A VC explains how VCs work with Kate Mitchell (Scale Venture Partners)

Venture Capitalists (VCs) have an outsized impact on startups, entrepreneurs, and the tech they invest in. But beyond the tweetstorms & headlines...

Venture Capitalists (VCs) have an outsized impact on startups, entrepreneurs, and the tech they invest in. But beyond the tweetstorms & headlines, the specifics of their business isn’t widely understood. Where does their money come from? How are their firms & funds structured? How does the pressure of returns impact their investment decisions? I catch up with my colleague, a partner at Scale and past chairman of the National Venture Capital Association, to discuss what you should know about VCs, how you should think about fundraising, and how VCs can be surprisingly close to the companies they invest in.

Tim Anglade, Executive in Residence at Scale Venture Partners: So it’s called the NVCA right, so it’s the National Venture Capital Association is that it?

Kate Mitchell, Partner at Scale Venture Partners: Right, right.

Tim: And I was always sort of wondering, is this more of like lobbying, or trade group, or it’s just kind of a little bit of both?

Kate: It’s a little bit of both. It’s a little bit of both. And it started gosh now, 35 years ago, but the real thesis was start-up companies don’t have resources to have a voice heard, nationally, in the press, and in particular in Washington, so that’s why it was formed.

Tim: Right, and it helps more than VCs, right, it really is kind of in general, I mean it’s a trade group, but you get help with the Jobs Act, and you guys work on diversity, and entrepreneurship, and NCV.

Kate: I was back in Washington last week talking about immigration reform, particularly HB1 visas, the start-up visa. So, no, it’s a relevant, and live, but it’s more than that. So we spend time in Washington, educating the importance of small companies that are out here and across the country doing a lot of work. But we also spend time convening people, entrepreneurs, VCs, to learn. There was an interesting statistic, you’ll love this one, that so we actually were talking about immigration reform, and looking at some of the statistics by state. When you get out of Massachusetts, New York, and California, the average size venture firm, guess.

Tim: Oh, I don’t know.

Kate: Guess. Just do a guess. You know it’s smaller than what you might expect.

Tim: In terms of partners, or money, or?

Kate: Money. What’s our average size fund?

Tim: I don’t know, maybe $10 million, $20 million, something like that?

Kate: You’re the first that’s been close. 17.

Tim: Oh, wow.

Kate: Isn’t that amazing? Well it makes you realize, venture firms are start-ups too, and we’ll talk about that later today, but it, yeah, I was really surprised. And that’s why they need some help. They don’t have a lot of resources, how can they learn from each other, how do they set up their firm. Just like entrepreneurs, what do you do, how do you get effective, how do you be successful?

Tim: No, it is kind of crazy, it is a very varied world. There’s many different kind of people doing VC, and I remember from my Boston days, there were just a lot of very, very small funds so that’s why maybe I guessed pretty close. But I’m still very surprised. Like most people in start-ups don’t really understand what VCs do. And so maybe we should start there, like what is the point of a VC, why does a VC exist in the landscape of investment and money?

Kate: That’s a great question. It is kind of a mystique, isn’t it. Well, the way I think of it, is venture is a conduit. What are we a conduit for? Our institutional investors’ need for return and the best entrepreneurs, and our job is to find the best entrepreneurs, nurture them with capital of course, but hopefully advice, and networks, and hiring expertise, and other stuff so that they deliver the best returns for their investors. My mom’s in a nursing union, and I think my job is to find somebody like you to do the best for my mom’s pension, going forward. So that’s kind of our role in life.

Tim: So people like, yes, state pension funds, universities, endowments, people like that, they put some of their money into a VC and they say bring me money back, and they do that because it helps them diversify from any number of other instruments, bonds or whatever else they might be doing, and ideally give them better returns, right, that’s kind of what we always keep hearing about from VCs, is that they want good returns for their LP, a limited partner, so that those investors, and so what’s kind of the timeline we’re talking about, what kind of returns are we talking about usually, what are the expectations from those investors usually in the landscape?

