In early 2019, I wrote one of my most-read blog posts, Two Simple Questions To Ask Every Potential Investor. Those questions were:
“What do you specifically look for when you’re investing in companies?”
And a followup question, “Now that I’ve heard everything you’re looking for, I think we’re a fit for your fund. But in your opinion, is that really the case?”
Now that we’re in COVID-19 times, those questions remain as relevant as ever. Here’s why.
First, what’s going on with venture investors?
Venture funds typically operate on 10-year cycles. The first five years are something called an “investment period” during which the fund invests capital into startups. During the next five year period money isn’t invested and the fund collects proceeds by selling their shares, or by their startup investments being acquired or going public. For the sake of this blog, we’re going to focus on the first five year period and why it’s important.
In the first five years, a fund’s General Partners (GPs) create an agreement with the people who invest in the fund, called Limited Partners (LPs). The LPs commit to place a defined amount of capital into the fund for a set period of time.
For example, if a group has a $50M venture fund with a five year investment period, the Limited Partners agree to invest a total of $50M over those five years. The General Partners can ask the LPs for parts of the agreed-upon amount at any time throughout the five years. So, if the fund was created in 2018, it has probably used around 40% of its capital by now (which would be $20M of the $50M in this example). The fund’s GPs still have another $30M that they can request from the fund’s Limited Partners at any point. Typically, no war, disease, or macroeconomic situation can affect this legal agreement. Limited Partners are still required to put capital towards the fund.
That extra $30M we’re talking about here is called “dry powder”, and in 2019 there was $2.1T (yes, Trillion) of dry powder available in private investment vehicles and $121B of dry powder in VC funds (according to a report released this week by NVCA). That means that there is a lot of capital ready to be deployed.
Secondly, what are investors going to do with that dry powder?
This is the biggest question on every GP’s mind. And, it boils down to three options of what they can do with this “dry powder”—
1) Invest in new companies, not in their current portfolio.
2) Invest in companies already in their portfolio.
3) Don’t make any investments right now.
Here’s what I’ve personally been considering and talking with my investor friends about as we think through those three options—
1) Investing in new companies— The only way we’re going to invest in a company today is if we see that the company has a clear path to revenue during this period or they’re going to be able to quickly ramp up as soon as business is back to “normal.” But, a reason to take the risk of investing today is that most valuations are lower because there a higher risk associated with investing in a company today than there was even just a few months ago, given the current circumstances.
2) Investing in companies already in our portfolio— If we have a company in our portfolio that is promising, we want to keep investing in them for two reasons. A) Because investing in them will help them get to a place where they can survive this season and increase their chances of growing exponentially post-Coronavirus and/or B) Because investing in them will help them scale during this season (because they have a tool/resource/product that is in huge demand right now).
3) Not investing right now— I would take this approach if there were no companies coming our way, or if we’ve already re-invested capital into all of the companies in our portfolio who need capital. But, just remember that if a fund has a “five year investment period” then that’s the only time period during which the fund can make investments. There is an inherent clock on when our “dry powder” needs to be distributed, so if we’re not investing now there will be pent up demand to invest in a few months/years.
Finally, why does this matter for startups?
As you talk with investors, the two questions we discussed last year (and one more additional one!) are more relevant than ever. In these uncertain times, the three questions I would ask investors are—
Question 1: “What are you specifically looking for when you’re investing in companies during this COVID-19 season?”
When you talk with investors, you want to make sure that they know that you have empathy for what they’re going through. Ask them this question and also highlight the three options you know they have above. It will help you look more intelligent and like you know what’s really going on in this season. And, you’ll want to make sure that you understand which of the three options above they’re considering. Are they doubling-down on their current investments, holding off on any investment decisions or actually investing in new portfolio companies. By getting this answer, you’ll know if you should continue to talk with the investor.
Question 2 (this is the new one): “Who have you committed to investing in over the past month?”
By hearing the answer to this question, you’ll quickly know if the investor is really making investments. If they don’t have an answer or can’t give you a quick one, beware. They may say that they’re really investing but aren’t. Or, if they say that they’re looking at new companies but are only doubling-down on their current investments, beware that you may be engaging with someone who isn’t serious about investing in a new company.
Question 3: “Now that I’ve heard everything you’re looking for, I think we’re a fit for your fund. But in your opinion, is that really the case?”
This is where you’re trying to avoid wasting any more of their, and your, time. Quickly finding out if your company is a good fit helps you know that it’s worth spending time with this investor. Otherwise, it’s a dead-end, and you want to spend your time with people who can actually invest in your company. It also shows that you take yourself seriously enough and are confident to ask if your great company is actually the right company for them, not the other way around.