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Jon Bradshaw & Peter Harris

How does one start a VC fund. What should you keep in mind while creating one. How much does it cost and what to avoid.

How to Start a VC Fund

How To Start a Venture Capital Fund

If you have ever wondered about starting a VC fund but felt overwhelmed. Jon speaks to Peter Harris who started a fund with his partner a couple of years ago. He breaks it down for us and shares his suggestions.

Questions Covered in This Episode Include:

  1. Peter, you and your partner started a fund 7 years ago. How did you do it?
  2. Where did you start?
  3. How much does it cost?
  4. How is it structured? 
  5. What is the process of raising the fund?
  6. Can you consider taking a bank loan?
  7. Are you responsible for contributing?
  8. Can you start one if you are not rich? How crucial is having a network of rich friends and family?
  9. What happens if you don’t have rich friends?
  10. What is front loading and how can you use it?
  11. What are some things to keep in mind when forming a fund?
  • Legal
  • Cash flow considerations 
  • Ask why would they invest 
Hosted By

Episode Transcript

Jon: All right. Today is February 3rd. We are at the offices of the University Growth Fund with Peter Harris. And today we're going to talk about how to start a venture capital firm.
Jon: All right. So today, buckle up and let's get started. So, Peter, you and Tom started your firm about seven years ago, correct? Yep. How did you get started?
Peter: So. To give you context. Tom and I had been running this other fund called the University Venture Fund for about eight years, and total. And that fund came to the end of its fund life. They decided to shift it and go a different direction. And Tom and I decided, Hey, we're having so much fun. We want to keep doing it.
Jon: Yeah, they became an impact fund, right?
Peter: That's right. So university venture funds still exist today. They're an impact fund.
Jon: Which is boring stuff. I mean, it's good because it improves the world, but you're looking for massive, easy returns. The best way to create wealth for nonprofits is to create wealth for yourself first, In my opinion, it's a good move.
Peter: Peter We think they're awesome. They're doing interesting stuff, but we just wanted to keep doing tech investing. So we spun out into that. You know, the whole goal of today's podcast is to talk a little bit about how do you launch a venture fund? And I think the first thing you have to understand is like how our venture funds structured.
Peter: So they're basically three main legal entities that go into a typical venture capital fund. Today you have what's called the limited partnership, and that's the actual fund. When people say like, I have a venture fund, that is the actual fund that is making investments in companies. You also have what's called a general partner entity, and then you have a management company.
Peter: And when people talk about like University Growth fund, they're usually actually referring to the management company because the management company owns the brand, it runs the day to day operations. Then you have the limited partnership, which is the actual fund where the money is stored and you have limited partners that are part of that entity and they commit capital to that fund.
Peter: And so when I when our firm makes an investment, like let's say we invest in Spotify, we call up all of our limited partners, our investors, in other words, and we say, Hey, remember that commitment you made to invest in our fund? Well, we're going to need like 5% of it or 10% or whatever it might be. They wire in that money, we collect it all together and we invest it.
Jon: It goes into which entity it.
Peter: All goes into, the general partnership, the.
Jon: General partner.
Peter: And then the general partnership makes the investment and actually in exchange for that capital, they hold the stock.
Jon: Certificate. So if I'm going to give $1,000,000 to the University growth fund, I'm an investor. I write a check to the LLP business entity, the LP business entity. When an investments made does that the investment in, say, Spotify would go from the LP entity to the general partner entity to the general partner entity to Spotify?
Peter: No, no, that's how it works. Let's say.
Jon: Am I being say that.
Peter: You decide to invest $100 into my fund?
Jon: A million? I'm not. I'm more than 100 investor, Peter. I am are.
Peter: You $100 million? I just want to use one because it's really easy.
Jon: Okay, let's just do 100. So a hundred.
Peter: Or $100 of the $100. Let's say you're going to ultimately you're going to pay a decent amount in management fees. So for for easy math, it's going to be about 20%. So 20% of your 120 bucks. Right. Is going to go to management fees. That money gets paid to the management company and that's used for salaries, office overhead, all that stuff.
