Most folks reading this will know that many startups were built in part with the help of venture capital. Most attention goes to tech companies ranging from Google to Genentech, but some non-tech companies like FedEx and Starbucks also raised VC early in their lives.
However, many folks probably don’t think about exactly where those VC dollars that help fund startups actually come from. So I wanted to dive a little deeper into what I call the startup capital supply chain. I’ve had a version of this post in my “drafts” folder for some time, but the confluence of three unconnected things (more on these later) prompted me to finally finish and publish it.
So where did that dollar that a given VC invested in a startup ultimately originate? Well it may be useful to illuminate this discussion with a chart.
(Click the image to view a larger version.)
Most of the dollars a VC firm invests come from outside limited partner investors (LPs). The actual partners of a VC firm (GPs) will typically invest a minimum of 1% of the total size of their fund,* though frequently this percentage is substantially higher (especially in many of the best funds).
The nature of LP investors can vary widely, but the bulk of the capital in the VC ecosystem comes from large institutions like pension funds, endowments of universities and hospitals, charitable foundations, insurance companies, very wealthy families (aka family offices), and corporations. A smaller portion of the total capital in the VC ecosystem comes from high net worth individuals. Very small funds may not have any large institutions as LP investors, just individuals, but even the largest and most established VC funds often have “sidecar” funds to enable a select group of individuals to invest in their funds (typically entrepreneurs the firm knows well).
To better understand VC capital, let’s look more closely at the various types of institutions (LPs) and their raison d’etre:
Defined-benefit (DB) pension funds are the entities which pay a fixed pension amount to retired employees of a particular organization. There remain many corporate pension funds still investing in VC, though a lot of DB pension funds in the private sector are no longer enrolling new employees. Today most corporations have 401(k) style defined contribution programs where employees pay a fixed amount and the performance of their investments determine the amount they have upon retirement.
For public sector roles, such as government employees, teachers, and firefighters, DB pension funds are still the norm, and many public pension funds still invest in VC funds (though some of these are very large entities, making scale an issue, which I’ll discuss more below).
Some VC firms have eschewed taking direct investments from public pension funds, as state laws now sometimes require these pension funds to publicly disclose information about their investments that VCs consider sensitive, confidential info, like fund-level returns or individual companies in the portfolio.
Endowments are the funds established by universities, hospitals, museums, and other non-profits to invest for the long term. The income these investments generate then help fund the operations of those organizations or capital investment (e.g. new buildings, etc).
University endowments are one of the main categories of LPs for VC funds, though there are also endowments for other kinds of organizations that are investing in venture.
Large charitable foundations like the Ford Foundation, Carnegie Corporation, Kresge Foundation, and many others invest in VC. These foundations then support other non-profits with the investment returns they generate.
Wealthy families arguably created the VC industry both directly and indirectly. Some of the oldest VC firms were essentially the direct investment arms of wealthy families like Bessemer Ventures (originally an outgrowth of the Bessemer Trust established by the Phipps family) and Venrock (originally an outgrowth of the Rockefeller family), though at this point both firms now have outside LPs that constitute the majority of their capital. Greylock’s first fund was also raised from a small handful of wealthy families primarily in the Boston area. There are different flavors of family investment offices today, some are “single family” offices which invest on behalf of one uber wealthy family and their descendants whereas others are “multi-family” that might aggregate the wealth of a number of rather wealthy but not uber wealthy families.
By nature of their business, insurance companies end up with very large pools of assets that they can then invest and use to pay out claims over the long term. A number of life insurance companies and a small handful of P&C insurers are active LPs in VC, though in general the overwhelming bulk of insurance companies’ assets are held in liquid investments.
A handful of large corporations actively invest in VC funds themselves. This typically has a dual purpose: generate a return on the company’s cash while also gaining insight into new startups and technologies that may be of strategic interest to the corporation.
As a result, most Fortune 500 companies aren’t investing in VC, typically only tech and healthcare ones, and some obviously have their own VC arms (e.g. Google, Intel Capital). So there are a handful of VC firms that get a large portion of their capital from corporations, but in general corporations are a small fraction of the overall capital in the VC asset class.
Why They’d Invest Indirectly in VC
Many large institutions from the list above invest directly in VC funds, but others from the same categories will invest indirectly through a range of different intermediaries.
Typically, there are four basic reasons why an organization would invest indirectly.
