, the desire to make a threat around a close date usually comes from some fear or feeling of insecurity within you as, like, a person who's trying to raise a fund about how it's going. So I'd say if you feel the need to threaten an lp, it's probably good to just, like, pause and say, like, where is this need to threaten someone coming from? Oftentimes it's some frustration or insecurity around the fundraising process. Now, listen, a fund that really is oversubscribed doesn't need to threaten LPs. You could just say, hey, listen, we have a ton of interest. We're going to make final allocations on Friday. If you want to be considered, I need your docs by Thursday. If not, it's fine. We have tons of interest and we're going to make decisions on Friday. And we're going to close the fund. That's what a fund that's in good position would do. And I generally think funds that are well supported and well subscribed don't need to make threats because they have plenty of capital in the first place.

So what you're saying is by making a threat you kind of can be shooting yourself in your own foot because you're sending a signal to the LPs that LPs probably by default will not quite believe because you wouldn't be communicating in that way or wouldn't have a need to do so. If you are truly communicating capable of closing the speed that you're indicating.

You.

Know many and I think most the thing to think about is Most of the LPs you talk to, it's a repeat game. You're going to talk to them over and over across multiple fundraises. And if you develop a reputation of well, this is someone who's always aggressive or trying to spin me or is a liar. Is that what you want your reputation to be as a gp? I don't think so.

That's right.

All right. Anything else?

Also, I feel like I shouldn't need to say this, but I will just avoid outright lying. I've seen people do this and get burned where you just say hey, our fund is 3x over subscribed, we're closing on Friday. Are you in, are you out? Or we're we're raising the cap because we have so much interest and we're closing it tomorrow. Are you in? I think most LPs are pretty good at detecting BS. I think what you don't want to do is be a 20 million dollar fund that tells LPs you have 50 million in demand. Excuse me. And you raise an 18 million dollar fund. Those two things are not consistent. One thing I've learned about LPs is the good ones. Take really good notes from every meeting and every interaction you have with them and they'll compare where you said you were with where you end up and it's just not worth it to lie. These people are very good at detecting bs, so don't do it.

So your advice? When you are starting to think you want to pull triggers like threatening or lying, stop and think again. Because ultimately it is a.

Very risky type of tactic with an extremely low probability rate of being able to come through with it. And even if you were to come through with it, you are managing relationships down the road and those relationships are the ones that will carry you into fun two or three or four because those are the people you will go back to, and if they feel like you screwed with them in the first one, you'll have a hard time convincing them to come again.

Exactly.

All right. Yeah. Fantastic. Okay, enough of this negative stuff. What are some of the things that actually do work?

I think at first close is just a really hard milestone to clear for a fund.

Yeah.

So I think there's a couple of things that can work. One is if you have the capacity to start making investments prior to your first close and warehousing those either with your own personal capital or with some other vehicle, it's great if you can make a few investments and then positive things happen with those companies between when you make the investment and when you close the fund. Everyone loves that.

What about what is positive? Are you talking about, like, crazy outlier, big things happening, or just like, okay, there's traction in the right direction? Does it have to be.

It can be. You invested in the seed round and the company raised the Series A in between the time that you made the investment and between the first close of the fund. It could be that they hired some great person. It could be. You know, generally, I think the easiest thing to evaluate are, like, fundraising milestones. So if the company raises another round since the time that you warehouse the investment, the LPs who invest after that are basically getting a free ride. They're going to get the benefit of the markup, and they're going to come into the investment at cost, which is sort of like free money, in a sense.

Yeah. Okay. That makes a lot of sense. What else is out there that can help you?

You know, I think.

We talked before just about constructing an LP pyramid for your fund that sort of balances the type of LPs you want. If you're getting real pressure or heat around the specific check that that LP wants to write, that can really help you get to a first close. So I think being able to tell a story, which is like, hey, I know we talked about a $5 million investment for you. We've got three or four other people in, like, late stage due diligence. I'm not sure where they're going to land, but if this is something that you want free and clear, like, now's the time for you to act that can, if it's credible, it's true, can be a really good motivator for people.

I also don't want to rule out luck.

Yeah.

I think sometimes you happen to find an LP who's ready to go for reasons you don't understand that you're influenced, they are ready to go on your preferred timeline and it just lines up. And it's a beautiful thing when that happens, but you don't really control that as a gp.

