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Broadening the On-ramp for Women-run Companies

Episode 40: Avoiding Venture Capital Fund Administration Headaches

I've spent more time than necessary on our fund administration and reporting, in part because of some of the easily avoidable administrative mistakes I’ve made over my 10-year journey as a startup investor. In this episode, I share some of the lessons I’ve learned to help you avoid the same headaches.

The two templates I mention in the episode are here:

The quarterly survey we send to our portfolio companies

Our quarterly report to our LPs

For those of you who prefer to read rather than listen, I’ve included the majority of the tips I share in this episode below. Let’s get started.

Choosing a Bank

The first easily avoidable administrative mistake I made was hosting our fund entity bank accounts at two different local community banks. Community banks do great work. I like the idea of supporting them, but in the ten years that I’ve managed those funds, one of the community banks has been acquired three times and the other has changed their online banking system six times. This caused a bunch of time-sucking headaches. While I want to support community banks, I don’t think they are a fit for VC funds.

Tip #1: House all your accounts -- personal and professional -- with one national big bank to keep everything streamlined.

Relatedly, I recommend asking your fund administrator and anyone else who is going to frequently interact with your accounts which bank they are most familiar with to limit their learning curve.

The Pitfalls of Special Purpose Vehicles

I’ve also learned that special purpose vehicles are more hassle than I anticipated. I started my investment career as an angel, investing my own capital, and then I started pooling my capital with other angel investors through special purpose vehicles which I volunteered to manage. It’s relatively painless to set up the special purpose entity and it should be relatively easy to file a tax return each year.

However, when you think about a potential 10+ year life span of an entity. stuff just comes up. Investors get divorced and have to split their assets. Investors die and leave their LP interests to spouses or children who know nothing about angel investing. You might be asked to make an important decision on the investors behalf eight years after you made the investment. You can outsource the management of SPVs, but that causes longevity-induced headaches as well. For instance, I’ve held one SPV so long that I’ve had five different account managers assigned to me during its lifespan.

Tip #2: Make sure the incentives will be worthwhile before forming an SPV.

The headaches of managing an SPV can be worth it in many cases. But not all. I’d recommend charging ample carry in exchange for management, and making sure that the investment offers enough potential investment upside to outweigh not just the administrative costs, but also the time and heartburn of unforeseen headaches.

The last lesson I’ll share regarding my transition from an angel to a VC is that I had no idea that my angel investing track record would be so scrutinized when I went out to raise a VC fund. I viewed my angel investing as a way to learn how to be a VC on my own dime. I made some not-so-promising small investments because I thought they’d be good learning experiences, or would help me build some important relationships. Then I transitioned from an angel to a VC. When we scored our first meeting to pitch our VC fund to an institutional investor, I almost fell out of my chair when he asked his first two questions: So what’s the TVPI and DPI of your angel portfolio? And tell me about the best and worst outcomes in your angel portfolio?

Tracking Investment Metrics

And that leads me to…

Tip #3: Proactively rather than reactively track portfolio metrics - both for your VC fund and your angel investments.

I grossly underestimated how much time it would take to retroactively collect metrics from portfolio companies. Before I sign any investment paperwork, I now make sure that, at a minimum, we’ve recorded the metrics we’ve determined to be the most important.

For equity rounds, that’s

  • Pre- and post-money valuation
  • Number of shares purchased
  • Our ownership percentage - and we set a reminder for two weeks after the round closes to confirm how much money was actually raised

For convertible debt rounds, that’s 

  • Interest rate
  • The mechanics of conversion
  • And the maturity date - Ideally, we like to invest in notes that automatically convert, but when that isn’t possible, we set a reminder for 30 days prior to the maturity date so we can remind founders to extend those notes if needed. I was recently reminded of the importance of this. One of our convertible debt investments was set to mature and the founder asked if she could hold off on extending the note until she handled a few more pressing items. She received an interesting acquisition inquiry during the time that she was dragging her feet on the extension. I’m confident that she would have done the right thing regardless, but it reminded me that we could really be up a creek if an acquisition or financing happened after a maturity date.

And for all investments, we make sure to track co-investors in the round, both because it’s helpful to know who’s in your corner, and also because LPs care a lot about the quality of your co-investors.

Then, we have a slew of other metrics that we like to know from the onset and over the course of the investment like the number of employees, diversity metrics, burn rate, churn rate, etc. But from my experience, it’s easier to get this information from some founders than from others. We have a good relationship with almost all of our portfolio companies, but in full-transparency, it’s like pulling teeth to get consistent information from some of our companies. We’ve decided that it just isn’t worth the brain damage in some cases. We’ve taken the approach of sending out a quarterly survey with nine required questions and about ten additional optional questions. When we 1) communicate our reporting expectations before we invest and 2) offer consistent support to our companies, our response rate goes up significantly. 

I’d recommend spending some time to think through what metrics you want to track and report over time.

I was much more bullish about tracking a lot of metrics when we had ten investments vs. now that we have 49 companies in our MergeLane portfolio, not to mention the close to 50 angel investments I track. The level of detail provided and the types of metrics tracked by VC funds seems to be all over the board. Which leads me to my next suggestion:

Invest in Other Venture Capital Funds

Tip #4: I highly recommend investing in other VC funds as a way to learn.

