Today, we officially kicked off our venture fund formation with our law firm. How exciting!
We’re still weeks away from getting the paperwork done, but we’ll do it right.
Right now, we have a bunch of entrepreneurs on deck and we need to select the method of collecting money now while investing it while it comes in. It is a slightly different way of operating than other funds, which seek to raise money first and then go out and look for investment opportunities.
It’s an interesting way to work.
The pros are:
1. We deploy money as soon as possible.
2. We collect management fees sooner.
The cons are:
1. Early investors carry more risk, as the fund is not diversified yet.
2. More paperwork for us, and thus more time and money spent on that.
3. Management fees come in, but we won’t get enough to support ourselves. Full budget is achieved when we raise the entire amount.
I think the most important part is that we get our entrepreneurs off and running. They need cash now and we shouldn’t hold them up….

So important in the venture world…
We had a meeting with some prominent folks today and presented our current line of thinking on our fund and how we want to operate.
At the end, the advice given to us was to start small and build up a reputation first, before attempting to tackle bigger projects.
This reputation would hopefully embody positive working relationships and performance. A big return at exit would have a hugely positive effect on our reputation, and our abilities as entrepreneurs and to generate great businesses and positive return for our investors.
In the venture world, my guess is that there are too many charlatans out there, those who are out to get your money and then can’t execute. Or, it ends up that it sucks to work with these guys, even though they seemed sweet in the beginning.
So at least I have a positive beginning with my work history. It has carried me this far and now I have to bring that to the startup/entrepreneurship world.
I can only hope I can deliver….

What kind of investors are venture capitalists?

Venture capitalists are professional investors who specialize in funding and
building young, innovative enterprises. Venture capitalists are long-term
investors who take a hands-on approach with all of their investments and
actively work with entrepreneurial management teams in order to build great
companies.

Where do venture capitalists get their money?

Most venture capital firms raise their “funds’ from institutional investors,
such as pension funds, insurance companies, endowments, foundations and high
net worth individuals. The investors who invest in venture capital funds are
referred to as “limited partners.” Venture capitalists, who manage the fund,
are referred to as “general partners.” The general partners have a fiduciary
responsibility to their limited partners.

What makes a good venture capitalist?

Management backgrounds and networks in specific industries, financial
skills, “people skills”, negotiating skills, statesmanship, and boundless
energy are some of the prerequisites of a good venture capitalist. But all
that’s not enough, because at its core, venture capital is truly an
apprenticeship business. It takes years of mentoring to learn how to assess
investment opportunities, set pricing and strategy, build and motivate
management teams, deal with inevitable and unpredictable threats to the
businesses, source additional capital and strategic partners, and, finally,
divest (for better or worse) these illiquid investments. The good ones view
it as a calling, not a career.

How are venture funds structured?

Venture Funds are usually organized as limited partnerships where the
investors are limited partners, and the managers are the general partners.
The majority of funds range in size from $5 Million to $100 Million, and
have between 2 and 5 GP’s. These partnerships generally have a five to ten
year life, which allows sufficient time for the managers to make
investments, assist in their maturation process over several years, and then
arrange appropriate sales of the partnership’s interests.

How do I invest in a venture fund?

Venture fund general partners accept “qualified” limited partners, who
commit in writing to invest specific sums in their fund. Limited partners
become parties to the Partnership Agreement, which spells out the terms of
the fund, and must be prepared to invest their commitments when called upon
by the GPs. Capital calls are made in some funds over the first years of the
partnership’s life, on fairly short notice.

How is my investment repaid?

When a company in the fund’s portfolio is sold or taken public, the
partnership receives compensation in the form of stock or cash. The general
partner typically distributes any cash proceeds to the limited partners
immediately and will distribute securities when they are free of most
trading restrictions and have reached a reasonable and stable valuation in
the general partner’s opinion.

What are the income tax considerations of investing in a venture fund?

Venture capital investments usually span several years and do not generate
ordinary income. Realized gains on the sale of these investments typically
qualify for long term capital gains treatment. In fact, in cases where the
LPs receive stock distributions, taxable gains are deferred until the stock
is sold by the LP. Most taxable investors find the characteristics of
venture capital investing to be particularly advantageous, as investments
normally compound in value over several years free of income recognition
until sale.

Excerpted from National Venture Capital Association and B4ventures.