Kate: Yeah when investors, when they think about their whole portfolio, and they might be a family office or even an individual. You said pensions, endowments, foundations, all the way to sovereign wealth funds. So it could be couple hundred thousands of dollars, to billions and trillions of dollars, so they vary in size, but most, it’s part of a bigger portfolio, and it’s probably somewhere between at the low one to two percent of course a low might be zero, but one to two percent, and the high might be 10 to 20 for a really aggressive endowment like Yale’s, so it’s a small portion. And it’s the high-risk, high-return part, and it’s what gives the returns, going back to my mother’s pension. She just puts it, you know today, in savings accounts and bonds. It’s adequate, but it’s not gonna grow enough, so this is where they hope to get their growth.

Tim: Right, and so of that kind of 1% to 20% of their capital for the LP, that even itself is distributed amongst many VCs right, most of the big LPs, they will tend to invest in any number, maybe like 50, 100 funds at any given time, to get those returns, and they’re hoping to get, the standard term is like 10-year, right? You invest, and you have a 10-year waiting period?

Kate: Well you asked the question about timing, and we should think about what their expectation are in terms of target. So, our fund is plus or minus $300 million. Our investors expect to get at least two and a half times their money back, so we’re talking about $750 to $900 million plus. So every dollar has to generate two and a half to three, that’s a big return. Over, our funds are 10 years. It typically takes 10 to 13 years, so a last investment in a particular fund might take 10 years to exit, so somewhere in that 10 to 13 years is the overall fund, but for any deal roughly a decade is when they expect the normal range to be. That varies by strategy and stage of a venture firm, but that’s roughly what they’re looking for. Three times their money in 10 years.

Tim: And so you have those LPs, those limited partners, and they’re kind of like “silent partners” in the investment, right, and they’re trusting general partners, people such as yourself, people that actually “work” for the VC firm, to make those investments for them, that’s the basic structure.

Kate: Well I think, you think about a limited partner, they’re coming to somebody like Scale or any other firm, and they’re giving us a blind pool of money to invest over 10 to 13 years on their behalf. That’s the ultimate of investing in people. And there really is no product to begin with other than the strategy, so, yeah, it’s a huge vote of confidence in the people they put the money in.

Tim: So you have your LPs, you have your GPs, and then there’s maybe other roles that people are familiar with, there’s associates, you know kind of more junior people, that are helping do the research, find the companies, do due diligence on the companies, and then you have people in the middle, you have VPs, you have principals, that are people moving on the way to becoming partners.

Kate: And entrepreneurs in residence, and all kinds of things.

Tim: And so that’s kind of the style that entrepreneurs would interact with. Usually you don’t interact with LP, and you don’t interact with the content of the fund, but that’s something that’s kind of interesting that underlies, right, a VC firm usually has multiple companies going on at any given time inside of it, they’re called funds. So how do they work at a high level?

Kate: Right, well you have a firm, a venture firm, and we raise funds probably every two and a half to three years. In our case, each one would be $300 million, you know again give or take, with about 20 companies in it. And we get a group of our institutional partners, who while they’re passive we sort of decide to emphasize less the limited than the partner. They love by the way meeting our entrepreneurs, but yes, we invest on their behalf, those 20 companies, and that might be a combination of both partners in our firm, because we invest alongside our limited partners, makes us stay up at night or work really hard, just like entrepreneurs, and I might have a certain group of institutional investors in that fund. Two and a half years later, I’ll build a new fund, while those are continuing to mature, we’re doing follow-on investing and hopefully exiting, and they’ll be a new crop of 20, and another crop of 20, and another crop of 20. And so they’ll all layer in over time, and we’ll have some that therefore are brand new, and some that are just about to go public over time, across a myriad of funds.

Tim: Right, so let’s talk a little bit about maybe like can change a lot from firm to firm, fund to fund. So at Scale we kind of have just those standard funds, but some firms sometimes they specialize, they have an early stage fund, they have a biotech fund, and they do that, I imagine, just to kind of be able to appeal to different LPs and different investors in a way?

Kate: Absolutely, yeah, and frankly different internal investors that have expertise, and the five partners who have a lot of experience in health care, will have a greater interest in a healthcare fund, if that’s how they decided to do it. And the tech investors in the tech fund, there may be some cross-ownership, because they’re a large firm taking advantage of the same resources. Likewise they’re firms that are conglomerates if you wanna think about it that way, who have big funds that within those funds, so it depends both what the individuals internally and the investors externally want to do.

