How VC Works

The VC Firm as an Investment Bank

This a thought experiment on how a VC firm would look like if it was a 1 to 1 copy of an investment banking department. To make it more accessible, the model looks at an asset manager with more than 50 funds under management and with each fund having a very sizable amount under management. In reality, all these activities collapse into less roles.

Surprisingly, the facewall on a typical VC website and the concept you get when you research VC managers on financial databases gives you an idea that there are at most two or three kinds of roles employed at each VC firm. The names vary as much as the background color on the homepage and some even include dogs on their website. The clear idea you get is that you are not really sure about what the people at the fund are doing and if all funds are playing the same game. More likely they are not: VC firms differ in almost all dimensions from zero sourcing zero brandname funds that invest in anything that they can find that doesn’t promise to blow up immediately to superstar funds that likely are more likely to have a repeatable and standardized process with clear roles aligned with skill and experience levels. Some funds even moved non-investment specialists to the profit center side and employ statisticians and quants or offer software platforms to integrate well with their investment portfolio. With that in mind, it makes little sense to compare IB (=investment banking) hierarchy with the venture capital world. But since venture capital is a subset of private equity, operating under similar structures and private equity more likely copies the IB hierarchy, why not give it a thought.

First of all, what do we have in a typical IB unit in a bank? In a stylized world we have four levels of hierarchy. Managing directors or MDs who are basically there to source client contracts. VPs who basically run the IB team and all cross-functional activities in the bank and who practically “own” the entire investment case. Some associates who basically run the entire IB activity – neglecting the cross-functional work – for the VP/Principal and coordinate the army of analysts. And analysts who basically do all the nitty gritty work. Makes sense and fits the entire process model of an M&A deal. This of course a simplification, but good enough.

How can these layers be applied to the venture capital world?

Let’s ignore fundraising which is typically a joint effort of the founder partners and eventually the finance and PR function.

The VC MD

The VC equivalent to the MD typically is refered to as executive (or non-executive) director or senior investment/portfolio manager or in short: fund manager, and he is in charge of the fund as a whole. What does that mean?

1) Single face to the customer: They make the entire fund work (a 10 year investment case) for the “clients” [= Investors of the fund]. Just think about a hypothetical asset manager with roughly 50 VC funds under its discretionary management. The founder partners and executives of the asset manager don’t sit in every fund related decision gremium, but the MDs or “fund managers” take the lead. They represent the interface or “single source of contact” of the asset manager managing the fund towards its investors. They sell the success and promise of the fund, it’s thesis, it’s performance as a dedicated portfolio with its own strategy and are responsible for making it a success, hold status update meetings and keep investors happy and interested in fullfilling their potentially non-binding commitment, and building trust to keep them on board in future funds.

2) Responsible for all fund success: Consider each VC fund has roughly 20 billion under management and will invest into 500 companies over its life cycle.

a) Not investment manager: Of course, the fund manager isn’t sitting in all board meetings and actively managing the investments. He is managing the lower level investment managers that run the investments for the fund. While he represents each investment in the fund gremia, he is in fact just reporting on what is done in his fund.

b) The fund gremium representative: As single face to the customer he is the one that sits in the fund’s supervisory and decision making gremia. He is the one that writes the opinions on the fund outlook in communication towards investors and in official reports. They also have to manage the individuals in the gremium and potentially problematic and conflicting interests of investors. In pro-rata funds, the issue is to keep everyone aligned to make a good investment happen. In subscription-based funds, where investors can participate or not in a particular investment, they have to ensure that the maximum amount of original commitment is actually invested. Things get even more intricate in master-feeder funds where a senior fund manager has to align investor interests in several funds. Aligning and executing transactions becomes more and more complex. Giving need of (c).

c) Ensuring mission success: Responsible for the fund performance, the MD is ultimately in charge of deciding which investments to present to investors, how the investment process is to be structured and how to measure execution performance. Unlike investment managers, he is directly supervising how the service functions of the asset manager – finance, controlling, valuation, legal, etc. – are performing their duties in context of achieving fund success. Aligning processes and rhythms that ensure successful investments in the fund focus area and under the legal structure of the fund us jey. By controlling processes and making investment decisions and supervising the investment managers, the fund manager is steering the fund towards higher performance, thereby fully relying on his investment managers to capture alpha, but still being a core filter and decision maker on when an investment likely will prove to be a risk and has to be disposed of via secondary or other means. In the latter function, he also still serves as a coach and oversighting function on the investment managers.

3) Preparing new mandates and developing new investment thesis: The responsibilities in (1) and (2) are already heavy for some managers. But they are hygiene factors. The lowest level on the hierarchy of needs. The core activity of the managing director or fund manager is – getting back to the analogy to the MD in banking – the management of client relationships.

