Who Is A Venture Capitalist's Customer?
So often, the customers of a company can explain the behavior of the company itself. What market - or markets - does it serve? What are the characteristics of the participants of the market?
Investors are customers too. Investors buy equity, debt, and other instruments from the company, and in return, the company gets cash or some form of credit. When someone takes something and gives you money, it meets the smell test for a customer relationship.
This framework can remove some of the mystique of venture capitalists. This sector gets a lot of attention from entrepreneurial community members but is not well understood. Most people I talk to are surprised when I tell them the VC has customers too. Aren't they rich funds full of money?
The answer is: they are middlemen. Institutional venture capitalists invest money on behalf of other institutions and individuals. Individuals could be fellow financiers who have made a pile, former entrepreneurs, inheritors of wealth, or even monarchs. Institutions could be family offices, pension funds, and even governments. So-called sovereign wealth funds are money put together by governments to invest.
All these investors have a lot of money they need to put to work to preserve and grow their wealth. A good part of this money goes into the same products you and I see: public equities, corporate bonds, insured government issues (e.g., treasury notes), and real estate. The concerns are the risk of downside and chance of upside.
Particularly as the strategies get more complex, even these wealthy institutions invest in outside funds instead of investing money directly. They are essentially hiring the managers of these external funds to handle the ever-more exotic instruments and combinations to create greater returns with lower risk. Sometimes this combines derivatives with the more standard types of financial products - like buying one stock while shorting another. Sometimes this is about working with more illiquid products that the wealthy person/institution does not understand well, like equity in private companies.
These outside managers are paid based on the amount of money they are managing for their clients and generate returns. The "classic" model for getting paid is a "2/20" fund. The "2" refers to a 2% fee on the total money that the investor is managing. So if a hedge fund manages a hundred million dollars of other people's money, they are taking $2 million of it to pay salaries and expenses for its people. Of course, if the funds shrink through redemptions (investors pulling their money out) or losses (fees and bad investments shrinking the value), the 2% is on a smaller base for the following year.
The 20% is "carry" - the upside in the investments that the manager gets to keep. So if that hundred million dollar fund generates, say, 20% returns in a year, that would be 20 million dollars. Four million (20 million x 20%) would go to the managers' accounts, and the other sixteen million would go to their investors.
The rich person puts in 20 million along with four other rich people, and that's how the hundred-million-dollar fund is born. The hedge fund manager manages that money on behalf of the investors. The investors can pull out their money with a bit of lead time since usually, the money in the fund is not in a bank account but plowed into the next round of investments to make more returns for the investors - and more carry for the partners! For legal reasons, the investors are "limited partners" in the fund investing the money.
So that venture capitalist deciding whether to continue the conversation with your startup is managing money for these other institutions on a fee plus carry basis. They make money when they can raise more from their investors and produce good returns.
The second tricky thing is that each of these relationships takes someone's time. The money manager (the VC) is looking to raise from the limited partners, but they can only handle so many conversations - it's like enterprise sales that way. Similarly, the limited partners have limited time, so they don't want to do business with too many outside fund managers. They want to deepen their trust in the ones they know and put more money to work.
Now, one sees the motives of the limited partners passing through the venture capitalists, too: they each need to put more massive checks to work with fewer deals to manage their time. Many venture capitalists may say they could write, say, a million-dollar check. But they will turn down the business that "only" needs that check. Instead, they want to use that small investment as a test to confirm they can put a bigger one to work. Big money is what the big clients want to apply.
To draw the parallel: an enterprise salesperson does a minor deal to grow into a big account but will turn down that same deal for a smaller potential client - no opportunity to put more sales muscle to work downstream. The same applies to the checks by VCs, and in turn, applies to the investments by the limited partners.
The limited partners themselves can be a varying group. Their identities and values are becoming more prominent in recent years. The identity of an investor can matter to the value system of entrepreneurs. The sovereign wealth funds of countries like Saudi Arabia and Dubai are "easy money" for venture capitalists. They like to invest through VC funds partially to remove the stigma of working with these nondemocratic companies. But it's still their money, and occasionally there are rumbles as to the source of the dollars going into back accounts. Did your firm take oil money? Blood money?
Limited partners can also assert their values. In what I call the "Bobby Axelrod effect," the professional managers of pension funds for the retirement savings for people who worked "real" jobs - teachers, firefighters, municipal workers - are getting pushback from their stakeholders - those real people - for how they invest. Instead of just being held to generating returns without undue risk of loss, the question of who they want to be associated with is increasingly arising.
These questions start with the outside manager's lifestyle - are their funds financing the vast houses and superyachts of money managers? Because that feels unfair, even if it is downstream of gainsharing. The increasing political salience of silicon valley tech may lead to more pushback like this in the future.
To put this in actionable terms: beyond simply generating returns, how does your business help
There are more financial models and more sources of limited partners - this is the tip of an enormous iceberg. I hope that it starts to get you thinking today. I plan to return to this topic in future essays as I evolve my understanding and thinking.
Know your customer. Know your customer's customer. We say this when building our own companies and looking at who pays for our products. Applying that same awareness and discipline to the sale of our equity and financial instruments will serve us well in creating businesses that drive both value and meaning.