Peter: The other $80 is going to be invested into the portfolio. And so you will be an owner of the limited partner. You'll put that $80 in, actually put the whole hundred and 20 of it goes to management company, then the other 80 will go to investments. Okay. And then in exchange for that, you will have like a partial ownership of the stock of those portfolio companies.
Peter: Okay. And then when we sell the stock for money, you will get your portion of that back in cash.
Jon: Okay.
Peter: So it never flows through to the PE, to the general partner. The part that does go to the general partner is the carried interest. So let's say I take your $100.20 of that's going to go to management fee 80 of it's going to go into investments, those investments perform well and now that $80 is worth $300 of that $300, first you get your hundred dollars back.
Peter: Right? Okay. You invested plus the 20 you paid in fees. You get that back first.
Jon: Okay. And then the.
Peter: Remaining $200 is split, typically 8020. So you're going to get 80% of that back or 160. And then I, as the investor, will get $40. Okay. That's that's how it works. Okay. So all of that has context for structure. You got to have this structure put in place, right? You have to have your management company, you have to have your general partnership.
Peter: You have to have a limited partnership.
Jon: Okay. Why three entities? Why can't just be one entity?
Peter: You could just do one entity, but there are advantages to doing three. So essentially what happens by having three separate entities is you can change things over time as you raise new funds. So typically a venture capital fund will raise a new fund, a new limited partnership every 2 to 5 years, depending on their investment period. And then what's tied to that is you also start a new general partner that manages that limited partnership, that fund.
Peter: So they're kind of tied at the hip, right? The management company decides if and when to raise those funds and create those entities. That's kind of its responsibility. But you do it because like, let's say, fund three, right? We decide. Tom and I decide, you know, we really need another partner. Like this firm is getting really big. We could really use some help.
Peter: So we bring them on as a partner at the fund. They become a general partner, right? They they get to make decisions soon. They help us invest that fund fund three. Right. But let's say they end up not working out like they don't end up generating good deal flow. They make bad decisions like whatever it might be. They decide like they want to do something else with their lives for Fund four and so on four rolls around.
Peter: We don't want them or they don't want to be in the partnership anymore. So we don't include them as a general partner and then they don't have any access to the economics, the compensation that comes from Fund four because they're not doing anything with it. If you had one entity, then it would be this like super painful divorce every time you had people enter and leave the business.
Peter: So that's one of the big reasons there are a lot of others.
Jon: But okay, but it.
Peter: Gives you a lot of flexibility having these three entities. And the other thing is, and this is really important for raising your own fund, like this is the standard today. One of the things you learn about fundraising, generally speaking, is the more like if you're explaining your losing to a certain extent. So if you have to explain why you're different than everybody else, I have this unique, different structure and blah, blah, blah, It just becomes more like one more distraction.
Peter: So you want to be like industry standard.
Jon: Okay, got it. So basically the summary is seven years ago you created three LLC. Well, that's how you started it.
Peter: Yeah. I mean, technically they're yeah, once a limited partnership. It's a partnership and.
Jon: Okay, so now all of.
Peter: The management companies, an LLC and the general partners and.
Jon: All registered in Utah or is it similar to Silicon Valley where they want you to be headquartered and are registered in Delaware?
Peter: Well, most of them are registered. I mean, yeah, some are in Utah, some are in Delaware, Nevada. Most of the time they're in Delaware. Okay. And the reason for that is because the laws are very well established in Delaware. And I mean, that's like that's a whole other thing.
Jon: But so how much does all that cost to put together?
Peter: Yeah. So just to put the structures in place, you're probably minimum $50,000 out of pocket with an attorney. Chump change. Right. It scales from there. So that's just like get the entities set up with the right documents in place because like you'll need to have what's called a limited partnership agreement that defines how the general partner and the management company are going to engage with the limited partner.
Peter: So and it covers things like who gets paid when and like what can you and can't you invest in. So, for example, we don't invest in sin stocks, so we don't invest in alcohol, drugs, porn, guns, anything like that. Okay. And that's detailed in the limited partnership agreement. So you know that documents like hundreds of pages long that that whole thing.
Peter: But then what happens is so you pay the $50,000 and you get like the templated sheet, you know, documents from like a Cooley or Gunderson or, you know, one of these firms. But now you have to negotiate it, right? So you're going to go and pitch to investors and those investors are going to review this limited partnership agreement and they're going to have, you know, pushback, right?
