How does your investor fundraise?
This is a crucial question for aspiring Deep Tech founders and those working within the Deep Tech ecosystem, as it helps align their goals with their partners.
To explore this topic, I had the pleasure of hosting Tülin Tokatli, CEO at Pitch Me First, and former LP at EIF. We provided an overview of the venture capital value chain with a focus on Deep Tech.
Key Themes Covered:
🌱 How Capital Flows Through the Deep Tech VC Landscape
🤝 The Role of Limited Partners (LPs)
⚖️ Balancing Impact and Returns
🛠️ Understanding the Operational Structure of VC Funds
📚 Decoding VC Vocabulary
🎧 Prefer to Listen?
KEY INSIGHTS FROM THE EPISODE
🌱 How Capital Flows Through the Deep Tech VC Landscape
Firstly, let's quickly outline the hierarchical funding structure where money flows from the largest investors at the top of the pyramid down to the startups at the bottom.
At the top are the mandators who allocate substantial amounts of money. Below them are public investors like fund-of-funds—for instance, the European Investment Fund, which is a significant player in this area. These funds allocate capital to regional venture capital and private equity funds. In turn, these funds distribute the capital to startups.
Every dynamic is based on generating value, bringing something to the table, and creating value for the one that is on the top, the investors.
In this dynamic VC ecosystem, the process of capital fundraising is central. Startups begin by seeking funds from venture capital firms, who in turn fundraise from fund investors. These fund investors then need to secure funding from their mandators. The entire dynamic is driven by the creation of value for investors at each level.
Service providers, particularly law firms, play a crucial role in ensuring proper governance, especially during disputes.
It's not just sophisticated investors involved: angel investors, high-net-worth individuals, crowdfunding platforms, and corporations in the Deep Tech sector also contribute.
These corporate entities are pivotal, often providing testing, insights, and network opportunities to startups.
LPs, VCs, and Startups: An Interconnected Ecosystem
The venture capital funding process is highly interconnected. If top investors, such as the mandators, don't invest, then fund-of-funds and institutions lack the capital to invest in VCs. Subsequently, VCs can't provide capital to startups.
This entire value chain is cyclic — successful startups eventually become investors themselves, reinvesting in the ecosystem.
🤝 The Role of Limited Partners (LPs)
Regarding limited partners (LPs), their investment objectives and criteria vary significantly.
Institutional investors are often bound by the mandates set by their mandators, focusing on policy-driven investments like tech transfer funds, which are crucial for commercializing university R&D. This could lead to breakthrough innovations, particularly in Deep Tech sectors.
LPs also prioritize investments with social impact, such as those benefiting marginalized groups or addressing environmental challenges like Climate Tech and Sustainable Energy.
The demand for innovation is constant; without a component of innovation, investments are less appealing to institutional investors.
In contrast, smaller investors like family offices and angel investors have more flexibility to set their investment appetites and objectives.
This dynamic shows the diversity of investment strategies within the venture capital ecosystem, where both policy-driven goals and the pursuit of innovative, high-performance tech investments play crucial roles.
⚖️ Balancing Impact and Returns
Regarding the financial implications of social impact in fundraising, the connection isn't always straightforward.
It's a misconception that investments in social impact necessarily yield lower returns. If managed well, these investments can be competitive.
Investors shouldn't expect lower performance from these ventures inherently. While some mandates may prioritize support over financial return, this doesn't mean the investments are philanthropic by nature.
In fact, many social impact funds have shown significant success.
Moreover, these investments often align with climate targets, adding another layer of value. Investors may set specific key performance indicators (KPIs) for startups, which helps manage investments more effectively.
These KPIs serve as a control mechanism, ensuring that investments not only aim for financial returns but also contribute positively to environmental and social goals.
Thus, engaging in social impact investing doesn't necessarily equate to philanthropy; it can be a strategic choice that aligns with both financial objectives and broader societal benefits.
In every investment, it's crucial to seek a performance return.
Without this, the cycle of reinvestment in the venture capital ecosystem—where we aim to regenerate value continuously—cannot be sustained. This principle is fundamental to maintaining a healthy and dynamic VC environment.
🛠️ Understanding the Operational Structure of VC Funds
A critical aspect of operating a VC fund, especially during fundraising, is the alignment and incentivization of all parties involved.
It's crucial that Limited Partners (LPs) understand that their investment goes beyond merely paying management fees; they are committing to a long-term engagement aimed at generating substantial returns.
Similarly, fund managers must prioritize performance over merely earning management fees, focusing on their carried interest, which aligns their goals with those of the LPs.
Fund managers must also share the risk with LPs.
For instance, in a traditional setup, if a fund is worth $100 million, at least 2% should ideally come from the managers themselves, ensuring they have skin in the game before allocating capital to startups.
Clear definitions of boundaries and roles are essential, and governance frameworks set by agreements play a vital role in this. Regular interactions, such as quarterly or semi-annual advisory board meetings, are critical to maintaining robust investor relations.
If governance falters or promises made during the fundraising phase, such as investment amounts and equity stakes, are not fulfilled, it can undermine future fundraising efforts.
These elements are often agreed upon during the due diligence phase and may not be explicitly detailed in binding documents but are understood as part of the operational agreement.
The due diligence process for an institutional fund typically lasts 12 to 18 months, reflecting the thoroughness required.
However, more flexible or risk-tolerant investors might expedite this process, potentially adjusting their strategies to make quicker decisions within about 2 months, but this approach shifts the dynamics significantly.
📚 Decoding VC Vocabulary
What is a Management Fee?
The management fee is essentially a payment to the fund manager to cover operational costs. This includes salaries for the team, administrative expenses, and ensuring the fund’s solvency.
The purpose is to allow the fund managers to focus on securing and managing investments without financial distractions. The fee should only cover necessary expenses and provide a minimal buffer, not generate surplus profit for the managers.
What is Carried Interest (Carry)?
The "carry," or carried interest, is more akin to a bonus. It represents a share of the profits generated from the fund’s investments, acting as a profit-sharing mechanism. If the fund performs well — meaning the investments are sound, the companies scale successfully, and profitable exits are achieved — the managers receive a portion of these profits.
This incentivizes managers to strive for high returns, aligning their interests with those of the investors.
Over time, successful fund performance can lead to substantial carried interest payments, which can be millions of dollars. This not only rewards the current fund’s success but also provides capital that can be reinvested in future funds, helping to build the fund’s reputation and legacy over time.
