VC Business Model

Teaching Example: SuperSeed Investments

Contributed by: Laura Parkin,
Executive Director, NEN,
Bangalore, India

As an entrepreneur, it’s helpful to understand the pressures on your investor. In

other words, in order to understand how the VC might behave, it’s important to
ask: how does the venture capitalist succeed?

Following is a walkthrough of a fictitious venture capital firm- SuperSeed

Investments.

Launching a Fund: 4 people want to become VCs

Lakshmi, Natwar, Joe and Hussain decide they would like to start a venture capital firm
together. They believe that there is a need for more funding for early stage companies in
India today, and that the time is right for them to get started.

They also believe that as a group they have the necessary experience, both in
operations and investing to raise funds and successfully invest.

As an added bonus, some of the group has worked together in the past. Joe and
Hussain worked together at a fast-growing, venture-backed IT firm; Joe in product
development and Hussain in sales and marketing. Lakshmi and Natwar have a track
record of successful investing, having been part of the venture capital arm of a large
commercial bank.

After working through the numbers, they decide to start their firm by raising $100 million
to invest.

They call their firm SuperSeed Investments.

Raising money – smart talk of big returns

Two of the would-be venture capitalists, Natwar and Lakshmi, hit the road and start
visiting people who manage large pools of capital. They do a great job convincing
corporates, banks, pension funds and some very rich individuals to let them invest some
of their money on their behalf.

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From SuperSeed’s perspective, these investors are their customers. And what Natwar
and Lakshmi have sold them is the promise that the investors will make more money by
investing with SuperSeed than they would by investing that same money in either
another venture fund, or the stock market, or the bond market, or any other alternative
investment vehicle.

Since the risk of investing in early stage companies is very high, SuperSeed has had to
promise it’s customers a commensurately high return. Typically, investors in venture
funds target a 25% annual return on their funds, net of the fees paid to SuperSeed.

Getting started: setting up an investment fund

Once Natwar and Lakshmi have received commitments for all the funds from the various
investors, they go about setting up the required legal structures for the firm and the fund.

The firm is organized as a partnership, with Lakshmi, Natwar, Hussain and Joe as the
partners. This partnership then sets up a “fund” in which the money of the investors is
placed, and the fund will in turn invest that money into young companies.

As usual, the fund is a “closed-end fund” that will be managed by SuperSeed. Closed-
end means that SuperSeed can’t add any more to that particular fund. Also, this type of
fund typically has a defined life, in the case of a venture capital fund, usually 10 years. At
the end of the 10 years, SuperSeed has to give the money back to the investors, plus
what they earned, minus what they lost. SuperSeed may also give back money to their
investors during the interim period.

Who has the control?

It’s an act of faith: investors commit their money to a fund, and cede control over the
decision making for the life of the fund – usually 10 years.

In the US and other areas with developed venture industries, “Limited Partnerships” are
a common way to structure the venture funds. The investors are called “Limited
Partners” – the name reflecting both their limited control as well as their limited liability
(they can’t lose more than the money they put in the fund). Legal structures in India are
different, though the basic economics work essentially the same way.

The control, and therefore the pressure, is on Lakshmi, Natwar, Hussain and Joe, the
“General Partners” in the fund, to make investments that deliver a financial return to their
Investors that makes everybody happy.

How much $$ do the VC’s make? Let’s negotiate.

Just as in any deal, the terms of the fund are negotiable: the control, the payback
requirements, the share of upside that goes to the Investors or the General Partners.

SuperSeed is a new fund, so their negotiating power is fairly neutral – they are happy to
play along with the industry norms on the fee structure.

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Management Fees: paying the power bills

Generally, a venture firm is allowed to take a small percentage of the fund every year,
usually around 2% or 2.5% of the total fund amount, to pay the firm’s operating
expenses. In SuperSeed’s case that means that they would be allowed to use $2.5
million each year to pay their operating expenses.