Fair enough, Exactly. However, there's one thing that you believe if you do that really well, it can actually have a positive influence on your likelihood of actually getting to where you want to go.

The one thing I found that's worked for us across multiple funds is if you properly understand what the people you're talking to really need to see line up to say yes, you can get them in a first close. The problem is when you're doing this for the first time, oftentimes you're learning about LPs at the same time as you're learning about what this specific LP needs to see from you.

Excuse me. In order to get to a yes. So the more skilled you get at understanding what is this specific LP you need to see lineup. And it could be they need to see a bigger institutional fund come into your fund, or they need to see markups, or they need to see you close another partner, or there might be some piece of data or information they need from you in order to say yes. And as soon as you figure out what that is, that's, I think, the key to pulling people into a first close.

That's really, really fantastic. And that's why you and I spend so much time recording videos about getting a story right, researching the right LPs, etc. Etc. So that makes a lot of sense. All right, so.

Right.

You mentioned that there are several, sometimes several closes.

What should one consider around getting to the first close?

Boy, I think there's a lot of mythology around what you see for your first close. There's some people who want to do what's called the one and done fun, which is one close, one time, everybody in, you're done. That's a beautiful thing if you can pull it off. Doesn't happen for most first time managers. Certainly was not my experience. What I tell people is once you've done a first close, you're committed to being a venture capitalist. So let's say you're raising a $20 million fund.

If you do a first close on a million dollars, it's not a lot of fees to manage the fund.

Excuse me.

Oh, man.

Yeah.

I'm so sorry for you.

I'm almost better. It's also not a lot of money to manage the fund or to actually make investments. So if I thought when on your first close, imagine A world in which there is no other close. Would you still run the fund for 10 years now? I didn't take my own advice. Our first close was less than 10% of our first fund.

But I did it because I was pretty confident that I knew where the next couple of closes were going to come from and I felt pretty confident that we'd be able to raise enough money to eventually get to a place where we had enough capital to run the place. But I would say be careful of doing a first close that's too small if the gap between your first close and your final close is such that like you wouldn't run the fund on the first close amount. So.

And what that right amount is seems to be a bit of an.

Gut feeling type of thing. Or do you think there's a rule of thumb?

I tell people if your first close is less than 10% of your total. That's really hard. You have a lot. I did it that way. I wouldn't recommend it.

It's pretty stressful actually, because you do a first close knowing you still have 90% of the work ahead of you and you're locked in, slash committed to running the fund. A lot of people I know like to get to 30, 40, 50% of the fund size in their first close in order to get there.

Awesome. So my last question for you is basically, what do you actually have to do? What do you need to actually close the fund?

The good news for you is, as a first time GP is that closing is mostly a mechanical process. The bad news for you is that you have to coordinate a lot of people to make it first close happen. So I think the two most important people other than the LPs who are going to be part of the close are to talk to your fund administration team, who's going to handle your back office and onboard those LPs and talk to your fund formation team, which is your legal team that's going to help you with the docs. I always tell people first, step one is talk to your legal team and just say, hey guys, I have a handful of LPs I want to close that XYZ date. Does that seem possible? And they'll tell you, hey, in order to close on that date, here's what we need. We need the LPs to sign up on the LPA. They'll give you a laundry list of things that have to happen.

And usually they'll give you some confidence interval, like, hey, there's a lot to do. We haven't seen anything from These folks, we're going to have to get their docs, we're going to have to review them and approve them, and they'll tell you that might be a slightly aggressive closing timeline. So start with your legal team. They're the key. And then also talk to your fund formation team about what they're going to need, because most of the closing process is really about a document collection and verification exercise that, if you haven't done it before, can be kind of maddening.

All right, any. Anything else?

I think there's two other things I would say is like, double, triple confirm with people that they're going to invest the amount in your fund that they said they would. I think sometimes people get excited about being an LP in a venture fund and they give you a number that's the high end of the range. And then they look at the capital call schedule and they think about, gosh, do I really want to write Charles a 50k check? Boy, that felt great. In the moment, I was excited, and now I think about it, 25k feels more comfortable. So, like, double, triple verify the amount that the people are going to invest.

And then also, like, make sure you talk to them about, like, your plans for capital calls. Like, how often are you going to be calling capital in roughly what amounts, how frequently, so that they can begin to make those plans.

All right.

I think that's really all we had for getting to that first close. Thanks for listening, guys, and we'll see you soon.