Peter: They're gonna be like, well, you know, I know you said you're not going to invest in tobacco, but I want you to add in like cannabis, too. I don't want you to invest in cannabis, okay? Things like that.
Jon: What pushback did you guys get on your fund?
Peter: I mean, I don't know that I would say it was necessarily pushback. A lot of it revolved around like who gets paid when what happens if one of us leaves, Right? Like those types of things.
Jon: Okay. And that was what they were pushing back on the talks that you provided.
Peter: Yeah. So but that whole negotiation, right, Like they bring their lawyers, you bring your lawyers and you like, pound out like some of the most expensive meetings in the world because both of them are charging a lot of money per hour.
Jon: Okay.
Peter: And so it's not uncommon for these docs by the time you're totally done and finished to be 100 to $200000.
Jon: How much.
Peter: Total spend.
Jon: How much was your spend.
Peter: Right in that.
Jon: Range? Okay. Did this cash come out of your own personal pocket or do the attorneys say, hey, once you raise your fund, then you can pay us from the cash that comes in?
Peter: So if you are if you've raised funds before and they have a high degree of confidence that you'll be able to, then they'll do it on a contingent contingent basis. You pay us once you've closed, right? Or you just, you know, pay us when you close, period. And if you don't close, then you still got to pay us.
Jon: But okay, so we'll.
Peter: Wait until you've closed. We get.
Jon: Really personal. When you and Tom came, you guys both threw down the cash for that.
Peter: Or so what happened is we actually had an amazing attorney. So if you're looking to raise a fund, you should go talk to Jim Kelly, at Dawsey. And, you know, we were spinning out of a fund and it was kind of a unique situation. So he worked with us.
Jon: So, okay, that helps a ton. It helps a ton outside of the formation documents. So I assume you got a domain 14 bucks from GoDaddy?
Peter: Sure. I mean, you've got you've got all the other kind of general business expenses, so you got to set up a website, you got to pay yourself, you know. Okay, something. Right. you might have to travel to investors or potential investors and pitch them on why they should invest. Yeah, I mean, it's just kind of all the normal expenses of running a business.
Peter: At the end of the day, you've also got to cover on top of that.
Jon: But outside most are pretty minimal. Like you don't have to have a fancy website. Now, did you even have a website when you raised.
Peter: Yeah, we did, Yeah, we, we did build a website. It was pretty simple. But then we built on it and added to it over time.
Jon: You had a few photos, probably a WordPress template, but.
Peter: It's not like, yeah, yeah, super necessary. Yeah, I.
Jon: Would. One I don't want to like get nitty gritty, but like with someone like you and Tom, when you're starting out, how do you decide who gets what piece of the pie?
Peter: Yeah, I mean, that's a good question. So a lot of like, let's.
Jon: Say you and me, I have written together, I've got very limited experience. You have a lot of experience. Yeah. What could or should I expect that agreement to look like?
Peter: Yeah. I mean, there are a lot of different philosophies in terms of how to structure these things. Just like if you're going to start any sort of startup, right?
Jon: So but like, what do you think? Like, let's say you were advising me. Yeah. And you were advising in a metaverse. You and a metaverse Me, right? And metaverse you and Metaverse me have the exact same experience, right? I've been a startup. I have operation experience. Sure, You have far more VC experience than I do.
Peter: Yeah. I mean, look, I think about it. There are different ways to think about it. I think about it in terms of who's creating value, right? Yeah, just like in a startup.
Jon: But how would you do this? Let's just like, so.
Peter: Where's value created in a venture fund? It's sourcing, it's in making investment decisions, it's in fundraising.
Jon: What if what if? So the question.
Peter: Would be like, to what degree does each person bring value in those three different areas?
Jon: What if you bring in 85% of the capital through your connections?
Peter: Okay, what if I do?
Jon: I'm just saying it as an example. And what if you brought me on?
Peter: Because like, what if you're going to bring like 85% of the deal flow?
Jon: Yeah, I'm just curious, right?
