Starting a VC Fund, Episode 7: The Core Questions Your Model Must Answer

Hey, my name is Patrick Iwes. I'm the founder and CEO of MindMaven. We're an executive coaching firm that helps leaders and VCs free up a whole work day every week. And then we try to figure out what to do with that time and help.

I hate it when I. The basic things. See, I had to start over.

Cut.

It's a takeoff reel, right? Here we go.

We got some good B roll.

Hold on.

Hi there. My name is Patrick Evis. I'm the founder and CEO of MindMaven, an executive coaching firm focusing on helping leaders and VCs free up to a whole workday every week and then taking that time and investing into relationships so that you can reach your fullest potential.

And I'm Charles Hudson, managing partner at Precursor Ventures. We're an early stage venture capital firm that invests in companies at the earliest stage. We are happy and excited to invest in people before the product is live and before there's any evidence of traction.

All right, super. So we are in the whole meaty topic of how to actually come up with a portfolio construction model. We talked about what you need to consider when thinking about this. Let's talk about what you have to do to actually build a really solid one. And so what. What comes to mind first?

I think most people start with the number of companies they're going to put in the portfolio, because that has a lot. That sends a lot of signals to limited partners about the kind of fund that you're likely going to construct. So for example, if you said, I'm building a $50 million fund with 10 companies, you would have say, okay, I think I understand. That sounds like a model where you're gonna make a few really big bets on a very small set of companies. Mm.

Sorry.

It's all right. We can start over again. It was close enough. So they just said, you're leaving.

Mm.

All right, good. Hey, come on. You gotta be honest. Like, we did like, four videos so far with one take. Yeah, that's very unusual. That's. That's actually pretty good.

So.

And we usually did it in the evenings. And so that these. Look, my camera changed too. I don't want to have that black stuff in there.

Hey there. I'm Patrick Evis. I'm the founder and CEO of Mind Maven. We're an executive coaching firm that helps leaders and venture capitalists actually free up a whole workday every week. And then we take that time that's been freed up and help them invest it into relationships so that you can Reach your fullest potential. Potential.

And I'm Charles Hudson, managing partner at Precursor Ventures. We're an early stage venture capital fund that invests in companies at the earliest stage possible, oftentimes before the product is live and before there's any traction.

Awesome. In our last video, we talked about why portfolio construction models are so critical to your fundraising success. Now I want to talk about actually what it takes to build a really solid one. And so take us, take us into this. Charles, what's the first thing that comes to mind?

I think the most thing, the first thing people start with is actually the size of your fund. You have to pick a number, and I think, you know, for most emerging managers, that number ends up being strategy specific. So if you're doing a seed fund, oftentimes it's $50 million or less for your first time. But the fund size you make will depend on the stage of investments that you want to make. I'm going to presume that if you've gotten this far, you've made that decision already. And I won't go too deep into that, because once you've chosen a fund size, the next most important thing to choose is the number of companies that you're going to put into the fund. And if you think about it at a high level, you can do some simple math with the fund size and the number of companies gives you some sense for how much concentration or, you know, how much of the fund is going to be piled into each individual company is likely to happen with a given strategy. So as you can imagine, you could have a $50 million fund with 10 companies in it. You'd assume, wow, that person's going to be very picky. They're going to make a few really large bets in a small number of companies versus a fund that's $50 million with 200 companies in it. You would assume that person's going to probably have less time to devote per company, is going to make many more investments, and probably have a different decision making criteria than the person who's choosing 10 companies. So choosing the number of companies is important not just as an input to your model, but because it has all these ripple effects. For example, if you have the 200 companies in your portfolio and you have a fund with two partners, most LPs will be skeptical that two people can adequately keep an eye on, let alone help, 200 companies. If you have 10 companies, by contrast, the belief will probably be that you can be fairly hands on. But you also have fewer opportunities to find winning companies. If you're only placing 10 bets per front.

And so let's say you have that 200 company example. You would have to expect to be able to have a really good answer of why, despite common belief, you can actually achieve that. Another question. So basically, if I know my fund size and I know the number of companies I want to put into the fund, does that kind of determine the check size and it's sort of automatic, or do I actually think about the check size as a separate variable in my model?

