Recent conversations with startup founders and their questions on VC’s ability to invest given the current market conditions have reminded me that many technologists do not realize how venture capitalists manage their funds. Unlike mutual funds, VCs should be able to invest regardless of the market’s state.
Many people tend to think of VCs as mutual funds that invest in private companies, but this analogy is wrong on several levels. Many mutual funds take money from investors on a rolling basis and begin investing in the market as they get these funds. Unless the fund gets additional investors’ money (or sells current holdings) it does not have capital to place in new investments (that is a generalization, but let’s go with it). Also, if current investors wish to withdraw capital from the fund they usually can do so on a daily basis. This results in the fund either using existing cash or selling assets to raise cash for these redemptions. Again, this is done on a rolling basis.
Venture capital funds are raised and redeemed differently. First, they are not raised on a rolling basis. Rather, a group of Limited Partners (LPs). These LPs sign an agreement with the venture capital firm agreeing to provide a specific amount of capital to the venture firm as needed. The summation of these LPs commitments is the size of the fund. If a VC has 50 investors who each commit, on average, $10 million then the VC has a $500 million fund.
It is important to realize that the VC has not actually taken possession of this $500 million. Instead, the LPs agree to send the VC capital for investments as they are required. This is very different than the mutual fund, where the fund has the investors’ capital in hand and is investing it right away. It is also different in that the LPs can not (under almost all circumstances) pull their commitments or investments out of the fund.
If a venture fund has a committed fund with unallocated/invested capital then it should be able to make new investments, regardless of the market conditions. Again, different than a mutual fund. In a bad market, a mutual fund may have difficulty making new investments if investors are pulling their capital out – there just won’t be cash to use for investments. All cash on hand will be used to redeem the mutual fund investors as they exit the fund.
However, there is a scenario where venture capitalists with legitimate, committed, unallocated funds may have problems making new investments – when their Limited Partners default. Charlie O’Donnell has a good post on LP defaults and the VC industry. I haven’t heard of this happening in the current downturn but it probably will. When this happens some VCs may have problems closing new deals or supporting their existing portfolio companies in follow on rounds.
Startups seeking venture funding should not be discouraged at this point. VCs are still making investments and looking for companies who can innovate through any market.
