“Focus on the customer”. “Fall in love with the problem”. We hear those all the time as absolute startup advice. What about venture capital firms? They’re not startups but shouldn’t that kind of advice apply to them? How? What problem(s) do VCs have to fall in love with? Who are their customers and how do they focus on them? Before giving an answer to these questions, let’s make sure we all agree on how venture capital works.

Startup founders are not the VCs’ customers

If you already know about this, skip to the last sentence of this part.
Say I want to build my own venture capital firm. I need to set up a management company that we’ll call Magic Capital. Then the management company will launch a debut fund, Magic Capital Partners I, with a target size of $10 million, and commit 1% of the fund. This means the management company itself will put $100,000 into Magic Capital Partners I: I have to pay $100,000 from my own money . Limited Partners (“LPs”) provide the remaining 99%. LPs usually are pension funds, university endowments, family offices, wealthy individuals, corporate groups, public institutions. Magic Capital is the General Partner (“GP”). It controls how to invest the fund in startups, which are the underlying asset. The deal between Magic Capital and the LPs is the following (simplified, standard terms in the industry):

  • The LPs believe the GP will make smart investments and so they agree to pay management fees to ensure the GP can work in good conditions. Roughly a yearly 2% of the fund size for 10 years – whatever the return of their investments. So the management company makes $200,000 revenue every year for 10 years even if all startups they invest in are total blowouts. The yearly $200,000 come from Magic Capital Partners I.

VC: money in

  • Once the returns from startup exits reach fund size, partners share all exceeding proceeds: 80% for the LPs, 20% for Magic Capital. This is “carried interest” and is useful to incentivize the GP to make the best investments. So if the startup exits generate $20 million in proceeds, the LPs get $10 million (fund size) plus $8 million, and the GP gets $2 million as carried interest.

VC: money out

So the LPs pay the GP twice: guaranteed management fees and carried interest as a performance bonus. The LPs are the customer. Now don’t get me wrong: the founders backed by venture capitalists are more than customers. Founders are heavily invested in the same assets as VCs and hold the keys to their investments’ outcomes.

Money, money, money: the problems of the LPs

Now that we know who the customer is, let’s try to find out about customer pain points. Here’s the big picture:

  • Pension funds have to make money to pay for future retired people. Family offices have to make money for the sake of the family. University endowments have to make money to pay for scholarships, research labs, prestige facilities. If LPs give one dollar in 2014, they want to receive at least three dollars back in 2024 (venture capital funds usually have 10-year lock-in).
  • LPs have hundreds of millions to invest each year. They need GPs to put money to work in large amounts. When a venture capital firm raises $1B+ funds, it enables LPs to make bigger checks and invest more money.
  • LPs spend lots of money and time to find, screen investment opportunities. They pay investment professionals to screen and select investment opportunities and manage the portfolio. They have to find the best teams to trust with their money.
  • Other pain points have less to do with money. For prestige purposes, LPs need GPs to invest in the hottest companies even if they don’t yield stellar returns. It’s the dinner party pain point: “I invested in funds which backed Facebook pre-IPO” always works…

For more specific types of LPs, other pain points appear. Public institutions need to invest in venture capital funds to show effort to back innovation and hope to spur job creation. Corporate groups want to build access to innovation/startups through venture capital funds. The jury is still out on whether this works or not.

The list of things VCs can do to delight their customers

Well, it’s not “the” list but “a” list:

  • Make smart investments and generate returns
  • Make smart investments and generate returns
  • Re-invest management fees. Meaning: re-invest the money you get from early proceeds so that the final amount invested in startups is equal to the fund size
  • Take more of the LPs’ money: raise larger funds. Caution: large funds mean lots of management fees which can de-incentivize GPs. Large funds also mean bigger tickets to startups hence higher valuations hence more difficulty to generate multiples. Also, startups with less money seem to work better.
  • Show LPs scalability and repeat. If you can build a long-term, scalable firm (train teams, build network of repeat entrepreneurs, show some sense of strategy), then you will make the LPs’ job real easy. They will just invest in your next funds. They will be confident the team will survive departures of star partners.
  • Offer co-investment opportunities: some LPs will like direct investments. What’s in for VCs? Additional capital, alignment of interests, pleasing the LP with great deals and exposure to real-life, behind-the-spreadsheet excitement.

Building firms that meet those needs is difficult. Teams like NEA and Andreessen Horowitz somehow manage to do it with their own style. If you’re a startup founder, never forget what (your) VCs’ end goal is: generating maximum return for their LPs.