I think you do need to think about your entry point check size as an independent variable. It's not just the output of the number of companies you're going to invest in divided into the size of your fund for a couple reasons. Some people have what we call a two check strategy. You have a strategy where you write a larger check in certain circumstances, in a smaller check in others. But the other thing, and we'll touch on this later, is your initial check size is just one of several checks you might write into a company. You've got to have some policy, a strategy on reserves, and we can, we can talk about reserves a little bit later. And depending on your reserve strategy, your first check might be large or small relative to your fund size, depending on how long you want to stay involved with these companies and how you think about future financings. But I think you want to have a, a position on check size. And I've always felt like you should have a good story about why your initial check is meaningful in the context of your strategy. And also it's worth noting that you know, in some investments, in order to even have the legal right to make future investments in a company, you'll have to write a check that clears some minimum threshold. Could be $100,000, could be $250,000. So it's also important to think about the interplay between initial check and fund size. Got it.

Okay, that makes sense. What comes next?

You know, I think the other thing that comes after that is usually target entry price and like what that means for ownership. So I think there's two schools of thought in venture. One is to focus on entry price and try to make sure the price you pay to invest in a startup is reasonable. There's another school of thought that says the most important thing is to buy a specific percentage ownership in a company. When you invest, if you think about it, there's a very clear relationship between price and ownership. Imagine two funds. One fund says we're going to write a 250k check every time. If that fund invests in a company with a $5 million post money valuation, they're going to buy 5%. If another fund says, hey, we always buy 5% of the company, no matter what, that firm is going to write the same size check. However, if that company raises at a $10 million valuation instead of a $5 million valuation, the person who writes a flat 250k check is going to end up owning half as much of the company as the person who buys 10%. Or conversely, buying 10% of a company that's twice as expensive costs you twice as much.

Do you think that's a fundamental decision you have to make in constructing your model?

Almost.

You build a model around, I'm going to be always trying to aim for that particular ownership versus a flat check size.

I would say the dominant consensus model and venture today is to focus on ownership and back into the size check. And this goes back to your fund model, your fund check size. You, as the fund manager, have to make some assumption on the prices that you expect to have to pay based on your strategy.

You then can say, in order to buy x percent of that company at that price, what is the implied initial check? And the reason this is important is that the venture market pricing changes. And if you go into a model, if you go into a world where you are assuming under your model that seed stage companies can be invested in at $5 million, and it turns out that the entry price for you that you have to pay to get into the ones you want is $10 million, kind of have two choices. You can maintain the ownership discipline and probably do half as many companies because it'll cost you twice as much. Yeah. Or you can do the same number of companies and buy half as much ownership or anything in between those two extremes. And this is another area where I think inexperienced managers trip themselves up. And I'll give you a perfect example if you're modeling out, hey, we think we're going to be able to get into seed investments at a $10 million post money valuation. That's perfectly fine unless your strategy is to invest in repeat founders who've been previously successful in the current market environment. Those companies are raising, quote, unquote, seed rounds, but they're not raising them at the prices that I outlined. And you'll end up with a disconnect between your strategy and, and the model. And this is the reason I keep coming back to the importance of portfolio construction. If you, if you're rigorous in how you build your model, you'll have lots of places to check your work and say, well, based on the strategy that we said about the kind of founders that we plan to invest in, do we think we can actually find them and their companies at the prices we've outlined here? And you can test that, you can test that with the market, you can test that with your fellow fund managers, and you can test it with LPs.

And again, that is very important that you have people. You, you will field questions around this and if you don't have good answers, it's just not going to help you with, with your goal of raising that first fund. Okay, from there on, what's the next most important thing you think you should focus on?

I think the next thing kind of the complete sort of the financial analysis. I think one of the next things people often talk about, and these are related things, is your strategy for reserves. And when we talk about reserves, what we really mean is how much of the fund is going to be allocated for first checks into new companies and how much of that fund is going to be set aside to do follow on investments for the companies where you have the opportunity or in some cases the obligation to write an additional check to support them. And I think this is a really important fundamental piece of the model that you have to have to observe because again, it goes back to strategy. If you're a price oriented investor, you could have a strategy that says, hey, we write a first check at a really low price. We don't follow on. We live with the dilution or reduction in ownership that happens over time. And we think that getting in at a low price will be enough that at the end of the day we'll still end up owning enough of the company that the multiples on those first checks will be good enough to make our fund model work. There are other models that say we're going to start with a medium sized check up front and as soon as we find companies that we think are working well, we're going to try to pile in and put as much money to work in those companies as we possibly can. And that's our strategy.