At a minimum, I recommend reviewing a handful of other funds’ reports to their LPs before determining the level of detail and the types of metrics you want to report to your LPs. See the links above for our reporting templates.

We decided to dedicate a portion of our current MergeLane fund to invest in other VC funds, and have learned a ton in that process. There are three things to think about before you consider that approach.

First and foremost, there is the double fee issue.

We decided to reduce our carry percentage and management fee to counterbalance the fund fees. For us, the learning, deal flow, and portfolio diversification benefits have been well worth it, but it’s certainly something to think about.

Also, if your allocation to funds is equal or greater than 20% of your portfolio at any point and time, your fund will be considered a fund of funds and will be subject to all sorts of reporting and compliance requirements and expenses.

This can be a little tricky with fund capital calls. For instance, if you make one $100,000 startup investment and then make a $100,000 commitment to a fund, you will be in the clear if the fund only calls $19,999, but you’ll be in trouble if they call $20,000.

You will also need to wait until your fund investments issue their K-1s to issue K-1s to your LPs. 

We just didn’t think about this when we deployed this strategy, and we had to delay our K-1 delivery this year. This irked our LPs more than I expected.

A few more notes on K-1s: I’ve learned that the longer we wait to deliver our stuff to our accounting team, the further behind we fall in the line with their other clients. We try to get everything we can to them the first week of January.

And when something like a K-1 from one of your fund investments delays the process, I’ve learned to make absolutely sure that your accounting team has everything else they need to process the return. We were delayed a full week after we got those fund K-1s, because our accounting and fund administration team had different opinions on how some expenses should be allocated.

Which leads me to my next lesson...

The Role of a Fund Administrator

Tip #5: Consult our legal, accounting, and our fund administration teams before making any changes.

As one example, we learned this lesson when we were approached by a Canadian investor who wanted to join our fund. I reached out to our accounting team to ask what would be required to accept a Canadian investor. It seemed pretty straightforward. My attorney happened to be on spring break and the investor was about to head off the grid, so I really wanted to close the deal. I thought, oh it’s just Canada, how complicated can it be? We got her to sign the docs and wire the money. When I talked to our attorney, I learned that accepting Canadian investors isn’t complicated, but investors are required to pay pretty hefty fees for Canadian compliance. She was planning to invest $100,000, so the fees were really going to cut into her potential return on investment.

Tip #6: We also would have saved a ton of time had we engaged a fund administrator before we started reporting to LPs. 

Our learning curve in tracking and calculating metrics sucked a lot of time, and we made some slight miscalculations which we had to reverse later.

With that said however, from my experience, it costs a minimum of $30,000 per year to engage a traditional fund administrator. Depending on the size of your fund, the makeup of your LP-base, and the time it will likely take you to close the fund, it may or may not make sense to engage a fund administrator from the start.

Just to share a bit from our journey, we raised a few small funds totaling about $2.5 million for the first generation of MergeLane. Most of our LPs were individuals who knew us well, and had relatively low reporting expectations. For those funds, we decided that it would not be in our LP’s best interest to incur a $30,000+-a-year cost to engage a fund administrator. This was the right move for those funds, but it has meant that I’ve spent hours and hours each year tracking the dozens of companies in those portfolios.

Our subsequent fund was a little more nuanced. We raised about $4 million and our LP base included more professional investors, but most of those professional investors were friends, neighbors, and well, mostly ski buddies from Vail. We decided to engage a professional fund administrator, but we waited until after we raised the fund and had made a few investments to do so. That saved our LPs about $75k in fund expenses, so I still think it was the right decision. but it was definitely more work for us, and we had to admit to some embarrassing mistakes that we made along the way.

For instance, and this leads me to my next lesson, we engaged a fund administrator before finalizing our legal documents and closing LPs. We agreed to some reporting and compliance procedures in our limited partner agreement which made sense for many funds, but not for ours. When we brought on our fund administrator, they explained that delivering on those requirements would increase our admin cost by about four fold. Fortunately, our limited partners agreed that the costs outweighed the benefits, and we were able to obtain approval to waive some of those requirements. However, it definitely caused some headaches and it made us look less-than-sophisticated.

For funds larger than $10 million, I think it makes sense to engage a fund administrator from the moment you start fundraising. For smaller funds and special purpose vehicles, I think it depends more on what you are able to do.

  • We didn’t have the cash to front a $30,000 fund administration fee, so we did it ourselves. 
  • I think it also depends on what you enjoy doing. I learn by doing, so I’m grateful that I did a lot of the legwork myself. I still do the outreach to our portfolio companies because it helps me stay informed and stay in touch with them. I think they are also more likely to respond to me than a fund administrator.
  • I would also think about your LP’s sentiments. For us, most of them prefer to minimize costs rather than see robust reporting. We’ve made some minor reporting mistakes for the funds that we manage internally, but for the most part, our LPs have been willing to live with the imperfection in exchange for the cost savings.

And that leads me to perhaps the most important point I want to make today:

You can spend hundreds of thousands of hours and dollars to ensure that your fund administration is perfect. However, at the end of the day, you are going to be measured by the return on investment you deliver.

This is hard for me to accept as a perfectionist.

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