I often talk to frustrated founders who are in early-round fundraising. They often wonder why venture firms, with their large sums of money, can’t just give them $200k - $500k. It is a valid point at first glance. Shouldn’t a fund with over $3bn in assets under management be able to quickly give out small checks?
The answer is both yes and no, but mostly no!
Having been on both sides of the table, I have come to understand the factors at play. These factors can be broken down into (1) time/opportunity cost, (2) prospectus, mandates, and business model, and (3) firm/investor type. These three factors come together at a delicate balance.
Time and opportunity cost
This explanation is quite simple. If you are a large fund investing a sum of $50k-$500k in a small company, spending time on that company is not justifiable when you have $30m invested in another. Investors have limited time in a day and must be mindful of where they allocate it. As an investor, you are also responsible to your LPs, who provide the funds for the VC firm to invest and generate returns. Dedicating time to an investment with such a small stake is not financially responsible when you have 600 times more invested in another company.
Aside from the partner’s time, there is also the issue of back-office work, which includes the legal aspects of completing the investment. Investing incurs closing costs, and it is possible for the expenses related to the legal work to exceed the investment itself. This is why there has been an increase in the use of quasi-debt-like funding mechanisms that reduce the need for extensive legal work in executing a SHA for a fully-priced round.
Prospectuses, Mandates, and Business Models
There are books specifically about venture capital business models. So, I will only go into a little detail here. But, I’ll discuss a few important areas. Just remember, VCs also need to raise money. And to do that, they must have a business model for each fund. A VC firm can have multiple funds to invest in companies. The partners have a financial interest in these funds. Typically, a fund will allocate around 60% for new investments and 40% for follow-on investments in existing portfolio companies. The goal is to maintain a certain ownership percentage.
Side note: if you want to learn more about pro-rata rights, you can read my post on how to model ownership & dilution and how pro-rata works.
When an investor raises a fund, they must submit a prospectus or a legal document to regulatory authorities. This document provides information about the investment security and the offering, which includes how the fund will operate and how investors will profit. Additionally, funds establish a mandate determining how the money will be invested. The investment committee (IC) makes decisions based on this mandate. Think of the mandate as a business plan with little flexibility. If you invest outside of your mandate, you may face legal issues with your limited partners (LPs). The fund’s partners have a fiduciary duty to their LPs, which involves managing risk and generating returns.
For instance, let’s say a fund aims to own 15-20% of a company with an average investment of $5-6 million from a $300 million fund. Throughout the investment, the total investment in the company could reach $10 million. If you’re trying to raise a Series A round with a pre-money valuation of $60 million, this investor may not be able to participate because they would only achieve less than 10% ownership, which is not enough for them to make a satisfactory return within their investment mandate. On the other hand, if you’re raising $1 million with a $5 million valuation, they could easily reach their 20% ownership target. However, you may encounter the issues mentioned earlier, such as time constraints, opportunity cost, and conflicts with the LPs’ expectations.
Each mandate is unique, and you can get an idea of this by looking at the fund’s pages in the Financial Times. Each entry represents a distinct fund with its risk appetite and profile. The same applies to venture capital funds, where each fund has preferences for industries, geographies, sizes, and other factors.
An interesting example to highlight is that some funds include exceptions or additions in their prospectus or mandates for incubator programs. Another exception you may encounter is established funds writing a smaller check into a company to invest a larger amount in subsequent rounds. This could be due to their strong belief in a second-time founder they have previously worked with, exceptional early-stage traction, or strategic value. In such cases, the term sheet often includes provisions guaranteeing pro-rata rights and/or aggressive liquidation preferences to mitigate the additional risk taken by the fund.
Firm / Investor Type
The final case to consider is the type of firm. Angel or super angel investors have complete control over their money, so founders are often advised to seek angel investors for their initial capital or are told they are raising too little for institutional investors to be interested. However, it can be challenging to find angel investors or maintain a meaningful database of them since they are only sometimes active.
Another category is firms or investment managers who are just starting and are trying to establish a track record of successful deals to attract more significant funds in the future. For example, a $10 million fund may invest in a series B or C round of a well-known or unicorn startup. At this stage, the focus is not solely on the investment dynamics, but on proving oneself as an investor and demonstrating access to lucrative opportunities. The main challenge for investors is gaining access to good deals and establishing network connections to participate in growth rounds where more data is available to manage risk and generate substantial profits.
Understanding these factors can help explain why large firms with significant resources cannot simply provide small checks to founders and smaller companies. It is essential to ask the following questions when meeting with an investor to determine if they can invest in your venture:
- What is your average investment size and desired ownership percentage?
- What stages of investment (seed/A/B) do you typically participate in?
- Who are your limited partners (LPs)? Are there any specific details about your investment mandate that we should know?
- Can you describe your investment committee process?
Asking these questions will help you assess if the investor fits your needs and save you both a lot of time. Raising money should be looked at like an interview for a job or a search for a partner.