Peter: Like, well, in that case, like you bringing, like something that's arguably equally valuable to what I'm bringing, like, okay, you know, then maybe it's maybe split 5050.
Jon: Okay.
Peter: Right. On the other hand, if it's like, Hey, yeah, I'm really eager and I can bring some deal flow and some expertise, but like, I'm not quite there yet, you know, like maybe it is something where, you know, I get more than you do, but I think generally, like there are a lot of different schools of thought. So some venture funds are very like, you know, one partner heavy versus the other or the others, generally speaking.
Peter: So a good example of that is Don Valentine over at Sequoia. It's like he passed away a few years ago, but for for a long time he owned 100% of the management company, right? based on stuff that's been published.
Jon: So what is the process of getting your capital?
Peter: B Well, yeah, I mean, so you put together a pitch deck usually.
Jon: Okay. And slide.
Peter: Strategy. Sure. Yeah. 10 to 15 sites, some sort of strategy that communicates like why are you going to be able to generate better returns than they could get on their own? Right. And frankly, like, oftentimes I'm super jealous of entrepreneurs because when they go and pitch me, they've got like this vision that they're laying out, right? They're like, yeah, like the world is going to look like this and here's how we're going to change it to look like that.
Peter: And here's our here's our like our vision and our plan and all of these things. When I go meet with investors, my pitch is like, you've got a bunch of money. You should invest in me because I can invest it better than you could and make more money. I don't know what it is I'm going to invest in yet, but I promise it'll be good, right?
Jon: So what about Metaverse? Peter Metaverse? John Yeah. What would be interesting strategies for them to to come up with? So, hey, we are going to have a focus on blockchain or hey, we're going to have a focus on clean tech or biotech or what would be, what would be like two or three good strategies to go with right now?
Peter: Yeah, it's a good question. Generally, I would think like what is our backgrounds lend us to be able to do right and our expertise and our networks. Okay. But then the other way to look at it is to say, Hey, what's the next big thing? Right? So like, I think there's some really interesting stuff happening in Web3 right now.
Peter: So I think it makes sense to probably spend some time there. I also think fintech, there's a lot of huge opportunities there. And then yeah, there's a question of like, are you a seed stage fund or are you as Series A fan, like early stage, are you growth stage, Are you late stage? Like where do you fit with within all of those?
Peter: And trying to find like, you know what my argument would be to say there's lots of seed stage funds. All the emerging managers go for seed, there's lots of series funds because a lot of those seed funds from back in the day have like grown up into Series A, but there's not a lot of Series B funds, right?
Peter: So there's this like chasm of like getting from series A to series C, right? Once you get to series, see, there's a lot of investors, but the Series B, you know, it's a little bit more challenging. So maybe, maybe we focus on like Web three at series B.
Jon: Okay, How many of these people who start funds get their 1% from friends and family and forth?
Peter: The first I think a lot of them pull it out of the the fund itself as well as like their savings. But it's a good question. Right. So that's one reason why you might need to be rich. The other reason is like how many people have 50 grand lying around? Well, like 100 grand lying around that they can risk on something that might fail, especially when, you know, you consider how hard it is to raise a fund.
Peter: All right. And then it's also like wealthy people tend to have wealthy friends. So. So who's going to believe in you enough, right? Because they're really just making a bet on you to invest in your fund to get started.
Jon: Right. Okay. Well, if you don't have wealthy friends.
Peter: And that's probably the one that our listeners care about, right? Because it's like, I would like to do this someday. How do I do? So I'll tell you, like the the things that you need to do in order to raise a fund, one of the biggest things is a track record. So if somebody comes to you, if somebody came to me and was like, Hey, look, I've been in all of these super hot deals, I get amazing access to really great investment opportunities.
Peter: I'm really good at making investment decisions and here's my track record to prove it. And I look at that and say, Wow, like, that's super impressive. Like, I wish that I was generating that kind of return. That's ultimately what you're going to be able to sell. What that means. And as a corollary is you if you want to start your own fund, you kind of need to figure out how are you going to build that track record?
Peter: And there are a lot of different ways to do it. So the most common way for like decades is you go join a venture fund as like an analyst, associate principal or whatever. You kind of work your way up, you work on a bunch of deals, you build that track record, right? And then you take that tracker and you sell it to ten potential investors.
