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Fixing the Venture Capital Model: Fund Term

Posted on February 12, 2006

On to the next post in my “Fixing the VC Model” series that I had promised a week or so ago. Sorry about the delay in posting. The usual excuses apply… Well, I really wanted to get a discussion going about the term of VC funds and how they affect the start-up business. For those who don’t know I will start with a quick background on VC funds and their usual term length.

So, as can be inferred from above, the VC set up is that of a fund. The money for the fund comes from many different places including institutional investors (college endowments, charitable organizations, etc.), high net worth individuals/families and a little bit even comes from the General Partners of the fund themselves. All of the investors in the fund with the exclusion of the General Partners (who are also the VCs) are called Limited Partners. These Limited Partners, or LPs, do not directly make any investment decisions.

The fact that VCs are set up as a fund make things very interesting. Since the investments VCs make are fairly illiquid a time limit for realizing those investments needs to be put in place. The usual time limit is 10 years. The first 3 - 4 years or so being the “investment” and the last 6 - 7 years being the “management” years. You can see how leaving a fund open-ended with illiquid investment could cause problems as far as returning money to investors goes. Theoretically an investment could never be realized and, even if it was eventually realized, the effective internal rate of return would be so low it wouldn’t even matter.

While the term makes sense if you look at things from the investors point of view it does cause problems for entrepreneurs. The main problem is that some entrepreneurs are rushed to exit. I think this is happening less and less now because entrepreneurs can bootstrap a lot of the way before taking VC money but, in the bubble, a lot of companies were rushed to IPO or sale and now continue to flounder or have closed their doors.

The question is: can the VC fund term be changed in any way that will benefit both the entrepreneurs and the VCs? I don’t know that it can because investors still need a way to predictably reclaim their capital. With that said: maybe it doesn’t need to be changed because people may feel that most entrepreneurs are not rushed to exit. Anyhow, I thought I would open the floor for discussion and see what everyone else has to say. Looking forward to some good comments and posts on this!

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3 Comments so far
  1. Adam February 13, 2006 8:23 pm

    I’ll kick off the discussion with a question for the VCs. What factors do you consider when determining the term length of a new fund? Which are most important?

  2. Bradley Twohig February 20, 2006 5:12 pm

    If its not happening at the end of 10 years its not going to happen. VC’s have extension periods to manage companies further after the 10 year period if necessary. But if you haven’t done it it 7 years as a growth company its just not going to happen anyways. I don’t see an issue with the term of investments given they are made solely in the name of high growth.

  3. eric February 20, 2006 5:20 pm

    Good point Bradley. 7 years is a long time for a high growth company. If things are taking longer than 7 years to materialize it is probably best to just pack it in and cut your losses. The only investments that may take longer than 7 years are biotech investments but that is a whole other story.