🎵 If I Had a (100) Million Dollars 🎵

If you’re of a certain age — and especially if you’re a Canadian of a certain age — then the lyrics to the Barenaked Ladies’ 90s hit If I Had a Million Dollars are undoubtedly etched into the recesses of your brain. For those too young to remember this folksy anthem, it’s an ode to all of the things the singer would buy if he suddenly had a million dollars (which, in those days, was a mind-boggling amount of money).

Maybe a nice chesterfield or an ottoman.

Thinking about how to spend money is something that VCs do regularly. In venture capital, “portfolio construction” refers to how a fund “spends” (invests) its capital. How much is invested in new companies vs. follow-on investments? How big should each investment be? How many companies will the fund invest in? And so on.

So let’s jump in and discuss the variables that come into play when a VC decides what to do…If I Had a (Hundred) Million Dollars.

Check Size

Check size is the first variable founders tend to think about: how large of a check does a VC write?

(That makes sense, since it’s the most important variable from the founder’s point of view.)

"We write checks between $500K and $1.5M.”

A nice reliant automobile.

Number of Investments

Naturally, the next thing to think about is the number of investments. How many $500K to $1.5M checks will our hypothetical VC write?

For simplicity’s sake, let’s take the median of their investment range. This gives us an average check size of $1M. The VC will, thus, invest in $100M / $1M per company = 100 companies.

"We write checks between $500K and $1.5M. This fund will invest in about 100 companies.

Simple, right? Not so fast…

I’d build a tree fort in our yard.

New Investments vs. Reserves

The number of investments isn’t only about check size. We also need to consider what percentage of the fund the VC intends to put towards new investments vs. the funds they will reserve to put additional money into portfolio companies down the road.

For example, a “60/40” fund will deploy 60% of its capital into new companies and then take the remaining 40% and put it into into second (or third, or fourth…) checks into a subset of those same companies.

There’s a wide range of “reserve strategies” employed by VCs. At one end of the spectrum, some funds (particularly smaller, emerging funds) write only “first checks”. They have a reserve strategy of 100% new investments and 0% follow-on investments. At the other end of the spectrum are “opportunity funds”. These are dedicated funds raised by VC firms for the explicit purpose of investing additional capital into existing portfolio companies.*

If we assume that our hypothetical VC has a 60/40 ratio, then the number of new investments evolves to: $100M x 60% / $1M per company = 60 companies.

"We write checks between $500K and $1.5M. This fund will invest in about 60 companies, with 40% of the fund held for follow-on investments.”

* Advanced readers will note that opportunity funds are technically 100/0 rather than 0/100. Although they are exclusively for follow-on investments from the perspective of the VC firm as a whole, from the perspective of the opportunity fund itself, each investment is into a “new” company.

They have pre-wrapped sausages, but they don’t have pre-wrapped bacon.

Stage and Ownership Percentage

Although we started with check size (because it’s important to founders), we didn’t talk about how a VC decides on their range of check size.

For most firms, the range of check size is a function of the strategy that the fund intends to use to generate returns. Key to this strategy is the stage at which they invest and the target ownership percentage. Some factors that come into play:

• The earlier you invest in a company, the less it costs (👍) but the more risk you take (👎)

• Also, the earlier you invest in a company, the more times you are likely to get diluted as a result of the company raising subsequent rounds of capital (also 👎)

How a VC thinks about the impact of dilution is the main factor in their reserve strategy. The combination of those two influences their approach to target ownership percentage.

For example, one fund might focus on achieving a high ownership percentage with the initial check, assuming that the impact of their follow-on investments will be minimal. Another fund might aim for a lower initial ownership percentage, preferring to see how the founders perform over the first year or two before deciding whether or not to invest substantial follow-on capital.

It’s worth noting that the size of a fund has a significant impact on all of this (a $100M fund, for example, can’t possibly invest in Series C rounds). Charles Hudson has an excellent post that explains how a VC’s fund size dictates their strategy.

Let’s assume that our hypothetical VC has landed on a strategy where they intend to focus on Seed stage investments, targeting an ownership percentage of 10% (astute readers will note that you can reverse-engineer the target valuation that a VC has based on check size and target ownership percentage).

"We invest in Seed stage companies with initial checks between $500K and $1.5M. This fund will invest in about 60 companies, with 40% of the fund held for follow-on investments. Our target ownership percentage is 10%.”

But we would eat Kraft Dinner.

Follow-On Strategy

Another important consideration is how the VC plans to invest their reserve capital.

Some VCs invest in only one follow-on round, while others will aim for more than that. Smaller funds might only invest their “pro rata” amount (the amount of money required to maintain their ownership percentage), while larger funds often try to increase their ownership percentage in top companies. And then there’s the topic of bridge rounds / extensions.

Many founders presume that their VC will support them with a bridge or other follow-on investment if they fall short of their objectives, but the reality is a large percentage of VCs do not write such checks. Instead, their follow-on strategy focuses on making additional investments only into their portfolio companies that are doing well (“doubling down on the winners”). Too many founders wait until it’s too late to ask their VC, “Do you still ❤️ me?”

"We invest in Seed stage companies with initial checks between $500K and $1.5M. This fund will invest in about 60 companies, with 40% of the fund held for follow-on investments. Our target ownership percentage is 10%. Our goal is to invest our pro rata amount in Series A and B rounds. We will also invest our pro rata into bridge rounds, but we do not lead them.”

But not a real green dress, that’s cruel.

Management Fees

So we’ve got it all figured out, right?

Wrong.

After all that, it turns out that our hypothetical VC doesn’t actually have $100M to invest.

Haven’t you always wanted a monkey?

Like most investment firms, VCs charge a “management fee” to their LPs, which typically averages 2% of committed capital. The management fee provides the operating capital for the firm (salaries, lawyers, accountants, back office software, travel, Patagonia vests, etc.).

Standard VC funds are structured as 10-year investment vehicles (3-4 years to make new investments and 6-7 years after that to support the companies as they grow), which means that VCs charge a management fee each year for 10 years.

If we assume that our hypothetical VC has an average management fee of 2% per year, then the amount of capital available for them to invest is actually $100M - ($100M x 2% per year x 10 years) = $80M.

Time to redo our math…

• Fund size: $100M

• Investable capital: $80M

• Check size: $500K - $1.5M (median check size $1M)

• Capital for new investments: $80M x 60% = $48M

• Capital for reserves: $80M x 40% = $32M

• Number of new investments: $48M / $1M per company = 48 companies

Which gives us the following portfolio construction:

"We invest in Seed stage companies with initial checks between $500K and $1.5M. This fund will invest in about 48 companies, with 40% of the fund held for follow-on investments. Our target ownership percentage is 10%. Our goal is to invest our pro rata amount in Series A and B rounds. We will also invest our pro rata into bridge rounds, but we do not lead them.”