Jon: Would another option B, I could just start throwing 510 K into a bunch of deals and.
Peter: Over the next shortlist and start putting a little bit of money into deals and be able to prove that as well. The more exclusive those deals are, the more impressive it'll be. So if I just go on to like Angel List and throw like, you know, five K into every single one of Jason Calacanis deals, not as impressive as if like because I'm going through him to get into the deal as if I were to invest directly in those companies and be directly on the cap table.
Peter: So trade offs, another thing that you can do and you see very commonly is to do SPVs. So an SPV is a single purpose vehicle and what you can do is you, instead of selling your track record, you sell the deal, right? We just talked about how like it's way easier to sell a deal than it is to sell like just blind faith in your investment abilities.
Peter: So what you do is you go find a really hot deal, a really great company. You convince the entrepreneur to give you an allocation of that, which is not trivial in many cases. And then you go to investors and say, Hey, look, I got access to this amazing deal. I love to bring you in into my SPV. And so they'll invest and you can actually charge fees on that, very similar to a fund.
Peter: So a lot of these SPVs are charging anywhere from like 1 to 2% annual management fees that on what they raise. And then they also charge carried interest which could be five, ten, 15, 20%, sometimes even higher, like up into the 30%. and so that could be, that could be another way. Like there there are individuals I know that have raised, you know, $80 million into one single SPV.
Peter: They pulled 5% management fee, well, 1% or five years off of that paid upfront. So 5% of the total transaction went in their pocket. Day one, they actually had to put some money in. So some of that went back into the deal and then they also get carry on the back end if it performs well. So, you know, you can do that.
Peter: That's another strategy and you can do it as early as like seed stage companies that are, you know, maybe you get $100,000 allocation and you go fill that, okay, all the way up to kind of growth equity rounds like like this person where it was like an $80 million allocation on a like $400 million round.
Jon: So okay, so broad range.
Peter: So that's one way super.
Jon: And the weird question though, is when if let's say that person who raised the $80 million round got 5%. Yeah. So you has to put two and a half percent in. Does he have to pay himself to an 8% pay income taxes then put it back in or is there a way he can he or she can put the money back in without actually getting you know.
Peter: Yes, you can do like a fee waiver. So it is possible to do that. But like we're not tax experts. So I'm not giving you.
Jon: I'm just saying hypothetically.
Peter: Hypothetically, Yes, it does happen.
Jon: Okay. This is not fair. They just like roll it. Not financial, not legal advice.
Peter: Okay. So that's one that's another way that you could build a track record.
Jon: Would this be considered the.
Peter: Other way that you could do it? Is go find some like really great angel investor who doesn't have the time or interest to to do all the legwork to do deals, right? So, you know, you find like a great entrepreneur that just exited their business and you say, hey, I will burn deals for you, right? And I will diligence them and I will do all this stuff.
Peter: And then like, you know, compensate me with something for all that hard work. But the big compensation is you're building a track record. And if you talked to do yoga over an album like this is very similar to how he got his start right? He worked with Warren Osburn and they made a you know, they worked on businesses together, They made a bunch of investments.
Peter: And Diogo was able to build this really impressive track record that allowed him to then it was helped him get in with album, right? So that's a very I don't know if it's super common, but it is a relatively common other way of doing it where if you don't have a lot of money.
Jon: Okay, so what is warehousing in relation to how to start a venture fund?
Peter: Okay, so that's a good point. So warehouse is another way that you could help like get a fund off the ground. So essentially what happens with warehousing is you don't have a fund that stood up yet. You don't really want to do SPV is because in an SPV like it's just a one off deal, you'd rather have that money that you're raising from investors come into a fund.
Peter: So what you do instead is you say, We're going to warehouse us. So you find the deal you want to do. You get your investors to invest. Maybe you even do it in an SPV structure. But the understanding is that it's going to convert into the fund. So you're essentially you're taking that deal and you're putting it in your warehouse.
Peter: And then when your fund is raised, you're going to take that out of the warehouse and put it into the fund. And the investors that were invested in the company like will convert into limited partners into your fund. So that can be another effective way because basically what you do is you go out and you sell and sort of you're selling your track record, you're selling these deals, right?