The first is a staff constraint. Some institutional investors simply aren’t big enough to have in-house employees to vet and manage a portfolio of VC funds. The definition of “big enough” varies widely but, generally speaking, entities that manage less than $1 billion in assets will often go the indirect route.
Next is access – some institutions may have staff but lack the robust network of relationships with the best VC firms to get access to their funds. The best VC firms have a large surplus of LP demand relative to their fund size, so a good intermediary may enable an institution to invest in higher quality VC funds than they would otherwise be able to do directly.
The third reason is less in the hands of these institutional investors, and that’s governance. In some cases, the rules governing how an institution manages its capital may actually require the institution to seek an outside third party’s advice when making specialized investments in “alternative” asset classes like VC.
Lastly, there’s the issue of scale. LPs typically seek to invest in a portfolio of several VC funds, not just a single firm. If you’re a comparatively small investor, you might be better off putting $5-10 million into a pooled vehicle that’s invested in a number of VC funds rather than putting it all just in a single fund. Similarly, large institutions with tens or hundreds of billions in assets such as the largest public pension funds (e.g. CalPERS, CalSTRS) or sovereign wealth funds (e.g. Singapore’s GIC or Temasek) may find it advantageous to make a single $500 million investment in a pooled vehicle rather than try to find many good VC funds to invest comparatively small (for them) amounts in.
What Are These Intermediaries?
There’s a wide range of intermediaries for venture capital and private equity investment, each with its own structure and business model. The main ones include:
Fund of Funds (FoFs)
FoFs take capital from institutions, wealthy families, and others, and then invest it in a basket of underlying VC funds. FoFs are typically structured as limited partnerships similar to a VC fund itself, and they typically charge an annual management fee and carried interest on profits – again just like the underlying VC funds in which they invest. Because of that structure, an investor in FoFs will end up paying more in fees and carry than if they invested directly in VC funds, but the benefits of access, scale, and staff often outweigh the costs for some potential LPs.
FoFs are typically a “blind pool” in that the people running the FoF have full discretion over which underlying VC funds they invest in, and so the investors in FoFs don’t know up front exactly which funds this will be (though they can look back at the VCs a FoF has invested in previously as a guide).
Advisory can mean a great many things in the VC LP world — there are lots of flavors of “advisory” firms. In general however, they can all be categorized based on discretion and specialization.
Some advisory firms have discretion over the assets they manage, meaning if LP X gives Advisory Firm A money to invest, then Advisory Firm A gets to pick and choose their VC fund investments. Other advisory firms are “non-discretionary,” meaning they vet VC firms and/or make recommendations to an LP, but ultimately the LP decides whether or not to invest in a particular firm. In addition, some advisory firms are highly specialized and just manage assets to invest in VC funds, whereas others advise on a broad array of assets ranging from VC/private equity to hedge funds to public stocks/bonds and so on.
What prompted me to think about this now?
It was the confluence of three unconnected things. First I read Semil Shah’s post reflecting on a recent GP/LP summit he attended. I was at the same event and Semil’s thoughts on “A dollar travels far before it reaches a founder” were spot on, but I wanted to elaborate a little more. Secondly we had our annual meeting with our NextView LPs the other week so some of this stuff was top of mind for me. Lastly I saw this tweet from Sequoia the other week, which put a spotlight on some of their LPs and why Sequoia’s exceptional returns over the decades have helped enrich non-profit causes.
Does any of this matter to entrepreneurs seeking investment from VCs?
I originally wanted to write this post to shed a little more light on how the supply chain of VC/startup capital actually works. I thought it might be useful, particular to entrepreneurs who may know a good bit about the VC business but perhaps not to this level of detail about where the dollars actually come from and how they get there. But it also got me thinking about Sequoia’s great causes microsite there. Do entrepreneurs actually care where the VCs they seek investment from get their funding? Should they care?
Anecdotally, I don’t think most entrepreneurs really care about this and personally I’m not sure they should. I believe great entrepreneurs do (and should) seek capital from VCs they think will be great long-term, value added investment partners. Whether that VCs success benefits this LP or that LP in the long run doesn’t really matter. I don’t believe that non-profit LPs (e.g. endowments, foundations) are morally superior to for-profit LPs (e.g. family offices or insurance companies or corporations). I don’t think one can even parse non-profit LPs… is it morally superior to build a new cafeteria for Harvard undergrads (by growing the Harvard endowment) or to ensure a secure retirement for public school teachers (by growing CalSTRS pension fund) or to construct a new exhibit at the Air & Space Museum (by growing the Smithsonian’s endowment)?
