AGILEVC My idle thoughts on tech startups

December 6, 2012

A little more inside baseball from the VC biz… why VC’s rarely make “crossover” investments, with capital from multiple funds the VC firm manages invested in a single startup (see note 1).  I was talking with an entrepreneur recently about this phenomenon.  This person is an experienced CEO and a veteran of several startups, yet appreciating this nuance of how VC’s operate their business was relatively unfamiliar to him.

As most of you probably know, the vast majority of VC firms make investments out of funds structured as limited partnerships with a 10yr life.  VC firms typically raise a new fund every 2-4 years but each of these funds is a discrete pool of capital.  Unlike a startup that might raise equity financing across several rounds all combined in a single balance sheet, VC’s do not simply commingle these funds into a single bucket to be allocated across all the companies in that firm’s portfolio.  If Acme Ventures III, LP invests in Startup X then typically Acme Ventures IV, LP would not.

Why is this?  If Acme Ventures has a new supply of capital with fund IV, wouldn’t they want to reserve some of that for companies in Fund III?  Wouldn’t they want a piece of the winners in the prior fund to be in the new fund?  There’s a couple reasons which basically all relate to potential conflicts of interest from misaligned incentives.

1) LP Bases Change Over Time – Most healthy VC firms tend to have stable relationships with the limited partners investing with them.  In other words, assuming things are going well the majority of LPs that invested in Acme Ventures III usually “re-up” and invest in Acme Ventures IV.  But inevitably there’s some shifts in the LP composition of a VC firm’s funds over time, either due to circumstances with the firm or particular LPs or both.  Of course a VC firm that has stellar performance will often attract new LPs interested in investing, or conversely one that performs poorly will have existing LPs drop out.

But even for healthy VC firms, as a firm grows or shrinks they are typically adding or subtracting LPs in each subsequent fund (still usually a minority of overall committed capital in the fund).  A particular LP might also go through changes in circumstance that dictate they increase or decrease their investment in the VC asset class generally or to a particular set of firms.  Or public policy changes may force GPs or LPs to end longstanding relationships.  About a decade ago Sequoia and some other top firms decided to end relationships with many state university endowments because as public institutions, they became required to publicly release VC performance data which some firms weren’t comfortable with.  More recently the “Volcker Rule” in the Dodd-Frank financial regulation overhaul has meant that most banks can no longer invest in VC or PE funds directly.

As a result, even for healthy firms with most existing LPs returning for new funds, you typically have distinct LP bases in each and every fund a VC firm raises.  Thus VC firms typically have a potential conflict of interest between two “distinct” sets of limited partners who’ve invested in different funds, which makes #2 and #3 more complicated.

2) Differential Cost Basis – Suppose Acme Ventures III invested in the Series A of Startup X and then made follow-on investments in the Series B and C.  Acme raises Fund IV and now Startup X, a breakout winner of Fund III, is raising a Series D.  Why wouldn’t Fund IV invest at this stage?  Well at this juncture Startup X’s valuation is presumably a lot higher than it was at the Series A, maybe even 5-10x+ higher.

Suppose Acme IV invests in the Series D and 6 months later there’s an acquisition offer for Startup X that’s 50% higher than the Series D post-money valuation.  For Acme III’s stakeholders a 10x+ return may look very attractive and Acme III would have a strong incentive to support the acquisition, but Acme IV might feel that the company should “go long” and shoot for a larger acquisition or IPO further down the road since they are seeking a return greater than 1.5x.  As you can imagine, it would put Acme in a tenuous position of being supportive of the transaction with one fund and potentially opposing it with another.

3) Differential Investment Time Horizon – In parallel to cost basis, cross investing creates mismatches in the holding periods of two different funds (see note 2).  If Acme invests at different times in Startup X with two different funds, they will have different willingness for how long they want to remain investors in Startup X before seeking exit.

The rare occasions that you do see crossover investing are typically when a firm makes an initial investment at the same point in time across two funds.  For example Acme III might be willing to invest in a Series B or C stage company in Year 4 of the fund (e.g. late in Acme III’s initial investment period) in parallel with an initial investment from Acme IV in Year 1 of that fund (e.g. beginning of the investment period).  But Acme III is unlikely to invest in a super early stage company at that juncture.  And firms typically reserve in parallel in this rare situations, e.g. if Acme III invests $1 and reserves $2 then Acme IV would do invest and reserve in the same proportion.

4) Fiduciary As a Board Member – On top of the potential conflicts across different funds, GPs also often face the risk of conflict when serving as board directors of portfolio companies.  This is true even if a VC has only invested from a single fund, where as a board director they must serve as a fiduciary for all the shareholders but as a minority preferred equity investor they occasionally have divergent interests.  But certainly crossover investing from multiple funds makes this potential conflict even harder to deal with.

Again, all of these boil down to having a potential conflict of interest for a VC firm given mismatches in cost basis, time horizon, and LP base across different funds.  So at the end of the day VCs rarely crossover invest, which means entrepreneurs just need to understand how the fund that’s invested in their startup is thinking about all of these things (e.g. VC’s reserve strategy, time horizon, etc).

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Note 1: Confusingly, the term “crossover” investing is also used in reference to the practice of some late-stage VC funds where they might invest some capital in a late-stage VC round when a startup is still private and then invest additional capital soon after the company goes public.

Note 2: Evergreen fund structures (where VC’s have a single fund that takes money in & out over time) obviate the issues around differential time horizon.  But given the other challenges associated with establishing and managing an evergreen fund, these are pretty rare in the VC world.

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