After a meeting with another lawyer, we got a deeper glimpse at the structure of a typical venture fund:
There is a General Partnership LLC which contains all the managers of the fund, and any other Special Limited Partners. These people generally run the fund operations.
A Limited Partnership also exists, of which the General Partnership LLC is a General Partner. This Limited Partnership also contains all the investors of the fund, but investors are only limited partners and generally do not participate in active management.
Then there is a management entity, typically a corporation or LLC, which hires all the operations people that do work for the fund. This is hired by the Limited Partnership. This management entity pays all payroll and infrastructure costs.
The Limited Partnership then goes and invests into new businesses. It is basically the venture fund itself.
Profits on investment flow in three directions.
There is a management fee that goes to the management entity, and then there are the profits, which go in two directions – to the investors, and to the General Partners LLC.
A typical deal is “2/20”, where there are 2% management fees off invested capital, and 20% profits that go to the General Partnership LLC for identifying/managing/creating the opportunities. The other 80% profits go to the investors as return on their investment.

Someone paid me the best compliment yet.
After describing who we were and what we were trying to do, this person, a prominent person in the business/venture community said we were BANKABLE. That means on our abilities and our ideas alone he thought we could raise money.
I think this goes to show what a confluence of factors can bring:
1. Personal brand – Gotta have a great brand. This is built over years of success and positive relationships.
2. Great idea – Our plan of attack is new in the venture space. It hasn’t been popularized yet. So we’re the first in many eyes. And our feedback has been that they like what we’re doing.
3. Timing – the venture community is ripe for change in the way it’s doing its work. We’re approaching it differently, creatively, and uniquely. So we gain positivity for being different and unique.
We have gotten some really great responses so far. I hope we can keep this going….
The next factor to work on is to have actual deals in our pipeline. It would greatly enhance ourselves in the eyes of the venture community and really help with us getting some funding. Stay tuned.

Money has the unbelievable capacity to turn everyone into the virtual opposite of what they are now. No other force I know of can make a person do a complete 180 degree flip.
I’ve heard stories now of friendships being destroyed, of family members making incredible demands, families being broken – the list goes on. All of these stories have been in context of starting businesses.
I’ve personally experienced an episode where a partner didn’t pay up his share of a business despite claims to the contrary and I’ve now had to exit that business. I’ve lost an opportunity and a friend.
Somehow in our society, money is some kind of magical force in our lives. It is the path to freedom, to getting things done, and also to nightmares and headaches beyond belief. We are programmed like this from the day we are born – to succeed, to go to school and make money, to buy things, to gain pleasure from buying things, to want more, to have more – as if money is going to solve all our problems by having more.
So therefore, when people are asked to commit actual money to a venture – that’s where the adventure begins or ends.
When you have skin in the game, you’re committed like nothing else. Because in our society, it’s not acceptable to commit one’s life (you succeed, you live – you fail, you die). So you commit the next best thing that has a similar perceived severity in one’s life – your cold hard cash.
Yes, that cash that you slaved over. That you worked years for. That you equate to other things which give you status. Status to attract a mate. To elevate you in society in the eyes of others.
Without which you are a nobody. You can’t eat. You have no roof over your head. You don’t have a mate. You suck.
So what have I learned:
1. No partners are truly committed unless they have put in some substantial level of cash. $100 is not enough. We’re talking at least $1000, if not much more.
2. Don’t start any work until the money shows up in the corporation’s bank account.
3. If it doesn’t show up, just cut loose as fast as possible. It ain’t worth the headache to chase it down no matter what the opportunity is with this partner.
4. I’ve learned to let go of the cash I put in any venture myself. You need to have that mindset that this money is gone and I may never see it again. Because if you don’t have that attitude, you’ll always be nickel and diming everything and you’ll miss opportunities because you’re not willing to spend to generate more cash.
5. Money ain’t everything. There are way more important things in life than money despite what’s been burned into our brains by our immigrant-have-nothing-hiked-50-miles-in-the-snow-to-school-every-day parents. For them, it was very much about making money and surviving. We’re past that.
6. Depending on externalities, like what money can buy, for happiness is an undependable road fraught with disaster. Work on your internal abilities instead. In the end, when you’ve left the poker table and you’ve lost your shirt, you’re still left with yourself and you better be ok with…YOU.
OK I’m diverging and giving you life advice when I should be talking about entrepreneurship. Sorry.
A few more business things I’ve learned:
7. DO NOT BE GREEDY. Be patient. There will always be time to make the next thousand, million, billion. Whatever. We all were greedy through the internet bubble years and look what happened to all that wealth. Take the time to build your business, your credibility, and do it step by step versus trying to make that last one killing. Why would you want to put all your eggs in one basket?
8. Working with friends and family adds another huge level of complexity, commitment, and obligation if you’re doing business with them. You can much more easily walk away from strangers if you don’t get along with them in business. Trying to walk away from friends and family can be hugely stressful, emotional, and/or impossible. It’s like a breakup or divorce of huge proportions. You should be aware of the pitfalls and make sure you set expectations with your friends/family you’re doing business with or taking money from. Most likely, friends/family won’t be experienced in this type of thing and are not used to losing money.
Institutional money, however, is different. They are professionals, and are used to losing money all the time – not that I’m saying you should lose it ;-).
Make your call if you’re going to work with friends/family and beware the consequences.

