A couple weeks ago, I had the pleasure of participating on the Lean Startup Financing Food Chain panel hosted by the Chicago Lean Startup Circle at 1871. Our discussion, moderated by Deb Hill, revolved around the flow of capital from its ultimate owners through venture capitalists and finally to entrepreneurs. We also spent some time talking about deals, terms, and gotchas but we won’t cover any of that here.

Since the event, a number of people have approached me asking for written notes, so I teamed up with Deb to summarize and share them here. This is by no means an exhaustive summary, but hopefully provides a good introduction to the funding food chain. Please give us a shout if you have additional questions. We’d be happy to help or point you in the right direction!

There are basically three major links in the funding food chain: asset allocators, asset managers, and you (the entrepreneur). Asset allocators are the real owners of the capital. Venture capitalists are asset managers. Asset managers raise money from asset allocators and invest it in your business. Simple right? Kind of…

Asset Allocators

One of the many things entrepreneurs should understand before accepting investment dollars from a VC is where they got the money in the first place. They should also have a good sense of how the success of their new VC buddies is being measured. Pensions, endowments, family offices, foundations (public and private), insurance companies, and large corporations among others, are allocators. They represent the vast majority of the money invested in private equity and venture capital globally. High net worth individuals also invest in venture funds but they represent such a small percentage of the total pool (generally said to be around 15%) that we won’t bother saying anything more about them here. 

Allocators are portfolio builders. They take the money they’ve been entrusted with, devise an asset allocation strategy and then hire managers to execute that strategy. Some allocators take an indirect route to investing in managers, hiring funds of funds or advisors to make the decisions for them. But regardless of the avenue they choose for deploying capital, the flow is basically the same. Allocators care a great deal about preserving and growing their capital efficiently and with as few risks as possible. They care because ultimately, they need to spend all that money on retirement checks, scholarships, medical research or whatever their mandate dictates.

To illustrate how allocators deploy capital, let’s take a look at CalPERS, the nation’s largest and most well respected pension fund. The investment team there is currently responsible for deciding how to invest a little over $300 billion dollars. Roughly 10% of that, or $29.3 billion, is invested in private equity (which encompasses venture capital). The other 90% of the pension fund’s assets are spread out across a host of other asset classes from real estate and forest land to publicly traded stocks and bonds. Allocators invest with many different managers in an attempt to create an asset allocation program that can achieve a desired return over time based on specific exposures across a range of asset classes and geographies.

Fund Managers (VCs)

If you think entrepreneurs are the only people spending lots of time trying to raise capital you’re wrong. Venture capitalists are almost always pitching too! Let’s go back to CalPERS for a moment to illustrate. The investment team at CalPERS says they want 10% of their assets invested in private companies. As you can imagine they have some pretty specific ideas about what kinds of companies, at what stage, in what industries they want to own. Of that $29 billion, they might want to invest 15% of it in growth stage healthcare technology, 10% in early B2B SaaS, 25% in special situation industrials, and so on and so forth.

Venture funds who specialize in B2B SaaS are competing with each other a piece of that $2.93 billion. They compete for multi-million dollar allocations the same way other businesses compete for new customers. In order for a venture fund to close a deal, they need to be able to demonstrate that they have a higher probability of producing the kind of financial return the allocator is looking for than the other VC’s pitching them. It is a hard sales job.

A manager’s real work begins after they get capital commitments from allocators (or Limited Partners as they’re called once they’re committed to the fund). Now they need to sift through all the deals they come across that fit into their strategy and choose the handful that seem most promising. Many managers invest in somewhere between 20 and 40 companies over the lifecycle of a fund. In today’s market, that means the average partner at a VC will lead 1 or 2 deals a year.

This means he or she might look at as many as 100 opportunities before making a single investment. What’s more, VC’s are looking for companies that not only meet their investment requirements, but also align with their fund’s objective at every stage of its life cycle.

You see, venture funds typically have a fixed life of 10 years (but allow for extensions where appropriate). This means that on average, a fund manager will only spend 3 to 5 years deploying capital into promising companies. The next 5 to 7 years is spent nurturing and then harvesting the fund. During this time they’re focused on making follow-on investments in their best portfolio companies, while preparing them for an exit.

Usually, a venture fund will begin raising money for their next fund once they’ve completed their initial investments and are moving into the nurturing phase. What this means for you is that even if you’re selling shares in the best thing they’ve ever seen, they may not be able to invest in your company because of where they are in the lifecycle of their current fund.

What does this mean for entrepreneurs?

Knowing about the funding food chain makes it easier to understand the motivations, constraints, and objectives of venture investors. Hopefully, that helps you make more informed decisions about the kind of capital you take and who you take it from. To take it one step further, having an informed sense of the return expectations the asset allocators have of their managers makes it easier to appreciate the terms that come with venture money.

Also, although you’ll probably never meet the pension fund managers who are invested in the venture funds that back you, there is something special about knowing a little about some of the other beneficiaries of your hard work.

Now that you’ve got your head around these basics, you can get cracking on your raise (a topic which is way outside the scope of this post)! There are many excellent resources out there that can help you figure out what to do next though.

I’m a fan of this guide to raising venture capital by Mark Suster. Venture Deals by Brad Feld and Jason Mendelson is also an excellent resource which every entrepreneur would benefit from reading.

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Have fun building your business!