Questions Limited Partners SHOULD Ask VCs… But Don’t

by Larry Chiang on November 29, 2011

Larry Chiang scandalously reveals how stuff really works and breaks it down. He edits the Bloomberg BusinessWeek channel “What They Don’t Teach You at Business School”. After Chiang’s Harvard Law keynote, Harvard Business wrote: “What They Don’t Teach You at Stanford Business School“ (it is the same title as his NY Times best seller). He is Entrepreneur in Residence at Stanford University.

If you read his hilariously awesome “What a Supermodel Can Teach a Stanford MBA” and “How to Get Man-Charm”, you will like his latest post:

Questions Limited Partners SHOULD Ask VCs… But Don’t

By Larry Chiang

LPs are miffed at VC results.

Limited partners (LPs) are the people who fund venture firms and financially back the general partners (GPs) that lead them. At secret annual LP meetings, LPs calculate total value: paid in (TVPI), internal rate of return (IRR), digest confidential past results, test the waters on new funds, jockey themselves into better funds and mentor their investor base as to what is new and emerging.

I get to go to these now that I’m a special VC. Its weird to be a fly on the wall. It’s extremely exclusive. And comprehensive. VCs and their specific funds were drilled down on. I was parallel track thinking after I arrived at the goal of the story and plot spoiler: VCs need to find a whopper of an IPO within every fund to meet IRR goals (internal rate of return).

Remember, my entire career has been doing credit card lead generation by crashing college campuses and migrating our campus efforts to legitimate VIP efforts. In the same way you do credit card application lead generation of a 19-year-old junior who eventually takes out a loan to buy a car at age 26, you also lead-gen 26 year-old CS major CEOs by finding them when they are 19. That’s the pattern that LPs recognize that I am attempting to replicate. But I am only be in the seventeenth day of being a VC, so it is still very weird to be a fly on the wall at LP investor meetings.

The meetings are extremely exclusive. And comprehensive. LPs drill down into the details of their specific VC funds –it’s all information the public almost never sees. While I listened, it hit me that the VC model is not broken. Silicon Valley is cyclical. LPs know VCs need to find a whopper of an IPO within every fund to meet TVPI goals and IRR goals (internal rate of return). But getting there is a numbers game. How many entrepreneurs, founders, CS majors, developers, pre-entrepreneurs are in your VC firms lead-gen funnel? Saying “deal flow is everything” does not put a concrete, executable plan into motion. I argue it paralyzes.

That led me to think up a few questions that LPs at these meetings should be asking their GPs—but don’t seem to.

1. What does playing Moneyball mean to your firm?

There is one right answer.

Your firm had better be building a massive farm system of IPO potential. We all might have zero clue about which firms will eventually go public, but the key is to have a specific, distinct, transparent, tactical, granular, measurable farm system program in place. That takes massive work. Executing Moneyball is about generating a large pool of talent, and making that large pool of talent more talented.

VCs have gone on record at public events talking about Moneyball. They have cited the OBP stat. The ‘on-base-percentage’ statistic does not have an equivalent in VC investing. (It is also inherently obvious that none of those VCs who poo-poo’ed the Moneyball concept never read the book or saw the movie.)

VCs who actually have read the book include Roelof Botha. He even recommended the book in public at MJAA conference 2006 in and around the time he invested in YouTube. In short, the data analysis of the Moneyball concept is not the nugget of knowledge… It is the work that scouts now must do to develop massive and specific entrepreneur farm systems.

From the movie:, “Every at bat is like a hand of blackjack played in a casino where your odds massively change based on each pitch dealt.” That has applications for farm team member mentorship and development. I want my fund to have entrepreneurs batting during 3-ball, no strike counts. Getting to a 3-0 count is more likely when you execute 2-7 guacamole recipes for entrepreneurship.

2. What matters more in how you recruit and develop venture staff: entrepreneurial experience or operations experience?

The answer I’d be looking for is entrepreneurial experience. You don’t have to have a team made entirely of former founders, like Founders Fund or True Ventures. But what experience do your GPs have as entrepreneurs, besides roping your one LP that launched Fund Uno?

3. How are you using board seats to generate leads and wedge your fund into the best deals?

The old way was to match an emerging hot portfolio company with sexy brand name partner at your firm. The partner or principal who sourced the deal might get bumped off the deal docket, but the marquee partner and team member gets a nice feather in the form of sexy new startup and an uptick in personal brand.

There is a new innovation in board participation.

Using board of director and board of advisor seats to do lead gen essentially increases the probability of buying stock at the best companies. This maneuver essentially adds you to the waitlist to buy stock in future fundraising rounds. It also allows a long look into the company. By adding value as a board observer or board advisor, you bump up the likelihood of wedging into future fundraising rounds. As GP, you and your partners should informally head up subcommittees with a specific purpose that builds shareholder value.

If the last formal training you got was a half-day seminar at Kauffman’s Center for Venture Education back when they were associates…, maybe you should spend some of that management fee and train your staff in Board of Director 2.0 stuff.

4. How are you planning to get your own presentation day at Y Combinator.

Sequoia gets their own presentation day at YC.
Kleiner Perkins gets their own presentation day at YC.