After talking to many of my entrepreneur friends, one big topic always
comes up – Trust.

They always ask:

How do you know your partner?
How long have you known him?

Have you worked with him before?
How do you know he/she will deliver?

And the list goes on and on. Questions upon questions. Some of which I do
have answers and many I don’t have answers for, dependent on whom it is
we’re talking about.

It seems that just about everyone has gotten burned in their past lives in
such business relationships. And unfortunately, I haven’t pinpointed any
reliable way of knowing how to trust someone completely unless you work
with them for a long time. And even then people can betray your trust.

So if you have to work with someone for a long time, then how did you start
in the first place, given your lack of knowledge about this person?

At one time, you would have trusted family members. But I don’t think that
is a safe criteria to go by either. Your aunts, cousins, brothers, even
your parents, can betray your trust in these matters.

I’ve heard stories of best friends becoming non-friends when they enter
into business together.

I’ve heard stories of people starting businesses under the euphoria of hope
of making tons of cash, but only to end their business relationship in a
haze of hate for the other person and how it was absolutely hell working
with them.

It is really unfortunate that so many people can’t get to some basic level
of doing what they say they will do, and if they can’t, then just saying
so. I think this is the core of trust. You need to be straight with your
business associates as to what you can’t and can do, and what you are
willing and not willing to do. Too many people hide behind some facade of
passive-aggressive fear of failure and false pride and refuse to just be
honest and clear with others around them, as well as with themselves.

I’ve already had an encounter where I had trusted someone, only to find out
that this person could not be trusted and actually lied to me at the end.
I got out as fast as I could but still I lost a lot of cash. Well, what
can you say- entrepreneurship comes with risk.

And so it is with trust. Trust comes with risk and yes you need to
minimize the risk associated with trust. So I try to do better in
listening to my intuition, read up on how to tell if someone is lying to
me, do some reference checking to see what others say. But somewhere along
the line, you need to fish or cut bait. You make a call and either it
works out or it doesn’t.

I think the key thing here is to know that trust is not without risk, and
that even after doing everything you can to maximize your trust in a
person, you can still get betrayed. The object lesson would be to minimize
the exposure of your assets to such risk, to be able to let go of your
investment if it goes sour, and to always learn and try again.

The worst thing you could do is to retreat into some cave and never trust
again…

VCs and investors like to see entrepreneurs with a great track record. It makes them more likely to invest in you versus somebody with no track record. These are:
1. Number of businesses started, and even better a number of wins (versus losses).
2. Ever increasing amount of money raised in subsequent ventures.
3. Great references, other entrepreneurs who love you, as well as investors.
4. You and your team have worked together in the past and thus, have shown the ability to have a successful working relationship.
It really makes you think about your own brand and how people have felt about working with you. I have met people with little or no brand and they are having a dog of a time finding funding in a time when it seems like money is flowing again. And I have met people with incredible brands who get money or are called back for subsequent meetings.

So first, the new dirty word in the world of venture investing is…INCUBATOR.
We learned this from a meeting with a law firm who had setup 24 of these over the internet bubble years and saw EACH ONE OF THEM FAIL. In general, what happened was that they built out way too big infrastructures and hired too many people, which caused their downfall when expenses got too high and not enough money came back in.
So now there is bad taste in investors’ mouths regarding incubators and their failure to bring returns on their investment.
We had started calling our little project an incubator, but now we’re looking for another name.
But we found out that this was still important to discuss, in the context of structures for venture funding.
INCUBATOR MODEL:
People give you money, you build out huge infrastructure to house entrepreneurs and the theory is you share resources from office space to CPAs to internet access to etc. and something good will come out of it.
Apparently, even though there are no existing incubators left alive, the activity is still being quietly pursued within many venture firms, under the guise of such things like Entrepreneurs-in-Residence (EIRs).
So the other models to discuss are:
SERIAL LLC MODEL:
You setup an LLC which is the vehicle through which funds flow, and this LLC is owns an interest in the target business. You are a member and a manager of this LLC, and the investor(s) are other members but not managers. The managers collect a fee for directing and managing the funds, and typically participate in the upside of successful ventures.
BLIND POOL MODEL:
This is the traditional venture capitalist model. You collect funds, and have no specific business to invest in but you have the ability to go looking.
HUNTING LICENSE MODEL:
Another variation, this one generally doesn’t give you any funds to start with but investors basically hire you to go looking for businesses for them. You get paid expenses and salary and start prospecting. You also get commitment upfront from the investors that they will participate in businesses you deem worthy. But the investors here do not put money into any vehicle upfront.
Interesting to hear the structures being used for this kind of work. Lots to learn still over the next few months….