Tim: Right, and you also see a number investment in check size, and the average size of check changing quite a bit, some companies prefer to make a bunch of small bets, especially in early stage, some companies kind of do bigger bets at other stage, they’re more kind of late stage funds, and then most companies that see most VCs are kind of doing something in the middle or a mix of all of those it seems these days.

Kate: Right, and this is where I think it starts to be interesting for an entrepreneur. Who fits me the best? If I’m just starting out, I want to be in an incubator, a seed, maybe a Series A fund. And I should focus my efforts there in terms of getting to know, network, that’s realistic. If I’m a later stage investment, I matured a lot, maybe even on my own money, or some local, even could be a real estate investor, and other kind of business person, there are a lot of great deals out there that get their capital to start up in many different ways. But if you’re more mature, and already have revenue, and you already have traction, you’re gonna look for a company that’s more mature to fit you better, so all that really makes a difference and the check sizes vary. Smaller, typically for early stage, and bigger as you start to scale.

Tim: Right, so what do you suggest entrepreneurs kind of really worry about. Do you feel like they should worry about, for example, what point of the fund it is, like is it early in the fund, is it late in that fund. Do you think they should worry about specific partners they’re dealing with? How much of this understanding the background of a VC do you think really matters if you’re fundraising or trying to grow your company?

Kate: Well I think they’re some myths that maybe I can debunk a little bit. But also give you some tips. When you think about working with a VC, first of all, where you are in a fund. Are you the first company in my 20, or are you the last one. I actually don’t think that matters very much, it shouldn’t. If I’m a good VC and I’ve been doing this over a long period of time, I reserve enough for my first deal and my very last deal. So that shouldn’t be an issue. What would matter is if it’s the fifth or sixth year, and we’re starting to figure out who deserves the last amount of capital in the fund. Have I reserved enough for you. That’s what you care about. So I think that’s more important to ask over time. When you think about who, this is the other thing. Everybody, understandably, wants to have the name partner in the firm on their board. That might not be the best partner to have on the board. Not because they aren’t good venture capitalists, they may not have enough time, they might not have the right expertise, et cetera. I often recommend entrepreneurs get to know that next generation of leaders in a firm. And I’ll give you some facts from our firm. But first I’ll tell you why. A. They have a lot more time. Given their age, and where they are in terms of their job before they came into venture, they’ll probably have much more relevant expertise, and are often the next generation leaders of the firm. So you wanna be with somebody who’s also hungry, very aligned with you. At the same token, it’s good to know everybody in the firm. It is important to have met that senior partner. It’s important to have met everybody in the firm. So I often tell people, get that next generation leader, and get to know the whole fund.

Tim: Yeah it’s very true, and I think you could say the same thing about funds in general and firms in general. You might not get a lot of time from the top-tier firm in Silicon Valley, but a hungry investor that actually has good advice, and is going up through the ranks, might provide a lot more value than going within the established names.

Kate: Well you want somebody, I always say to entrepreneurs, you should due diligence us as much as we’re due diligencing you. Much like our limited partners, we’re developing a partnership together. You have the expertise and the depth in your company, I bring a breadth of knowledge, a network, I know how to hire people, et cetera. And by the way we’re gonna have pits and twists and turns if it’s the normal life of a start-up. So how we can get along, communicate, problem-solve. You can understand that if you’re really listening and watching during the due diligence process. And feel comfortable asking questions. And presenting issues together, both opportunities in your company and the risks, so you now understand how they react and how the two of you can problem-solve going forward.

Tim: Absolutely, I think not enough entrepreneurs do that work of really establishing a relationship with the investor and you’re absolutely correct what you said at the top, VCs are very similar to start-ups in a lot of ways, much, much closer to a start-up than to an institutional investor, a traditional bank or anything like that, so it makes sense to think about the people and think about the relationships that you have with them, just as much as you think about the money.

Kate: Absolutely.

Tim: Thanks a bunch.