A presentation day allows for your firm to get a nice long look way before the 80 other venture firms. If the YC startup you love loves you back, you can have them pulled from demo day and just fund them without a bidding war. Buy some deal flow insurance and send all available partners to Demo Day anyway.

5. How are you formalizing sidecar, portfolio founder funds?

No one really knows what a sidecar fund is.

Sidecar funds are little funds with complex structures and more complex tax implications. Funds have founders bird-dogging new startups. By bird-dogging I mean lead generating new founders. Sidecar funds are meant to share the upside of the VC investment with the founder that brought in the new deal.

First Round Capital has a pooled risk where your startup owns a little stock in the rest of the portfolio companies. Formalizing sidecar funds might be worth examining, clarifying and formalizing. Sidecar funds do not have to be exactly the same fee structure as the parent fund. Sidecar funds can differ from the 2/20 structure in that it can be 0/20. 2/20 means 2 percent management fee and 20 percent carry. Management fee is percentage of total fund. Carry is percentage of the gain that is kept by the VC.

I like the concept of “pay me to do lead gen”. It is similar to a ‘reverse VC pitch’. I recommend a side-car fund with 0/0. The founder brings you deals and they do not get paid. Their reward is attendance to an industry conference where your firm pays expenses and the founder and their startup gets promoted. It is a glorified way of simplifying the sidecar fund to pay zero out, pay travel expenses out of the management fee, have full transparency with your LP, and get paid to do lead generation.

Having money not coming from an LP with a different 2/20 structure is just strange. 2/20 means 2 percent management fee and 20 percent carry. Management fee is percentage of total fund. Carry is percentage of the gain that is kept by the VC.

6. Do you ever eat at dorm cafeterias?

Jesus mentored his 12 co-board members by eating with them. A lot.

Eating at Stern Cafeteria on Stanford’s campus is demeaning, so let’s at least see if you as the GP can have partners willing to crash the dorm at 5:00 pm and eat with undergrads. This is the Fortune 100 executive equivalent to eating lunch with the third shift. The 3rd shift eats at 3:00 am, since third shift works from 11:00 pm – 7:00 am.

The Silicon Valley equivalent to third shift lunch is eating a 4th meal with CS majors at approximately 12:30 am. Plot spoiler: when you show up you’re treating. The difficulty is getting the kids to come out from under the rock where they are coding.

Have you trolled computer science majors at Stanford? How would you?

Sure it’s a hit driven business, but what drives the hits are CS kids.

How do you charm a CS kid? Where do you take these CS kids on field trips? You need a strategy to find the next Larry and Sergey. Remember, according to Silicon Valley lore and urban legend, KPCB found Sun on the second floor of the Stanford CS lab, but lost Cisco to Sequoia because KPCB didn’t check the basement.

7. How are you adapting to a world where some investors are offering $800k convertible note rounds with no board seat and no cap?

There is a problem when you are taking equity-level risk with near commercial debt lending-level returns. Getting all the downside risk with a small sliver of the upside is not going to help anyone’s TVPI. (TVPI distributed and undistributed portfolio value to original invested capital.)

Me, I am doing guaranteed exits while they’re in school and looking to fund pre-seed pre-preneurs.

By ‘guaranteed exits’ I mean having 2-5 CS majors executing 20-45 steps. Their startup isn’t concocted from scratch. It is a sequel business meaning it is 80 percent stuff that exists already and 20 percent new. The industry problem is sourced from some industry expert veteran. It is “guaranteed” in that it works about 60 percent of the time. It is done under the umbrella of a course called “Unofficial ENGR 145” at Palo Alto Community’s College (aka Stanford).

Upon ‘sale’ of company in the $20K-50K range, the CS majors commit the next two summers.

When I say ”fund pre-seed, pre-entrepreneurs,” I mean you should pay to get students pre-entrepreneurs into tech conferences like Web 2.0, TechCrunch, Launch, DEMO, SXSW, Summit at Stanford and CES. The management fee itself can and should be invested. It is the execution of ‘pay me to do lead gen’ from above point #5

LPs might be asking you tough questions, but hopefully this gives you, the VC, intel from inside their annual investor meetings.

If you liked this…
Larry’s mentor Mark McCormack wrote this in 1983.
His own book came out 09-09-09. It is called ‘What They Don’t Teach You At Stanford Business School

*** BONUS ***
a party invite for you…

This post was drafted in an hour and needs your edits… email me if you see a spelling or grammatical error(s)… larry@larrychiang com

Larry Chiang started his first company UCMS in college. He mimicked his mentor, Mark McCormack, founder of IMG who wrote the book, “What They Don’t Teach You at Harvard Business School”.
Chiang is a keynote speaker and bestselling author and spoke at Congress and World Bank.

Text or call him during office hours 11:11am or 11:11pm PST +/-11 minutes at 650-283-8008. Due to the volume of calls, he may place you on hold like a Scottsdale Arizona customer service rep. If you email him, be sure to include your cell number in the subject line. If you want him to email you his new articles…, ask him in an email :-)

You can read more equally funny, but non-founder-focused-lessons on Larry’s Amazon blog .

What A Super Model Can Teach a Harvard MBA About Credit

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