However, that amount is not paid to SuperSeed on top of the $100 million fund, but
rather is subtracted from the total.

This creates a nice tension: SuperSeed’s performance is measured as if they were

investing the entire $100 million. The more money they spend on themselves in the form
of management fees, the less they have left to invest. Therefore, the money they do
invest has to work that much harder – their deals have to perform that much better to
make the returns they have promised.

An option many firms elect is to spend less than the permitted amount on management
fees, and return the balance to the fund. This allows them to both look prudent to their
investors, as well as lower the pressure on their investments.

The Big Money: JACKPOT!

Technically, SuperSeed partners are not supposed to get rich from the management
fees, though undoubtedly, you will not see them running around on old Bajaj scooters!

Venture capitalists are supposed to make money at the same time as their Investors.
The goal of this compensation arrangement is to align incentives: SuperSeed and their
Investors should be motivated by the same goals.

To this end, SuperSeed, unlike investment bankers, will not get paid a “transaction fee”.
Instead, they will share in the “upside” or the gains created by investing their fund. They
have negotiated a typical arrangement that will give the venture firm 20% of the gains.

The 20% share that goes to SuperSeed’s General Partners is not based an amount of
money they have invested, but rather on the work they have put into the process.
Therefore, this percentage is referred to as a “carried interest”.

How much is that, anyway?

If SuperSeed invests the entire fund of $100 million, and if they make some good
investments, at the end of 10 years they might have built a total value of the fund of
$800 million.

First they pay back to the Investors their original investment of $100 million. Then, in the
arrangement they have negotiated, SuperSeed takes 20% of the remaining $700 million,
or $140 million. The Investor Partners receive the balance, or $560 million.

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Variability of Fees – can the VCs get even more?

Management fees and the amount of carried interest are negotiated by the venture
capitalists with their Investor Partners, along with a range of other terms that shape the
fund.

These fees do vary, based on factors like the size of the fund, the track record of the
venture capitalists, and the state of the market.

For example, if the fund size is very large, over one billion dollars, typically the
management fee goes down to 1% or 1.5% per year.

SuperSeed is a new fund, so they are happy to negotiate terms that reflect the industry
norms. Some very established top tier venture firms that can command a 30% or higher
carried interest in their funds.

General Partners – share and share alike?

How Lakshmi, Natwar, Hussain and Joe share the $140 million amongst themselves is
something they negotiate with each other. These negotiations between partners are not
always successful – it’s interesting to see that many new venture funds are formed by
younger partners of existing established firms.

But given that the four founders of SuperSeed are old colleagues, and they value each
other’s experience equally, their internal negotiations conclude happily.

The VCs’ Performance Pressures

High Returns: promises, promises

In the light of recent stock market performance, maybe delivering a minimum of 25%
annual returns doesn’t sound like such a challenge.

So why do all VCs focus so much on companies with such high growth potential? Why,
in some cases, do they limit themselves to companies with market sizes of over $500
million?

The challenge they face is not in returning a minimum 25% for one year, but doing so
over the life of the fund, net of the rather substantial fees.

What’s SuperSeed’s target number?

For convenience, let’s ignore management fees and imagine that SuperSeed invests the
entire $100 million.

If they want to return a minimum of 26% to their Investors, over the 10 year life of their
fund, how much would the fund have to be worth at the end of 10 years?

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The answer: $ 1 billion.

That means that on average, the venture capitalists at SuperSeed have to make 10
times their money on the deals in which they invest. On average. Given that some of
their investments do fail, one can see why SuperSeed Partners can’t afford to invest in
companies with limited potential.

Now granted, once they get going some of the pressure is taken off the overall value,
because they will return some capital in the intervening years. They will not wait until the
last minute to give funds back.

But generally, this provides a good idea of how much pressure the VCs are under to
have all their deals “go to scale”.

Giving back the Money: Deadlines

“You’re only as good as your last exit,” explained a leading venture capitalist to the
newcomers at SuperSeed.