At the end of the day finding a great long-term investment partner is what it’s all about for entrepreneurs. The definition of “great VC” will be situation specific… it might mean a VC that has a specific stage/sector focus, it might mean a well-regarded firm brand, it might mean a specific GP who has highly relevant experience, etc. I applaud Sequoia’s transparency about their non-profit LPs, but many entrepreneurs will continue to choose Sequoia because it’s a great firm that has backed exceptional companies… not because of where there LP capital comes from.
* The 1% GP contribution is a statutory minimum for the legal & tax structure of most VC funds. Again a lot of funds have the GPs investing substantially more than 1% of the fund.
eBay announced today plans to separate itself into two companies, one the core eBay marketplace business and the other is the PayPal payments business. This is a move that’s been contemplated by folks both inside the company and outside for many years. Recently prominent activist shareholders have also been “encouraging” eBay management to spin off PayPal as a way to maximize shareholder value.
First let me say that it’s made a lot of sense for the two companies to be a combined entity over the last 12 years. When we sold PayPal to eBay in 2002 we had just gone public earlier that year. The business was strong and profitable (>$100M revenue, gross margins 50%+), but PayPal also faced challenges… diversifying beyond eBay sellers (many sell both on and off eBay), increased regulation, continued international expansion, etc. Being part of eBay helped PayPal tackle all of these things, plus it allowed PayPal to continue capturing payment share within eBay (today >70% of all eBay transactions closed with PayPal). eBay’s marketplace cashflows also provided capital to grow the PayPal business.
We had an immensely talented and entrepreneurial team at PayPal which famously went on to build many other businesses (the PayPal mafia). But in all candor it’s not obvious that we would have been best positioned to build PayPal as a public company for a decade. The payments landscape was different back then… Visa and MasterCard were not-for-profit consortiums owned and controlled by the largest banks. The “smartphone” consisted of Palm Treos and early Blackberries.
So all in all, eBay’s acquisition of PayPal was good for PayPal and great for eBay and the two as a combined entity made a lot of sense for a long time. But for PayPal to maximize it’s potential as a payments platform the company must be unshackled by eBay. Today’s payments landscape is far more dynamic… Visa and MasterCard are publicly traded companies themselves. As incumbents they’re still not terribly forward thinking, but they’re more innovative today than they were a decade ago. There are obviously other companies that have attempted and largely failed to build meaningful payments businesses (e.g. Google, Amazon) and now others like Apple that will try. Crypto currencies are still in their infancy but regardless of whether Bitcoin ever becomes a widespread medium of exchange, the blockchain has significant potential to change the way transactions are conducted and how counterparties interact.
There are two things that are incredibly hard to do but are essential to building a valuable payments company. One is to build large scale consumer adoption + merchant acceptance… we did this at PayPal by piggybacking on the growth of eBay’s marketplace, and as a combined entity PayPal pushed strongly into offline payments. The most remarkable thing that PayPal achieved, and what it makes it different than pretty much every other attempt at payments innovation, has been to create a lower cost source of funding for digital transactions. We did this by getting consumers comfortable with funding via bank account (ACH) and by building innovative and robust risk management systems to deal with all the inherent limitations of ACH (not real time, no guarantee of sufficient funds, etc). We did this out of necessity back when PayPal was still a private company. Had PayPal relied solely on credit cards for funding buyers’ transactions, we would have probably failed on multiple dimensions… it would have been extraordinarily difficult to build a profitable business and the credit card associations cumbersome rules (and at times adversarial approach to PayPal) may very well have put us out of business.
The opportunity and challenge for PayPal going forward will be to take this competitive advantage and further extend the usage of PayPal into online and offline transactions. People frequently fixate on “mobile” as being the next big thing in payments… we’d all like to be able to use our smartphone as the payment token rather than a plastic rectangle with a magnetic stripe. But the grand slam opportunity isn’t simply to use a phone tied to a credit card account (as Apple Payments is attempting to do), it’s to tie a mobile app to other ubiquitous stores of value as PayPal can do with bank accounts or credit accounts (old BillMeLater). Unshackled, PayPal has a shot at this now.
GrabCAD today announced their acquisition by Stratasys (NASDAQ: SSYS). All of us at NextView extend our congratulations to founder Hardi Meybaum and the rest of the GrabCAD team. There’s a variety of coverage of it in the tech press (BetaBoston, TechCrunch), but I wanted to share the story of how we came to know the company and how the future (now past) unfolded.