The definition of clients for venture capital is what makes the analogy interesting. The fund manager has to execute on a good fund thesis and then has to find a new thesis. The execution on the current fund and the ability to identify relevant investment areas for future funds is all focused around industry relationships.

First of all, industry relationships create exit opportunities. By creating and managing relationships with industry players that are likely to have an interest in a portfolio company, the managing director can listen to his industry network on who might have an interest and how big the demand in the exit market really is. In a geographic area as the US where corporations are actively buying technology companies, managing relationships is straight forward. In markets like Germany, with lower exit valuations and a wider net of smaller companies that buy investments, such relationships become harder to manage. Managing relationships with M&A departments and innovation leaders with key buying hungry corporations tells the fund manager which companies have the financial power to buy and have yet not satisfied their hunger in a particular industry segment. Understanding the level of financial resources available in each potential buyer, understanding their thought leaders view on the market, and understanding the buying behaviour and satiation of buying hunger gives all the information needed to assess who might be willing in a company if it is performing strong enough in its direct competitive landscape and if it is timing the market correctly. If he/she considers every corporation as a manager of a innovation portfolio that builds its portfolio by buying companies, he can directly assess the short- and mid-term demand in particular critical technologies.

The relationships created in the course of seeking buyers of portfolio companies has a critical side effect for steering the valuation of portfolio companies. If the relationship is strong, the thought leaders will create leads towards departments and business units that shop for subscriptions into B2B start-ups. These departments all run on a budget and within a typical political environment found in corporations. Understanding budgets, internal networks and interests and hence hunger for specific services as well as satiation in services is critical to assessing how fast and easy a viable sales pipeline can be built. On top, the more companies are successfully served to such clients, the more interactions take place and the higher the probability the gatekeepers in each company will talk about other opportunities – creating leads – and talking about companies with particulary strong sales departments – and hence sales managers that might be key assets to hire for future portfolio companies targeted towards these companies.

Finally, using the exit network and sales network strategy combined yields a consenus view of a company on the development of technology and future areas of interest and a clear picture on how the procurement pipelines / sales cycles work in these companies. If a fund manager can scout the company wide interest in a technology segment from more and more key buyer companies, he will be able to identify segments that he can use to built a new fund thesis and hence raise a new fund. Thereby eventually obtaining investors from the buyer networks and allowing him to grow the size of the fund.

This reveals how much Venture Capital is a relationship business and that the core activity of a fund manager should be focused on external industry relationships. But who manages the investments?

The VP level / Investment Managers

Below the fund manager or MD level are the VPs or investment managers. The individuals that manage the investments. Again we have to use the analogy with investment banking to understand that investment managers don’t just manage the investment [ that would be equal to saying a VP runs the activities in the IB department of the bank, but we argues he manages the intersection between all business functions of the bank ]. The question is now what managing the investment really means.

(1) Single face to the customer: Again, the investment managers serve a single face to the customer function. But this time, the customers are not the investors of the fund and not industry players relevant for hunting exits. In analogy to banking, they are all external parties involved in the success of an individual portfolio company including the portfolio company. Relationships again, but on another level. The relationships include lawyers, advisors, coaches, human resource networks leveraged for staffing the portfolio company, to some extent relationships to industry clients of the portfolio company and – and this is most important – the venture capital/financing ecosystem of around the portfolio company : The investment syndicates.

(a) Syndication: MDs managed industry networks. Investment managers focus on networks to co-investment syndicates and other funds. Dealflow sharing, idea exchange, relationship management. All possible by joining negotiations during the investment and exit period and by sitting in the board together, trying to steer individual companies towards success. In some sense, portfolio companies they manage become their vehicle of networking. Overall, investment managers cultivate and nurture the networks of their fund. All in an environment where everyone is competing with everyone else – investment mangers among each other, with other funds, etc. Which leads to a competitive and efficient capital allocation from investors in the mid- to long-term. By managing these relationships, the asset manager creates stronger relationships with other players in their space, harvesting ever and ever better co-investment opportunities that align with the asset manager (=company) and fund manager (=person) philosophy on how to approach investments and opening networks to industry players that can be fed back to fund managers or used to rise the ladder in the hierarchy.

(b) Relationships with external stakeholders around an investment. (a) will likely take up much resources and is the primary function of the VP. Ensuring success of the investment for the managing director level – fund success – by ensuring success of the investment and the investment syndicate – investment manager level. This should naturally take up enough time to reduce the level of actual exposure to deeper operative issues of the particular investment – which is the job of the associate -, but still serving as the single face to all the external parties involved in the process. Hence, similar to the IB VP, where associates basically “own” the process and investment case and VPs merely serve as face and responsible individual, the VC VP is only managing the investment in his fudiciary role – by sitting in the board and maintaining active contacts – and takes the bullet of responsibility for the investment, being the single source of contact managing touchpoints. In this role as single face, the key goal is to use his associates to successfuly oversee and steer the investment, later on picking up ideas from the fund manager about the direction the company needs to take to become a viable exit candidate.

