(If you already know the internal VC fundraising drill, feel free to skip the next three paragraphs.)

First, here’s a short review for those neophytes out there who have never done business with professional VC’s before.   VC funds are limited partnerships, run and managed on a day to day basis by professionals, but using money invested mostly by outside third party investors.  Those investors are typically pension funds, wealthy family trusts, and endowment funds.  The VC partners who actually manage the fund go out and raise a chunk of money from these folks about once every three years, placing it into a partnership that is created with a 10 – 12 year life.  Between these triennial fundraising efforts, they deploy the cash in a variety of venture investments (like your deal!), which they hope will mature in the aggregate into a nice economic return over the long life of their fund.  Why do they raise new money for a new fund every three years, when the funds survive for a decade or more?  Because all that money needs to be invested in about a three year window, and then allowed to grow within the investee companies until they either go public or are sold, a period that can easily take 10 years or more in the bioscience field.  While the money is “at work” in the investee companies, the VC’s must go out and raise more to fund still newer deals.  This is also essential for their personal compensation.

VC professionals are paid in two ways . . . through a management fee and through a carried interest.  The fee, typically 2% per year on the total amount of money in the fund under management, tends to pay for their base salaries, plus rent, travel, legal work, consultants, etc.  For a $400 million fund, that amounts to a fee of about $8 million per year, to be split among the partners and other employees as salaries and for operating expenses.  Partners in big funds can pay themselves a lot!  On the other hand, managers of a small fund can barely get by on the fee.  In a $30 million fund, the fee is only $600k per year, barely enough to pay two full time partners plus the rent for a small office and one secretary.  Also, these fees are usually structured to decline in amount after the first few years of the life of the fund, since the fund’s investors believe that the VC staff isn’t working as hard doing oversight as they were in the investing phases.  Thus, to keep the management fee cash flowing, VC’s must go out and raise new funds, starting the management fee clock all over again.

But the big hit for all VC’s is in their “carry.”  In principal, the carry is a share in the profits over and above the return of principal of the entire fund.  So, in the example of our $30 million VC fund, if the total payback from their entire $30 million portfolio of deals is good . . . say $100 million . . . then the partnership typically receives a fee of 20% on the profits (i.e., subtract the $30 million initial investment from the $100 million payout, and you get a net profit to the fund’s investors of $70 million, from which the partnership receives 20% as their carry, or $14 million).  But carries take many years to hit, and VC’s must live on the management fees for a decade or more, until their various investments mature.  They are thus highly motivated to beat the bushes every three years to raise new funds, even in as bad an environment as exists today.

Now, what does this have to do with funding the proverbial “last deal” in a fund? 

Well, in my view, everything!  For one thing, that last deal must have a near term payoff date, i.e., it typically should be a very late stage company that can be sold in just a few years.  Otherwise, the deal won’t cash out within the overall life of the fund, which may now be down to just 5 or 6 remaining years.  Perhaps more importantly, though, closing that last deal also has profound effects within the fund.  Once a fund is fully invested (save for some dry powder being saved to support existing portfolio companies), the VC firm’s staff can be reduced quite a bit, since due diligence work is now finished (until a new fund is raised), and the top few general partners can easily oversee their ongoing investments themselves without expensive support staffs.  So . . . if you’re a junior guy in a fund looking for a last deal, and if there is no near term prospect for a new fund to be raised, then do you really want that last deal to get done right now?  Does anyone like unemployment, especially in this environment? No!

So, time and time again we’ve trotted our best clients into bioscience VC firms to present their prized business plans, only to learn when we arrive that the fund only has room for “one last deal.”  What can we assume?  Assuming may be dangerous in general, but in the VC world you can pretty much take to the bank the conclusion that this firm is not going to fund you, at least not now.

OK, that’s the bad news.  Now for the good news:  At least the fund manager was being honest with you in admitting the fund's status.  Being out of money is no crime . . . after all, isn't that exactly where you and your company are right now?  But if you call on a major VC fund, only to find a suite of mostly empty, box-filled offices and cubicles, with perhaps one secretary and just the person you’re about to meet in residence, you should hope that your contact freely admits to either being fully invested or on the fund’s last deal.  Sometimes you will be told that they’re “actively investing,” when it is plain to any grade schooler that they really aren’t.  Lying buys no points with me, and it shouldn’t with you.  VC deals and relationships last for many years, and they must be based on honesty.  So if the fund manager is honest and forthright about his/her fund’s status, you actually may have been presented with a golden opportunity.  Go ahead and give your pitch. Do the best possible job that you can.  Then listen carefully for feedback.  These days, many world class VC professionals are stuck in this awkward position, not because they’re not good at their jobs, but rather as a result of the lousy environment for investing in bioscience VC funds that persists today.  The comments and advice you get come at virtually no risk to you.  You aren’t going to lose an investor by taking on the challenging points raised in this meeting, so push hard, ask tough questions, seek advice, listen, and learn.  We’ve picked up a lot of wisdom from such meetings, and rest assured, this VC is seriously listening to you as well.  Raising their next fund relies in part on their team’s perceived expertise in the industry.  They learn a lot by staying plugged into the deal flow.  That’s one very legitimate reason why they still take these meetings. 

There’s another reason to put aside your sense of urgency and to make the effort to build this relationship.  These folks often do eventually get funded, sometimes within just a few months after your meeting with them.  And having already been there, presented to them, and impressed them with your willingness and eagerness to learn and to improve, you may find that VC right back in your deal . . . or perhaps in your NEXT deal, after you’ve built this one into a great success, sold it, and are on to a new one.  Good luck out there!

You can send your comments to me at Reed@MackinawBio.com