I first met Hardi at the beginning of 2011 here in Cambridge. He was wrapping up GrabCAD’s participation in the Seedcamp accelerator program, and the Seedcamp startups were in the US to visit potential advisors and investors in Boston, New York, and SF. My partner Rob had also been introduced to Hardi separately by an experienced CAD exec (Mike Volpe – now Hubspot’s CMO).
I was impressed by Hardi as an entrepreneur in our first meeting there in the Seedcamp mentoring sessions. He had a clear vision of what he hoped to achieve with GrabCAD… to make collaborative CAD design easier in our connected world, where CAD engineers and product designers are more distributed.
It was still early days for the company then, at the time we invested in GrabCAD’s seed round in the spring of 2011 they had around 3,000 engineers in their community. But my partners and I saw the potential for the community to grow virally, just as LinkedIn did, and to be monetized with a variety of products built on top of this community. GrabCAD also had very high engagement in terms of the % of engineers actually sharing large, complicated CAD files in the system. CAD software is used in designing nearly every man-made product on the planet, and a substantial amount is spent per engineer on CAD software but when GrabCAD started there were few good tools for collaboration.
Hardi moved the company from his home in Estonia to Boston to be embedded in the deep CAD software ecosystem here (Solidworks – Dassault, PTC, etc) and was part of TechStars Boston’s second class. Fast forward to today and there are over 1.5 million CAD engineers and product designers using GrabCAD. That’s something like 30-40%+ of the CAD engineers in the whole world that are part of GrabCAD’s community, or using their paid products like Workbench (SaaS storage / collaboration). Companies like GE, ABB, and others are also using Workbench or have tapped the GrabCAD community for outsourced design work.
Working with Hardi as an investor has been rewarding. I saw that even first time CEOs can be very decisive… Hardi never put off important decisions, even when they might have been challenging for him personally. I got to share some of our early dashboards from LinkedIn as GrabCAD crafted their own dashboards for early viral growth. And thanks to Hardi I got to meet the President of Estonia.
Congrats again not only to Hardi but to the entire GrabCAD team. The distributed design & manufacturing revolution is still in its early innings. As part of Stratasys, who’s also acquired MakerBot and other startups, there’s a lot more to do with the GrabCAD community and platform. Onward and upward.
One of our portfolio companies, Plastiq, announced yesterday that they raised a $10M Series B led by Khosla Ventures and are planning to move their headquarters from Boston to San Francisco. We’re thrilled for the company to have a great investment partner joining the syndicate and one with deep payments expertise having backed companies like Square, Stripe, Fundbox, and others. In fact I introduced Plastiq CEO Eliot Buchanan to my former PayPal colleague Keith Rabois at Khosla.
Some lament the relocation of Plastiq and other companies who start in Boston but end up moving to Silicon Valley or other startup hubs. To these folks, Boston’s founder pool is a leaky bucket… a young founder who moves to Silicon Valley, New York, or elsewhere is a sign of frailty of Boston’s startup ecosystem.
I believe this is completely the wrong way to think about things.
Boston is utterly unique as an innovation hub, particularly when looking at the pool of young entrepreneurs starting businesses just out of undergrad or grad school. Yes the Bay Area has Stanford and Berkeley and New York has NYU and Columbia, but here we have this immense group of talented people… a quarter million in total at more than 50 colleges and universities in greater Boston, 7-10x the college population in other cities. And this is a truly renewable resource as every year a new crop of smart, ambitious people with innovative ideas walks in the doors of Harvard, MIT, Tufts, BC, BU, Babson, Northeastern, and all the other schools just as one crop walks out. Yes some will depart Boston immediately or in time, but an incredible number stay both short term and longer term. Far more than the number of my classmates who stuck around Philly after Penn.
In that regard our startup talent pool here in Boston isn’t a leaky bucket… it’s a everlasting, self-replenishing spring. And talent flows in many directions (all three co-founders of NextView are all Silicon Valley transplants to Boston).
At NextView we’ve been privileged to collaborate with Eliot and many other entrepreneurs who set out to build a company right after college or grad school. In fact if you look just at Harvard, something like 15% of NextView’s portfolio was founders starting right after Harvard undergrad or HBS. We’ve worked with entrepreneurs from other universities around Boston here too, but this is just an example of one university. Plastiq has spent the last 3+ years building here in Boston, and even after their HQ moves a good chunk of their team including some core engineering will remain here in Boston. Similarly ThredUp founder James Reinhart built his company here in Boston in the early years after graduating from Harvard (HBS/Kennedy) before deciding to continue building ThredUp in SF. But others like InsightSquared (co-founder/CEO Fred Shilmover started after HBS, now approaching 100 employees) and Whoop (co-founded by Will Ahmed & John Capodilupo as Harvard undergrads) have remained in Boston and are building great businesses here for the long term.
