Back of the Envelope: Determining Fund Size for Emerging VCs
🍎 Fund Size = Strategy
As an emerging GP; your first (or second) fund size is one of the most; if not the most important decisions you will make in the long process of fundraising for your fund.
As VC Lab eloquently puts it; “fund size influences the stage of investment, the accounting requirements, the number of deals that are invested in, the amount that you can invest in every deal, the follow on strategy and many other variables. Most importantly, fund size determines the budget to pay the..GPs and the team”
🤏 Smaller Targets Are Easier To Achieve
As a general rule, don’t set too high of target fund size. GPs in fundraising mode need to create momentum in the speed of fundraising; which is easier to achieve with smaller targets.
According to a great episode on fundraising from 20VC, one should set a target size that is on the lower end of your target interval to make it achievable and convince LPs you can actually close and create momentum in the fundraise which is essential to the process success.
On the other hand, a bigger fund size can ‘unlock’ institutional LPs who are capable to write bigger cheques. For an emerging GP though; the hurdle here is building relationships and trust with these LPs long before you start that fundraising process.
So then, how does one determine the target size? There are two simple and practical ways to go about this:
1/ ↘️ The “Top-down” method
Create a back of the envelope hypothesis around portfolio construction (i.e number of investments X average/blended cheque size)
average cheque size will obviously depend on multiple factors including the stage you will be investing at (pre-seed/seed/Series A); geographies, state of the market, your ambition to lead or follow rounds and so on.
number of investments: factor in enough diversification based on the strategy you are pursuing (for the pre-seed and seed funds around 30 investments per fund)
discount the cumulative fees over the lifecycle of the fund which (so if the blended annual management fee is 1.5% over a 10 year fund lifecycle; this will amount to 15%)
figure out your pro-rata strategy that is capital set aside for follow-on investments into your primary portfolio (again, depending on the investment thesis the range may anywhere between 0 - 70%; with the)
By way of a simple example, 20 mil. USD target size with 15% blended management fee and 30% follow-on capital reservation leaves you with (20 x 0.85 x 0.7) = 11.9 mil. USD of net capital available for primary investments.
There are a few key questions for a you GP to answer:
Does the net capital figure allow you to execute on the fund’s strategy as you envision it?
Does the net capital figure allow for enough diversification in your future portfolio?
Is the fund size big enough so that you can reasonably assume to cover your OPEX costs (team/legal/travel/office, etc.) from envisioned management fees?
Does the gross fund size seem achievable based on your and your partners track records, market conditions and so on to create traction in the fundraising?
2/ ↗️ The VC Lab “Bottom-up” Method
The VC Lab method takes a different approach - what I call “bottom-up” . and that is to quantify how much you can raise from your network and existing contacts first.
“As a rule of thumb for a New Manager, the upper limit of your fund size is 10 times the amount of what you think you can easily raise from contacts that you already have.”
Using the previous example, for a 20 mil. target size fund one should be able to create a realistic scenario of closing on 2 mil. from ‘friends and family’ LPs.
A simple tactical way to go about this is to create a pipeline of LPs that pass this filter and estimate the commitments and probabilities of closing on them. You can head to VC Lab’s page linked above for a detailed breakdown and tactics on this method.
✅ Using top-down and bottom up methods for a sanity check
I think the best to take a shot for both of these - first, put your desired fund strategy on paper (top-down) and figure out what is a feasible fund size.
Then; measure this against the strength of your and your partners’ immediate networks to see if you have enough leverage to fundraise the first 10% capital in order to get the fundraising ball rolling.
The above is of course just a very simplistic and back of the envelope exercise you can do to estimate your future fund size.
For an in-depth dive into the topic on creating a full-fledged fund model check out Open VC’s How To Model a Venture Capital Fund.