As everyone wants to rise the ladder, the big shot of the VP level is to identify better technologies and understand key industry segments better than other investment managers. Trying to choose the right industry exposure and using the associate and analyst research to drive the network strength in a desired industry. Networks in this case are mostly networks to lead generators, possible targets, thought leaders in this segment, eventually industry players, and so on. In the end, pitching a superior view on the industry to the fund manager, advising him in formulating a successful investment thesis, is what makes the investment manager more valuable beyond his investment performance.

(2) Fudiciary responsibility. Finally, the investment manager carries the full responsibility of pre-selecting investment opportunities and ensuring the success of the investment strategy – negotiating and optimizing terms, steering and strategically managing the board, preparing the company for an exit and negotiating the exit. While most prepatory thought work is happening on the associate level, the investment manager must bring the skills to essentially buy low and sell to the highest bidder. And doing anything in between skillfully to make the investment a success. And it is the ability to perform top quartile that should justify any participation in typical VC returns.

The associate level

Remembering the IB model, the associate – or several associates – manages all the activities within the investment banking department and preps the VP in his supervisory role. With the previous discussions, the associate is the individual that will know each investment best among all individuals in the fund.

(1) The expert and strategist: He will know the complexities behind the selection process, the negotiation processes, the interplay of other board member’s interests, the operative milestones of the company, the financials, product roadmaps and whatever. He will be the de facto expert in each investment. All information collected at the higher level is channeled to his level and all the resources at the analyst level are there for him to create the best possible understanding of the portfolio investments he is put in charge of. Analogue to the IB world, they are the masters of the process and the relevant details, supervising the analysts and prepping the VPs. Whenever the investment manager needs to know something he does not yet know but could know about an investment, the associate is there to know and prepare the material.

(2) the process owner: Understanding that industry research is somewhat the work of the analyst, the associate will understand that his prime role is to understand what the VP is responsible for and managing the level of exposure of the VP to this responsibility. The associate will not network with the investment syndicate, he will not negotiate terms and confer with advisors. But a superstar associate will be under the skin of all those stakeholders, knowing their minds and hearts and being able to navigate all the intricacies of investment managing. Any negotiation strategy and the data needed to built it will run through the desk of the associate as to make the investment manager serve as a filter and sanity function for the associate. In principle, the associate will learn at the end of his life as associate how to run the entire deal, but he will not have any touchpoint with the parties involved in the deal. Any board meeting is prepared and any issue in the board meeting anticipated by the associate.

The role is clearly defined by allowing the investment manager to focus his energy on the networking part and preparing his non-networking related activity in the best possible way.

(3) Rising the ladder: The key for the associate is to basically own the entire investment of his investment manager. If he is luckly, his investment manager is not particulary apt and the associate can take on more responsibility, stepping into the role of managing the investment. Attending board meetings as an observer, taking phone calls with lawyers and syndicate partners. Being able to built a better market understanding and networking with the industry and thought leaders around a particular industry that might become relevant in a future fund is a key sucess factor.

Analyst Level

Analysts in banking, PE and VC are the number crunchers, market researchers, presentation and marketing material owners. Everything that does not scream strategy and process is in the hands of the analyst. So while the thought leader on company financials is the associate, the actual in depth expert is the analyst. The associate is simply the single face to the customer within the VC firm: he manages the touchpoints to the VP level. The analyst manages the touchpoints to the analyst.

Analysts don’t sit in negotiations, don’t even see or hear about negotiations, likely don’t even get to see term sheets. They are the end of the food chain. They have no idea which industry is relevant at the moment, but they become the experts in the industries they cover. They do the grunt work during due diligence, prepare the technology and market assessments and are reviewed and scrutinized by the associates on everything they do.

The only thing even lower than the analyst is the analyst or associate intern.

How it really works in Venture Capital

This is a role model for a VC firm that has a high level of differentiation among the different levels within the firm. In reality, VC firms are very small, everyone is a alpha type and everyone wants to do everything. There is a lot of alliances, a lot of politics. What really differentiates things is the travel budget for visiting events that help build a company, tech hub, VC and industry network, how board seats are used to build relationships, how actively people are using deals to get their foots into doors and what people do in their free time. It is a highly competitive game where every opportunity of meeting and mingling with people has to be managed well to both manage time and energy and opportunity. It is tough. The sales and bullshit bingo game is an entirely different story.

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