The Boston ecosystem may have failed young entrepreneurs 7-10 years ago. Facebook is of course the highest profile example, as Mark Zuckerberg famously moved to Palo Alto after early attempts to attract capital, advice, and mentorship here in Boston were unsuccessful. We should rightly reflect when Boston fails young entrepreneurs as we might have in the past, but this isn’t the case today. When our ecosystem supports founders and helps them thrive we should celebrate these companies, even if at some phase they expand beyond Boston.
As investors, once we join with entrepreneurs as capital partners we are 100% committed to their success. For the record I believe Plastiq, ThredUp, and other startups which build early in Boston but ultimately relocate have ample access to talent, capital, and customers here to build very large businesses for the long term in Boston if they so chose. Even Zuckerberg said shortly before Facebook’s IPO “If I were starting a company now I would have stayed in Boston.”
I would have been happy if Plastiq had decided to remain headquartered here in Boston. But by the same token we support founders who decide that their company is best served by opening offices elsewhere and even relocating their HQ. And I celebrate the companies like GrabCAD who relocate to Boston because they feel this is the best hub for their startup to prosper.
I hope that the Boston ecosystem can start to realize we don’t have a leaky bucket, we have an everlasting spring of talent which is a singular blessing. Maybe it’s the curse of the Bambino from 100 years ago when some of the first young talent departed Boston. But either way we should acknowledge that our startup hub is truly unique in terms of our constantly renewing talent pool, and celebrate when our ecosystem successfully supports these founders even if they don’t remain in Boston forever.
Those of you who know me are probably aware that I’m a rabid soccer (football) fan. I’ve been a devoted fan of Arsenal for nearly two decades, former MLS season ticket holder (both San Jose Earthquakes when I lived in the SF Bay Area and New England Revolution here in Boston), attended World Cup 2002 in South Korea, and was fortunate to see both gold medal soccer matches in Bejing 2008 Olympics (US women’s victory, Argentina men’s victory). Every four years the whole world gets to celebrate this great game and our shared passion for it with the World Cup.
Success in the World Cup, just like success as an entrepreneur, depends on a mix of skill, hard work, and luck. Virtually every sovereign nation on the planet fields a squad in an attempt to qualify for one of the 32 spots at the World Cup itself and of course only 16 progress to the knock-out phase and only 1 will ultimately lift the cup in victory.
The winner of the World Cup will play only 7 matches in the span of a couple weeks which doesn’t seem like a lot. Yet the tournament winnows the field in a fairly deterministic and consistent fashion. Luck (good or bad) impacts nearly every team at some point in the tournament, and some squads make it farther than their skill might predict through sheer effort and will. But no country has ever won the World Cup on the basis of luck or hard work. Ask England how they feel about their bad luck in 1986 when Diego Maradona’s “Hand of God” goal knocked them out of the tournament. Yet anyone who’s seen a meaningful chunk of the 1986 World Cup will tell you incontrovertibly that Maradona was the standout player of the tournament and Argentina’s overall victory was well deserved. You’d be hard pressed to say any of the winners in the tournament’s 80+ year history hadn’t earned their triumph.
The ecosystem of tech startups is a similarly efficient winnowing machine. As a tech entrepreneur you know that the odds are long from the outset, that most startups are ultimately unsuccessful. Luck plays a role and with the benefit of hindsight, there are obviously startup outcomes that benefit from bull/bubble markets or seemingly irrational behavior. And hard work and perseverance does sometimes help some companies seemingly overachieve what otherwise might have happened. At times it may feel as though just a little more hard work can manufacturer success or the success of other startups feel like flukes.
But at the end of the day, the marketplace and the World Cup are both ruthlessly efficient. Just as a select few nations have truly earned the right to call themselves World Cup Champions, only a select few transformative and enduring companies will emerge from the startup ecosystem. The Microsoft’s, Google’s, Facebook’s, and other startup champions have earned their success just as Brazil, Italy, Germany, and other World Cup Champions have.
Enjoy the drama, splendor, and excitement of World Cup 2014!