And you need to understand what you're doing strategy is. So for example, if you have a fund model that's very focused on using an initial check to get an anchor position in the company and then using your follow on dollars to build ownership, you really better be sure that you're going to be able to secure access in those future rounds. Which means for your model it's going to be really important to have what we call a pro rata. Rights agreement in place such that you have the legal right to invest in the next round of the company. Even more importantly, you're probably going to have to make sure that you build strong relationships with the founders that you back such that they make space for you in these rounds. And the risk under a strategy where you have, you know, a small check to buy access and a big check to buy ownership is if you aren't able to convert on the ownership piece and do those follow on investments, you'll end up owning too little of the companies to have them have an impact on the fundamental and you end up with too much in reserves that you're not able to deploy.

And so for that it's really important, for example, if you had that strategy, it's really important to understand what happens in later stages. Is it actually really easy to use the standardly accepted Pareto stuff or is it actually not that easy to do and what could change and so on and so forth makes a lot of sense.

It also just means to finish that point. It also means that you as a fund manager have to be hyper aware of the companies in your portfolio, the ones that are doing well, and figure out how to make sure that you get dollars to work in your best companies.

Makes sense. Okay, talk to me about is thinking about board seats and that kind of stuff something you need to put into the model or is that a different thing?

I do think not everything you put into your fund model is purely economic. Some of these things are about how you're going to spend your time and energy. And I do think it's worthwhile to think about up front. Board seats I think are the manifestation of an engagement model. So I ask every GP like what kind of relationship do you want to have with your portfolio companies? There are very successful investors I know who are completely passive. They give the company money in the beginning, they wish them good luck and they have no plans to engage or support those companies. For some people that's the right style. It can be effective if you have access to really great founders who, who are willing to take small amounts of money from you on a, on a no contact, low contact basis. But most people who get into venture don't want to practice the business that way. They have some expectation for engagement. And if we go back to our sort of two polls model, the 10 company fund and the 200 company fund, if you think about a 10 company fund that that person could probably credibly claim, I'm going to talk to every founder I back once a Week for an hour. I only have 10 companies. I can do this every day. If I talk to two of them every day for an hour, I could talk to everybody once a week. I'm also going to take a board seat. I'm going to be very involved because the portfolio is small. That's a strategy that holds together, it's concentrated and you're concentrating your time.

Charles, are you saying that basically I should start thinking about how I would engage with, with my portfolio, how I will operate my VC business this early? Isn't that something where I could say like, don't worry about it, I'll figure it out once I have the fund raised?

I think you have to think about it in advance because your portfolio construction is going to dictate how you spend your time. So if you're only going to make 10 investments over the life of the fund and you have a five year investment period, you're only going to make two investments a year, which means you're going to be ultra selective on what you say yes to. And when you say yes, you're going to be making a very significant time commitment to those companies. And if you think about it, you could probably run a 10 company fund by yourself, without any junior folks, without any additional staff, because you'll know what's happening intimately with those 10 companies and the need to have people keeping up with them behind you is probably limited. On the flip side, if you had 200 companies, you can't credibly be on 200 boards. That's just not possible. But also, that's a lot of companies to keep track of. You might actually need people on your team and software systems in place to help you get your arms around all the data that those companies are generating about their burn rates and their performance and who's fundraising. That's probably a model that's difficult to pull off as a single operator.

Yeah, fair enough. So basically what you're really saying is, man, you got to get really deep and find finances. You might actually have to learn what it takes to support a portfolio size of whatever number of companies. And the only place to learn that is by going out to those people that are doing it. I would assume that when you do that very often you will realize that the assumptions you walked into were maybe a bit naive or a little bit off. And that is important to get right when you're building this model.

It's almost always the case that some of those are naive and I would also just say the board, just to go one layer deeper. It's these board conversations get even more nuanced. It's like, hey, if you're going to take a board seat in each of these companies, how long are you planning to stay on the board? Because if you do 10 companies in the first fund and you take 10 board seats, again, we get in this conversation of graduation rates, like, at what rate are these companies going to raise new money and will you be able to get off these boards? Or by the time you get halfway through fund to your second fund, are you now on 15 boards and totally maxed out and unable to either meet new companies or even be an effective board member for those companies where you're already a member?

And LPs look at that, right?

LPs will look at that and they'll ask you, so what's your strategy for coming off these boards? If you come on this early and you have this deep relationship with the founders, are they going to let you off these boards?

Right. And you don't want to be caught saying, well, I haven't really thought about that in those conversations. Not a good place. You brought up graduation and sort of follow on rates. What exactly is graduation with the name.

VC fund? That's all right. Yeah. Graduation. Define that for me.

