Startup investors, also known as venture capitalists, are always writing blog posts providing helpful fundraising tips for entrepreneurs.
But how do VCs themselves get the millions of dollars they use to invest?
The truth is, the first skill a new venture capitalist has to utilize is not an ability to invest in great startups.
Before a new VC can invest in anything, that VC has to convince people sitting on huge piles of money to part with some of it to become “limited partners” or “LPs” in that VC’s new fund.
How does a new VC do that?
The perfect person to ask is Hunter Walk.
Earlier this year, Walk quit a high-powered job at YouTube to form a venture capital firm with his buddy, Satya Patel, a former Twitter executive and partner at Battery Ventures. Patel and Walk call their new shop Homebrew.
In just a few months, Patel and Walk raised $35 million, and are already using the money to invest in early stage startups. (They are looking for startups like Twilio or Stripe – companies that make tools for the small to medium-sized businesses of the future.)
So how did Walk and Patel do it?
In a blog post and in a conversation with me, Walk provided some answers.
The first step is finding the right people.
Walk says Homebrew sought money from institutional investors – fund of funds, foundations, and endowments – rather than rich individuals, “because of their goal to build a long-term platform with us across multiple funds, their ability to bring additional capital to bear in special situations and their broad perspective on the marketplace.”
Walk says he and Patel were able to meet with those types of fund managers thanks mostly to “warm introductions from other early stage funds.”
So there’s your first tip: If you’re going to start a VC firm, you should be friendly with existing VC firms.
Walk says he and Patel emailed ~40 investors, 20 of whom took a meeting, 10 of whom agreed to meet again, 5 of whom agreed to invest.
Over the course of these meetings, Walk came to realize that potential LPs want positive answers to five questions before they’ll invest in a VC firm.
Those questions are:
- Will the partners at this firm have good “deal flow”? In other words, Homebrew’s potential LPs wanted to know if Walk and Patel were plugged-in enough to the startup scene that they were going to constantly have a big pool of startup investments to choose from. Do they have an ability to meet the new great entrepreneurs?
2. Does Homebrew have good “partner dynamics?” The institutional investors wanted to see that Patel and Walk got along and had a plan for continuing to get a long in the future. “There were a number of questions about the partnership,” writes Walk. “How well do we work together? How do we reconcile disagreements? Did we have the same vision for Homebrew? Would we be dividing work in any specific way? I think Satya even got asked what my favorite food was (not kidding). ”
3. Are Patel and Walk “good pickers”? This is a basic one. LPs want to invest in VCs who can actually invest in the right startups. Patel was able to point at the startups he invested in at Battery Ventures. Walk, who hadn’t been a VC before, was only able to point at his smaller, personal investments in startups and where he worked, or “how I voted with my time.”
4. Will Homebrew bring something new to my portfolio? Walk says it’s very important to understand the portfolio strategy of the institutional investors you’re meeting with. You have to be able to fill a hole in their strategy. Homebrew plans to invest in early stage startups. If an institutional investor is already giving money to a VC betting on similar startups, it’s much less likely that institutional investor will also want to be in your fund. You’re not diversifying their bets.
5. Are these guys good guys? After getting positive answers to all the above questions, institutional investors do a ton of due diligence on new VC firms.
Walk and Patel eventually raised enough to start their firm. But Walk says anyone going through the process has to “expect to hear No.”
He says there were three kinds of rejections.
Process Issues Largely Out of Our Control – Fund of funds that were between their own fundraising cycles and thus had no more money to invest; institutions in the midst of reviewing their VC allocations vis a vis other private equity sectors; our process moving too quickly; their check size being larger than our entire fund!
Satya is a Good Investor, Hunter We Don’t Know Yet – This was totally fair given my smaller history. My answer was always “look how I voted with my time, not just my dollars,” being very willing to stand on my operational track record. For some this was fine but others didn’t want to bet on me yet (the ole’ “let’s build a relationship”). One investor even commended me on my ability to “prevent losses” in my angel portfolio which I think is like saying “he has a nice personality.”
- We Don’t Buy Your Thesis and/or Your Ability to Execute Against It – We only had a couple of these rejections and to be honest, that was fine because not everyone is going to see the world the same way. I would worry if every investor nodded enthusiastically at us. I want some smart people to challenge our assumptions. It makes us think about their feedback, refine our thinking and charge ahead. To these potential LPs I’ll only say, maybe we’ll let you into Fund 2
Walk says he plans to keep in touch with the LPs that said no.
“Whether for future funds or to just share market data, it never hurts to follow the money.”