#28 - VC Terms Startups and Emerging Fund Managers Need To Know - Part 2 of 3
The Agile Growth Entrepreneur Newsletter
Reserves
Reserves are money VC firms hold aside to make additional investments in portfolio companies.
The use of reserves as a strategy is a hotly contested topic in venture capital. Reserves are kept by only some funds, and some funds save up to half of their money for sequels.
Follow-On
After an initial investment, the fund manager makes a second investment in the same company (a "follow-on"). Those investments may come directly from the fund or via a special-purpose vehicle.
Businesses frequently use a variety of subsequent approaches. Some players do their fair share in the majority of the following rounds. Others perform separate assessments after each one. Few people ever elaborate.
Management Fees
Funds charge shareholders an annual "management fees" fee to cover the fund's costs. This is used more often to meet operational costs than to fund capital expenditures.
Management fees for venture capital funds are typically 2% per year of LP commitments. However, many people need to know that fees can be front-loaded to advance operational cash flows to the point where they are most needed in the fund cycle. This is especially helpful for smaller funds, where even 2% per year may not be enough to pay workers' salaries.
Carry
Carry (or "carried interest") refers to the portion of a fund's profits that go to the general partner (GP) and any other members that contribute to the fund's operation. Most funds charge a 20% carry, but others (generally larger, more reputable ones) ask for 25% or more.
As with any incentive, carry percentages might increase whenever certain performance thresholds are attained. Funds typically impose a load of 20% on the first 3x DPI and 25% on distributions above that.
GP Commit
General Partners are required to make a financial commitment, or "GP commits," to a fund. This averages 1-2% over time. Therefore, it is essential for GPs to have some financial stake in the venture and for their motivations to align with those of their limited partners (LPs).
Nonetheless, many GPs find it difficult to donate even 1%. This is especially prevalent among new managers who need more capital to put $100,000 (or 1%) into a fund with a lower target return target, such as $10 million. Fortunately, we've seen LPs loosen these regulations, realizing that it's not the absolute monetary amount Simple Agreement for Future Equity (SAFE)
Waterfall Distributions
Waterfall distributions refer to the sequence in which returns are paid out to different investors in a fund. It explains how earnings are distributed among the various categories of investors.
LPs often get an amount equal to or greater than their contributed money before GPs. As soon as the fund returns 1x DPI, the GPs are "in the carry" and begin receiving distributions according to the carrying structure they agreed upon.
Deployment Period
The fund will invest its whole corpus over the deployment term. The average deployment period for conventional funds is 18–36 months.
Assets Under Management (AUM)
A venture capital company's assets under management (AUM) are the whole sum of its financial resources. So instead of considering only the value of a single fund, it feels the value of all funds managed by the same fund manager.
Simple Agreement for Future Equity (SAFE)
To attract investors for a future equity round, a SAFE might guarantee them the right to buy a certain number of shares at a certain price or discount. At the time of the first investment, there is no set per-share price.
They are a quick and easy method to raise capital for a startup. Y Combinator first launched the SAFE in late 2013; since then, it has been the go-to method for funding startups.
Convertible Note
Convertible notes are a form of short-term debt that can be exchanged for equity later. Depending on the note's ceiling or discount, the debt may automatically convert into shares of preferred stock upon the closure of a later round of funding. Convertible notes, like SAFE agreements, simplify the negotiation of legal terms for seed funding.
Simple Agreement for Future Tokens (SAFT)
Financial institutions that foresee the widespread adoption of digital tokens may offer SAFTs to investors. It's similar to a SAFE in streamlining the legal negotiating process.
Token Warrants
A token warrant is a form of investment collateral that provides the buyer the right to buy a certain number of tokens at a specified price at some point in the future.
Liquidation Preference
In the event of a liquidation, the amount that investors would get before any other shareholders will be determined by the Liquidation Preference (i.e., the company is acquired or IPO). So it's a contract between a company and an investor.
It is often stated as several times the starting capital. For instance, if one shareholder has a liquidation preference of 2x, they will get a payment equal to twice the amount of their initial investment before any payments are made to shareholders lower on the preference stack. It is important to remember that creditors usually have higher priority than shareholders.
Liquidation preference structures are rarely requested by early-stage investors.
Ratchet
A ratchet prevents early investors' stakes from being diluted during future fundraising rounds with reduced entry fees.
With "full ratchet" protection, if a later investor purchases shares in a firm at a lower price per share, the original investors' purchase price will be adjusted to reflect the new lower price.