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Small Funds and the Pro Rata Right

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In our previous post we discussed our view that small venture funds were right-sized to generate attractive returns in venture capital. Mark Suster and Fred Wilson recently penned excellent pieces on the changing dynamics in the venture capital market related to this bifurcation between small and large funds.  Large funds grew up in the late 1990s as the result of capital market dynamics.  These firms realized that when they had winners, they should back them all the way.  As the small-cap IPO diminished as a viable exit option in the 2000s, companies found themselves needing increasing amounts of growth capital from private investors in order to bridge the gap from a small to mid-cap potential IPO, furthering the proliferation of large funds.

Typically, when venture investors purchase shares in a private company, they get what’s called a “pro rata” right to invest an amount in later rounds that enables them to maintain initial ownership levels.  Constrained fund sizes do present a challenge to fund managers who think they have a home run brewing in their portfolio.  “What do I do with my pro rata rights in subsequent financings?”  As a limited partner in leading small venture funds, we’ve seen a number different models utilized successfully.

Option 1. Pass and take dilution

Perhaps the most difficult thing for an early stage investor to do is to tell an entrepreneur that he or she is not going to participate in the newest round of financing.  This situation is even more difficult from the investor’s perspective if the company appears to be a winner.  However, LPs measure a venture fund’s success using one simple metric: Fully realized net distributions divided by contributed capital.  Period.  There are other performance metrics that LPs look at, but this is where all roads end.  If a VC looks at its fund and decides that the marginal ownership purchased in later rounds will have little impact on its fund, the best decision may be to pass in these rounds.

Option 2. Form deal-by-deal Special Purpose Vehicles (“SPVs”)

The deal-by-deal SPV formation for growth stage rounds seems to be the avenue of choice for most small funds in today’s market.  In an attempt to monetize its pro rata, the GP of an early stage fund simply sets up an affiliate SPV for one or a handful of its LPs to participate in growth stage rounds of financing.  Generally, these SPVs come with minimal set-up fees and varying carried interest arrangements, but typically not better than the economic arrangement for the original early stage fund.  This option allows for LPs to opt-in on a deal-by-deal basis allowing for some level of independent analysis rather than trusting the GP explicitly. These SPVs do open fundraising and timing risk around specific opportunities as well as ongoing oversight and increased LP management for the GP.  In this case, we believe a fund’s portfolio companies benefit from increased ongoing exposure to their original investors.

Option 3. Introduce LPs directly

It is a rare LP that is able to process direct company deal flow and invest in a timely and responsible manner. For the LPs that can handle the risk and make direct investments without being overly burdensome on a company’s time, an introduction to management is an interesting way for a VC to “monetize” this excess pro rata.  The VC would not benefit directly from this introduction but could potentially curry favor with its LP.  Of course this only happens if the deal does well and as such should be used as a strategy sparingly and only in situations when a company might benefit from having that LP involved directly. Pitfalls abound.  We’ve recently noticed a number of new LPs raising their hands to directly co-invest who have little to no experience investing in earlier stage technology companies.

Option 4. Form a Growth Fund

At this point, we are not positively disposed towards our managers raising blind-pool growth funds.  While these funds can mitigate fundraising risk for specific opportunities and benefit GPs though discretion over a captive pool to manage, the LP has no ability to opt-in or out of deals it likes or does not like.  LPs backing early stage managers to invest growth capital are relying on that manager’s access to information and trusting them to use that information to produce a return rather than to prop up faltering companies that are unable to raise new outside capital.

While it may be enticing to capture more potential upside by investing full pro rata amounts into growth rounds, inviting limited partners to participate in a more concentrated way in specific portfolio companies does not come without risk.  If these investments go well and are successful for those involved, a GP can benefit from the goodwill but if the deals falter, the GP may have created suboptimal circumstances for raising a subsequent venture fund.  Growth investing from early stage managers can be defocusing from what that investor does best – helping companies at inception.  In many cases, absent the right partners, Option 1 may be the best available to the VC.

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