The implicit requirement in delivering returns is, of course, that the venture capitalist has
to “realize” his return. In other words, it’s not good enough to point to a fast growing
company and a fast growing balance sheet. Venture capitalists have to actually hand
cash or freely tradable shares back to their Limited Partners during or at the end of the
10 year fund.

Therefore, SuperSeed must be able to “exit” their investments in order to capture the
upside from their deals.

If you ask the SuperSeed partners, they will tell you: you only get into a deal, if you can
see several good ways to get out.

Wait until the last minute?

No procrastinating if you’re a VC.

SuperSeed’s fund’s life is negotiated as 10 years. So if the average time from

investment to exit is 5 – 7 years, then it means that SuperSeed must invest the entire
fund during the first 3 – 5 years.

Strategies for Success

Managing the Risk, Earning the Return

With so much pressure to deliver returns, and the very high risk associated with each
early stage company, how do VCs deliver on their big promises?

The answer might lie in the ways they can manage risk, at two levels: the individual
investment level, and at the fund level.

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Diversify the deals?

At the fund level, SuperSeed can manage risk and return by balancing the types of
deals: sub-segments of industry, and mixing earlier and slightly later stage deals; and by
simply having multiple investments.

Choosy, choosy?

Lakshmi and the team can also manage their risk through careful selection of their deals,
and by working closely with each of their portfolio companies to increase the chance of
their success.

Of course, careful selection and working with companies takes time, which means that
each partner in SuperSeed would only be able to handle a limited number of
investments.

Not either or…

The SuperSeed partners develop a carefully balanced strategy: enough investments to

spread risk, but few enough to have time to work with each.

In fact, SuperSeed partners decide that they will each handle 2 – 3 new investments per
year. Given that the entire fund must be invested, on average, in the first 4 years, each
partner will end up with 8 or so deals over the life of the fund.

Some of the implications for SuperSeed

While doing the math, Natwar and Lakshmi also realize that if each partner can only
invest in 8 deals, with 4 partners at SuperSeed, the average deal size will have to work
out to just over $3 million over time.

If some deals fail, that means that the companies have to be able put $5 million to
effective use, with the investments in each company staged over time.

A nasty shock

As they close their fund, the new partners hear some disquieting news.

In the past few weeks, some major changes have taken place in the Indian venture
scene. Changes that could pose quite a challenge for them.

Three of the top overseas VC firms have established strong presences in India. Each
firm brings years of experience and a winning track record.

SuperSeed partners hold a council. They address two major concerns: one, will the top
entrepreneurs prefer to get money from these well-known VC firms? Will this mean that
SuperSeed will not have top choice of deals?

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And even if entrepreneurs decide that they would like to work with SuperSeed, the fact is
that there is much more capital in the market, all targeting the same deals, with the same
range of investment size and stage. Will this drive up valuations and make it difficult to
invest well?

The challenge – how to respond?

SuperSeed’s young partners are nervous. They are worried that with their inexperience
they will not be successful in this new market situation.

They are debating possible changes in strategy. One idea they are seriously considering
is adding a fifth partner to the team. They have identified someone with strong operating
background, and excellent connections in the internet space.

Should they recruit the new partner? They sit in the conference room, surrounded by
pizza boxes and coffee cups, trying to reach a decision.

Teaching suggestions:

o This example lends itself well to role playing in small groups.

o Suggest that the case is assigned ahead of time, and students come prepared
to class to discuss.

o Initiate a group discussion on the basic economics of venture investing to

ensure that most of the class has a good grasp of the fundamentals.

o Break students into groups of 4 or 8 – clearly assigning the roles of each

partner in SuperSeed.

o Ask them to decide whether they will be recruiting the fifth Partner.

o Groups can present their answers, with particular focus on the following
implications for their decision:
o Deal size, type of investments
o Team dynamics
o Economics – fees, partner compensation.

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