How to Model a Venture Capital Fund?

Fund Fellow Founders How to Model a Venture Capital Fund?

A well-crafted financial model is essential for any aspiring or new fund manager to showcase their investment strategy, predict expenses and fees, align with industry norms and draw the attention of both founders and investors.

Summary:

As a prospective or emerging fund manager, you have the challenge of creating a winning investment thesis to attract founders and investors. Crafting a financial model for your fund is the key to detailing your investment strategy and expectations for capital deployment and returns in quantitative terms.

Despite the challenges of forecasting in the speculative world of venture capital, creating a forecast is invaluable. You can outline expenses and fees, reflect your investment strategy, forecast capital reserves and operating budgets, demonstrate a solid plan for capital deployment, and align your thesis with industry expectations.

Foresight, founded by an ex-venture capitalist, has a wealth of experience working with over six hundred emerging and prospective fund managers to create financial models for portfolio construction and operating cash flows. This post will guide you in creating a financial model for a closed-ended venture fund, using tools such as spreadsheets, pre-built templates, or web-based tools like Causal.

The focus is on building a model that reflects your investment strategy and helps you understand the impact of variability in your assumptions.

Full Story: HERE (OpenVC)

Below you can find key takeaways:

As a prospective fund manager, you will spend most of your time crafting your investment thesis, and creating a financial model allows you to detail your thesis in quantitative terms.
Outline to potential limited partners the fund's expenses, your fees for operating the fund, and their expected capital calls. Reflect your investment strategy, and create a forecast of capital reserves and operating budgets.
As the founder of Foresight, I've worked with over six hundred venture fund managers, mentored at accelerators for prospective fund managers, and analyzed investment portfolios for angel investors.
This post will explain how to create a financial model for a venture capital fund.

Before you get started

Modeling a venture fund can vary from modeling other types of private equity investments. Hedge funds and open-ended venture funds have different fund structures and expectations around investment and limited partner liquidity.
The best models for venture funds reflect their investment strategies, and help managers understand if their strategies "work" based on their assumptions.
Spreadsheets are the most common tools used to build financial models for venture capital funds, because they are accessible and familiar to most emerging managers.
Causal is a web-based tool for building models that can replace Excel or Google Sheets, and is easy to use as an analysis tool for yourself and potential limited partners.

The 10 components to building a venture fund model

To model a fund, first consider the overall fund, then add on modeling the cash flows over time. This adds rich detail to understand the key metrics that managers are judged on.
For your first attempt at building a model, start simple with a one or two sheet model and add in more complexity and detail as you develop your competence in modeling and understanding of venture economics.

Capital Budgeting

Fund size determines management fees, organizational fees, and operational fees. Organizational fees are a one-time charge in the first period of operation, whereas operational fees are charged annually while the fund is operational.

Portfolio Construction

Once you have created a capital budget and decided on the core timescale necessary for your current needs, you can start creating your portfolio strategy.
In the average investment approach, we assume an average new investment and an average allocation of capital to follow-on investments, and assume an overall return multiple on invested capital. In the detailed per-round follow-on strategy approach, we create specific assumptions around each new investment. The most detailed approach, the specific investment approach models each specific investment amount, timing, and follow-on, and also assumes a follow-on, valuation, and our exit returns from that investment.

Returns Expectations

Distributions are capital paid back to investors, typically defined as the fund's limited partners. General partners receive carried interest, or a percentage of the distributions paid based on the performance of the investments.
In many models, assuming a gross exit multiple and calculating gross proceeds using that multiple provides a straightforward way to model return economics.
This method abstracts away the multiple occurring, and does not require one to model the underlying changes in the invested capital post-investment. If worthwhile, creating a more detailed portfolio construction can help show how you expect to earn the gross exit multiple.

Capital Deployment

Capital deployment modeling involves creating a schedule of investments, fees, and capital calls over time.
With this forecast of invested capital per period, you can create a schedule of called capital, and apply the logic for calling capital to create a forecast of available fund capital.
Many funds will additionally want to create a forecast of reserves for follow-on capital, based on their schedule of new investments. This can be very important to help with capital deployment budgeting.

Realized Cash Flows

If you are creating a time-based fund model, you will likely want to create a forecast of proceeds and write-offs. This can be done using an assumption of gross exit multiple and average hold period.