Peter: And you could do multiple deals so you could line up like one, two, three, four or five deals. Investors are super excited about those deals. And then when you go and pitch other investors on your fund, you basically say, hey, look, day one, you're going to get access to these five deals that are all crushing it so you know exactly what you're getting yourself into, at least at the very beginning.
Peter: Right. And so that can be another, like compelling way to sell this because it's like, cool. Like, I'm going to invest in the I'm going to invest in your fund. I'll immediately get allocation in these five deals. And some of those deals are performing really well. And so I'm going to see an immediate gain on my investment, which can be like, you know, pretty interesting to potential investors.
Peter: It's like, like day one, I'm going to double my money. Like, that's pretty cool. Like, yeah, I'm interested in that kind of investment. So that could be that could be another strategy. Well, that is another strategy that's used very often.
Jon: So the guys that acquired a firm when they started their fund, they have a they've got a podcast I think acquired LLP.
Peter: Okay.
Jon: What they did is they had a bunch of angel investments and they threw those angel, those investments into their fund. So anyone who invested got got to take advantage of any of the other deals they've previously have done.
Peter: Yeah, Yeah. I mean that's, that's very similar to warehousing, that's just like a type of warehousing strategy that's impressive that they were willing to do that because basically like let's say you were like a seed investor in Uber and you like, like they will let you in like you just, you just like massively diluted, like your returns, right?
Peter: But maybe they're like, hey, we're going to play the long game here. And we you know, this is what it takes to pull these investors in, give them a little bit of some carrot incentive, right?
Jon: Yeah, that was a lot of it.
Peter: And then they stick around for the next like two, three, four or five funds.
Jon: All right. Is there anything else we should be considering about you know, if we're looking to raise our own fund or to start a venture capital fund.
Peter: Yeah. So I think the big things are, one, it can take it can take years. Well, I mean, it could take a year or two to raise a fund. So you got to figure out like, how are you going to sustain yourself during that time period. it's also one of those things where it's risky, it's hard to do.
Peter: It's hard to convince people to invest into a new fund, especially if you, you, you don't have the track record, right? And even if you do have a track record, it's still hard. Like a lot of people don't really want to invest in funds. They want to invest directly into a deal. So it can be really challenging. I think another thing to keep in mind is, you know, how are you going to resolve those issues around splitting if you're going to bring on a partner or not.
Peter: Right. and how are you going to compensate people until the fund is stood up? The other thing is most first time funds are really small. So, you know, they're in some cases like sub five, sub $10 million. That's not generating a lot of fee. Right. So it's expensive for your investors because they're paying 2%. And you know, that's high fee relative to like a normal financial advisor.
Peter: But if you only have like a $5 million fund, you're pulling in $100,000 of fee annually. And that's got to cover everything, right? That's got to cover your salary. It's got to cover your travel is got, you know, like the bunch of these things, all your, you know, legal and blah blah, blah. So it can be really challenging on that first fund.
Peter: You're just you're not making a lot of money and so you have to be okay with that. yeah, for a lot of people, they're taking massive pay cuts in order to raise a fund. but, you know, look on the flip side and you know, we're going to talk about this in another episode like having a fund and running a fund is super fun and it gives you a lot of stability because these are ten year vehicles, right?
Peter: You kind of have certain certain degree like guaranteed income for ten years, which is super nice and gives you a lot of stability. So there are upsides and benefits to to operating a fund versus other vehicles. But like you should know, going into it, like it's really hard to raise once you've raised it's really hard to do a good job investing like most venture funds fail and and then after like a fund has failed, like it can be tricky to transition into another career, if that makes sense.
Peter: So a lot of risks are decent upside. But you know, something to think about before before making the jump.
Jon: Also, Mort, thanks for sharing, Peter, on how to start a venture capital fund. And if you've got questions, can they ping you and say, Hey, Peter, what do I do?
Peter: Yeah, drop them in the chat.
Jon: All right, let's do that. Drop him here in the comment section below on YouTube. So thanks everyone for the Venture Capital podcast with Peter Harris from the University Growth Fund. And we'll see you next time.
Peter: Thanks, Aaron.