Thread by @dunkhippo33

A thread on capital calls:

-why VCs have basically no cash on hand?
-what are they?
-why should founders and emerging managers care?

>>

1) When you hear that a VC has raised $15m, the biggest misnomer is that you think their investors have actually wired them $15m.

However, that couldn't be further from how things actually work as funny as that sounds!

2) Here's why - when investors (called limited partners or LPs) commit to investing in a fund, they are making a commit over a period of time.

If an investor commits $500k, they don't have $500k just lying around to send to anyone. Usually that money is tied up elsewhere.

3) That $$ may be tied up in other investments.

It could be tied up in real estate or in future income that hasn't been earned yet. Or in that fund's commitments from their investors.

Most ppl or groups don't just have cash lying around.

4) So when ppl agree to be an investor in a fund, all they are doing is signing they will somehow come up with the money on a certain time period.

Usually the amnt they need to actually wire at the time of signature is only a small portion of their commit.

5) This "commitment timeline" is a schedule of *capital calls*. When a fund calls capital, it means they are asking for a portion of an investor's commitment.

E.g. a 10% capital call today means that if someone committed $500k in total, $50k needs to be wired now.

6) It's funny - we think VCs have all this $$ lying around but they don't!

They need to plan their investments. This is why a lot of VCs try to pace their investing as best as they can. They set expectations w/ their LPs on when capital calls will happen over the next few yrs.

7) There are 2 common capital call schedules:

A) Deal by deal. Some funds will do a capital call on every deal they commit to.

B) Schedule. Some funds will do a capital call on a regular cadence. E.g. every 4 mo or every 6 mo.

8) Deal by deal capital calls are the most ideal way to do capital calls in theory, because VCs are measured by their IRR -- their rate of return.

IRR is in essence how quickly are you growing the $$ from the fund.

For ex: if I deploy $100k on Jan 1 & return $200k...

9) ...at the end of the year, I will have a 100% IRR. Meaning I doubled the capital in 1 year.

The clock starts ticking in measuring my IRR as a fund manager when I do a *capital call* NOT when I deploy the money.

10) So let's modify the example and paint 2 scenarios:

A) Let's say I do the capital call Jan 1. But I only find that same startup in the middle of the yr. And I double my money by end of yr.

Because I did the capital call Jan 1, it's 100% IRR.

11) B) Now let's say I do the capital call in the middle of the yr and deploy immediately into that same startup and double my money in 6 months.

My IRR is now 200%.

As you can see *when* I did the capital call affects my performance metric.

12) This is why it's advantageous to do a capital call *right before* deploying into a startup and having the cash sit around around for very little time.

I.e. the ideal scenario for VCs is to never have any cash on hand because it counts against their IRR.

13) Of course, ideal is different from practical.

For @HustleFundVC we have 200+ portfolio companies. Can you imagine if we did a capital call every time we invested?

Our LPs would be super annoyed. We'd be calling them to send money 2x per week!

14) This is where the 2nd capital call model is more popular w/ firms who do a lot of investments.

Instead of doing capital calls for every investment, some firms will do them on a cadence.

15) However, per the IRR example above, even w/ a schedule-based capital call model, you are still incentivize to do a capital call with only the min that you think you will need to avoid having cash sit around and not growing.

16) But sometimes cadences don't work out. Sometimes you don't invest in any companies this wk and next wk you see 8 that are amazing.

What do you do then?

Well there are loans that VCs take out. (I know crazy right? VCs taking out loans??)

17) So not only have we moved from thinking "oh a VC must have $15m lying around" to "oh a VC has near $0 in their acct", we are now moving to "oh this VC now owes money to the bank for taking out a loan to invest in startups!"

18) Switching gears slightly, for emerging funds, the other consideration is in "catch up" capital calls.

So let's say we get $5m in LP commits signed. And we call 10% of it today. ($500k to start investing) And in parallel, we continue to raise the remaining $10m.

19) We keep plodding away. And let's say 1 yr later, we pull together the remaining $10m in the next and final close.

At this close, these newer LPs need to "catch up" to the capital calls already made -- in this example 10%.

20) So when these newer LPs sign, all of a sudden we are receiving 10% of their money -- in this case $1m in one fell swoop.

While getting a lot of money may sound nice, this can actually be a problem per the IRR example above...

21) If we cannot deploy it all more or less at once, then we will have cash sitting around...

So for emerging mgrs there's this dance between managing cadence, doing as small of a capital call as possible, doing closes so the catch ups don't yield too much excess cash, etc.

22) The 2 close $5m / $10m -> $15m fund example wasn't so bad. But what if we did the first close at $500k and then the remaining $14.5m in a 2nd close calling 10%?

We'd have $50k to work with at first. And then $1.45m all of a sudden next!

23) OR even worse, because $50k isn't much to work with, say we called 50% to get $250k to work with.

Then on the 2nd call, we would have $7.2m coming in in the form of catch up calls of that 50%!

24) So you can see fund mgrs often think through their capital call strategy, their fundraising close strategy, as well as whether they take out debt, etc.

But how does this affect founders?

25) If you are pitching emerging fund managers, I think it's fair game to ask about some of these details.

-How big is your fund?
-Have you done a first close / first capital call?
-When are you planning on doing that?
-How much will you have called in that first call?

26) This is impt because there are a lot of fund mgrs who may have $$ committed but they may not be doing a capital call for a while per some of the thought process mentioned above.

So a fund may exist but practically speaking may not be able to invest if you don't ask.

27) I think it's perfectly fine to say, "Hey, I love what you're doing, and I'd love to learn a bit more about your fund. I know that you're new -- can I ask you some qs?"

And then ask those qs.

If there isn't capital coming in for a while, that isn't a dealbreaker per se.

28) But then everyone is at least on the same page with what is happening. And you can decide whether it makes sense to pick up the conversation / decision later or whether it's too late.

29) Most fund mgrs don't volunteer this info! So it's impt, as a founder, to find out. In my yrs investing, I can count on < 1 hand the # of ppl who have asked me qs like these.

(You can find more qs to ask here: elizabethyin.com/2016/01/22/wha…)

Pitch mtgs should be a 2 way st.