Waterfall Distribution of Proceeds

In a typical USA-based venture fund, a waterfall model involves modeling the return of capital to the limited partners, then any distributions above that multiplied by the fund's carry to calculate carried interest. In many non-USA venture funds, there are additional structures that can complicate waterfall modeling.
For a time-based model, you will need to track the distributions of proceeds against called capital to show the return of capital to limited partners, and optionally GP catchup.

Unrealized Changes in the Portfolio

When building your fund model, you can choose to show the changes in valuation in the underlying portfolio. This is necessary if you are doing a time-based model, since once all investments are exited, residual value is equal to zero.
Typically you will use a detailed portfolio construction approach to show the expected timing to write-offs, additional funding rounds, and exits.

Performance Metrics

Two primary metrics are used to evaluate investments, IRR and return multiples. You will want to create a model to report two variations of these, by gross and net.
You will want to detail gross and net IRR, so create one line for gross cash flows and one for net cash flows.
By definition, these metrics only measure realized returns, so Interim IRR is only valuable to show the changes in value over time for a fund that is currently investing and not fully exited from their investments.
Paid-in Capital, Residual Value to Paid-in Capital, Distributed Value to Paid-in Capital, and Total Value to Paid-in Capital are calculated.
These metrics show how much value is in the current investments and how much has been distributed to investors. They are not as relevant as multiples and IRR.

GP and LP Economics

Many funds will want to show the return metrics separately for GPs and LPs, but most funds will not detail out the specific returns to each LP in their fund model.

Management Company Budgeting

Budgeting for the management company operating the fund is similar to budgeting for any operating company, and involves a forecast of hires and salaries, insurance, accounting, legal, and overhead costs.
Funds will model their management company through the entire fund life, but as the management fees expire, they will either assume they will raise another fund or show how their expenses will decrease over time.

Special Considerations in Venture Fund Modeling

Revenue-sharing funds make investments into companies that earn them distributions over time, in advance of exits. The basic structure of the fund still holds.

Venture Debt Funds

Similar to revenue-share funds, venture debt funds have different investment structures and distribution of returns. A debt amortization schedule is necessary to model a venture debt fund.

Fund of Funds

Fund of funds model is similar to modeling venture capital funds, except there are many more "rounds" of capital calls than follow-on capital into companies.

Crypto Funds

Crypto funds are typically modeled in much the same way as other funds, and need to track token prices, liquidity timings, and residual and realized value.

European v American Waterfall

Most venture funds use a European waterfall, where proceeds are distributed on a total fund basis. If you are using an American waterfall, do the calculations per investment.

Rolling Funds

AngelList's Rolling Funds require special consideration when modeling, since fees are collected differently than traditional funds.

GP Commit

Some funds will model their waterfall treating the general partner commit as a limited partner interest, some will not. If the fund treats the general partner commit as an LP interest, then the waterfall is amended to show the return of LP capital first.

Management fee recycling

Recycling management fees or recycling proceeds will increase invested capital. Some managers will choose to recycle management fees up to the amount of the management fees charged to the fund, in order to boost their fund returns.

Management fees based on invested capital

Modeling management fees based on invested capital is more complicated than modeling fees based on committed capital, because the fees are typically a percentage of the total invested capital at the end of each period.

Evergreen or Open-ended Funds

Evergreen funds typically recycle a large share of proceeds back into new investments, while open-ended funds allow investors to redeem invested capital based on agreed timelines, and pay distributions over time.

LP side letters and varying terms

Some funds will create special terms for limited partners, such as first-loss capital, preferred return or a portion of the GP carry.

Modeling multiple funds and SPVs

Often managers will invest through multiple funds, and the best approach is to model each separately, and then combine them into one comprehensive model.

Management Fees, Cashless Contributions, and Fee Waivers

Managers may choose to reinvest their management fees back into the fund, or pay for their GP commit using their management fees.

Using your Venture Model

Creating a forecast is easy, but making sure it's believable is hard. Data is sparse and difficult to collect, and may not be relevant for your strategy.

Scenario Modeling

Range-based scenarios are good for analyzing scenarios and discussing options with potential limited partners, while situation-based scenarios are better when evaluating different fund strategies.

Tracking Actual Investments

Once you are making investments, it can be valuable to track them and see if your original budgeting strategy still holds.

Strategy drives model, model reflects strategy

Don't lose sight of the big picture. A model is only as good as the data used to create the assumptions.
There are a number of additional resources available to people who want to learn more about venture fund economics, such as Slack groups, accelerators, and books.

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