In VC funds, there are two target customer groups for the business, startup founders and limited partners (LPs). Most first time VC fund managers (VC founders), including myself, tend to focus on the first target group. That’s why, in my opinion, most of them fail to raise a second fund.
As a first time fund manager, you would usually have a small fund ($5m-$25m). Conventional wisdom suggests that you invest smaller tickets in more seed stage startups (20–50 pre-seed/seed companies). This way you can diversify more, reduce your risk, and increase your chances of some return on the long run, while slowly developing your VC firm and your investment thesis. It sounds like a good evolutionary process where you learn by doing. It’s also much easier to access such deals as founders are more desperate to get started and there is less competition on those early stage deals.
Every new VC fund manager I meet wants to lead or be the only investor who writes the first check in pre-seed startups! They want to prove that they can spot good companies as early as possible. They also go crazy about building the brand through social media, blogging, and speaking at conferences to connect with founders.
But, there are a few issues with this suggestion. First, you don’t have the luxury of time! You’re fund is small, the fees won’t last you many years to prove that your selection criteria is good enough, and when time comes to raise your second fund, your portfolio won’t be in a position to impress LPs yet, even if you’ve selected the best seed companies out there. Second, by focusing on seed stage startups, you’re inherently accepting higher levels of risk knowing that most of new startups don’t make it to the next stage. There are team risks, technology risks, market risks, competition risks, funding risks, economic risks, and legal and regulatory risks. Third, if you think about it from an LP point of view, you would add even more risks related to the team running the fund. Fourth, being out there and meeting lots of founders might actually harm your brand as you might look like you’re overpromising.
I think seed stage investing is a luxury that only big funds (and angel investors) can afford, but not small new funds.
As a first time fund manager with a small fund, the target customer group you should focus on is LPs not founders. Contrary to the conventional wisdom, I think you should invest bigger tickets in less later stage companies (5–10 Series B/C companies). This will dramatically reduce your risk, and speed up the process of building an impressive portfolio, that will enable you to raise a second fund faster.
Whenever I mention this, the first reply I get is: “But founders of good later stage companies go to well established firms, we can’t get access to such deals!”. Well, that’s an access problem, and there are a few solutions for it.
First, forget about being a lead investor, you can’t get control now anyway. So always be a follow investor until you have a big fund.
Second, focus on building value-based relationships with top VC firms to include you in their deals. Your value could be through market research, or specific domain expertise, or connections to a minority group or an emerging market. In other words, focus on helping those big VC firms instead of competing with them. They will include you in their deals as a value-add follow investor once they know you can help. In other cases, if you can, bring them deal flow from domains you know best based on your operational background.
Third, connecting with more VCs will open up opportunities for you to buy portions of their holdings in secondary transactions when a fund term ends, or when a portfolio company runs a tender offer to provide liquidity to its employees.
With this deal access strategy, you can afford to spend more time building your brand among LPs (as opposed to spending all your time building your brand among founders). There are multiple sources of investment data such as CrunchBase or CB Insights, use that to continuously post new research on VC funds performance, or case studies on funds, or new investment trends. Then meet new LPs every week, and use your research as an entry point, i.e., to share with them your findings and initiate the relationship. At the end of the day, not every meeting with an LP should be for fundraising, connecting with institutional LPs takes years of relationship building.
In summary, I think first time VC fund managers with small funds need to think more late stage via other VC firms (as follow investors) and focus on LPs relationships, as opposed to, thinking seed stage and focusing on founders relationships.