So graduation is the percentage of your companies that move from one stage to another. So one example of graduation is a seed stage company that raises a series A, that's a graduation. And most LPs think about graduation in percentage terms. Okay.

But it's not just getting out of the portfolio like they have an exit. Okay, that's right. And what's important there in respect to the model?

Well, this is where I think the conversation about reserves, initial check size and graduation, there are sort of three legs of the same stool. For example, if you say, hey, we're going to write a small initial check to a bunch of really great companies and we think 80% of them are going to graduate to the next level. That implies you need to set aside quite a bit of money for the next round of investment. And then, you know, for most companies, you're going to raise more than two rounds of financing. So of that 80%, we think 75% of those companies will raise another round of financing, and we're going to want to participate in that round too. So when you start applying kind of compound math, now you're talking about, wow, 60% of your companies are going to raise two rounds beyond your initial check. Are you going to have the financial resources to continue to support those companies? And remember, this is A model. You're going to build a model and then you're going to go run your fund. And I think it's important to understand what happens if you're overly optimistic or overly pessimistic about graduation. If you think about it, if you're overly optimistic and you think more companies will graduate than do end up graduating, you'll probably end up with more money in reserves than you thought because money will set aside for future follow ons you won't use. And then the question is, well, what do you do with that excess money? Do you try to put it to work in companies that you're already investor in? Do you try to save it for, you know, unforeseen things that will happen later in the fund's life? Do you use that money to go make new investments out of the fund into new companies? And if you're overly pessimistic, you'll end up under reserved. You'll have more companies that graduate that are counting on you for follow on than you can afford to finance on.

That for specifically those that are really new to this is like why wouldn't it be just easy to get more dry powder like you just raise another fund so that you can do those.

You know, for the most part when you raise a fund, it has a finite life, it's got a 10 year life and you've got a pool of companies that you've committed to back. And part of what limited partners are paying you to do is to be a good asset manager, be a good fund manager and have a strategy about what's going to happen and to make sure you're making appropriate reserves. Sometimes you have the good fortune, I say in quotes, of having more success than you anticipated, having more companies that successfully fundraise at higher prices. And you can go look at raising something like an Opportunity Fund or using an spv or you can find other structures that allow you to participate in those companies. But part of what limited partners are paying us for is our judgment. And so if your model says, hey, we think this percentage of our companies is going to graduate and we're going to be able to participate in why number of them. This is the amount we should set aside for future reserves, it's probably good to have a cushion on top of that. So if the model says hey, we're going to need 5 million in reserves, if you really don't want to get caught short, you should say hey, the future is unknowable. Instead of setting aside five, let's do seven.

Let'S make sure we have a buffer and a cushion that's not allocated to a specific company or a specific opportunity. We just happen to think that the model is going to produce additional opportunities for us.

And that's basically a great example of how you can build in flex into the model so that it can withstand all sorts of scenarios that might happen.

All right, early on you said something that you want to talk more about reserves and reserves planning and the management of that one. I think we covered some part of this just now. We kind of slipped into it. But are there other elements that people should really think about?

I think everyone.

Excuse me. I think people tend to focus on the positive side of reserves planning, which is when companies raise new rounds at higher valuations from good outside investors. What should I do? What are I going to do? How many of those am I going to participate in? But that's not the only reserves situation that comes up. Yeah, as an investor, you have to also think about what am I going to do for my companies that are doing maybe not quite as well, where they ask me for a bridge or an extension or additional capital to try to work through issues, what do I want to do? And some firms have a policy like, we just don't do those as a rule. We won't do them if company's not doing well. We won't give them more capital, period. Full stop.

Which might work. But tying it back to this board seat thing, if you're on the board of the company and the company is raising an extension and you choose not to participate, that is a very, very strong signal to the market about your belief in the company. And your lack of participation might actually tank that company's ability to fundraise. So I'd also argue that depending on your strategy, there are some areas of reserves planning where I think you have less flexibility than you might think as the lead investor or board member. Other people are going to look to you and are going to make inferences based on your decision to participate. So it's also important to make sure you have reserves set aside or strategy for what are we going to do for the companies that need more capital for these in between rounds?

All right.

Basically, I never learned that much about VC from this particular video. So it was really insightful. I appreciate this.

Anybody watching Stick around. The next video we're hoping to get out is basically, what do you do once you have that model done? What are some of the questions you should ask yourself to really pressure test the model and what are some of the meta questions that need to also be answered as a consequence of you having built your model. Thank you for listening.