89. The Economics of VC Funds

Hello everyone and welcome to another episode of the operations room a podcast for COOs. I am Brandon Mencinga joined by Bethany Ayers. How are you doing today? I am shattered.

Shattered. Shattered! The honeymoon of being a CEO is over. I was ready for the weekend on Monday, and I don't know why I found the energy for the next four days.

Okay, so the bubble has burst. How many weeks are you in right now? I'm saying six, but I actually have no idea. Yeah, it's all a blur.

I went from knowing the exact number of days that I've been in to now, just like most of my life. I don't remember a world before this. Okay, so the honeymoon is over so that the reality of your situation and the reality of everyone's situation is now ever present as you head into next week. Yes.

But it's also, it's amazing going from not really understanding cybersecurity, not really understand, like understanding high level what's needed and the words being used. And luckily the problem that we're solving is a problem that I can just understand having been an operator, which is basically in a nutshell, everything in our businesses is over permissioned. And then you throw AI on top and suddenly everybody can access the things that they have permissions to access even though they shouldn't and they never knew it because they can't find it on our horrible shared drives or buried in confluence or JIRA or whatever and with AI it all comes to the surface.

So it's a very easy problem to understand as an operator but like what are the gaps, what are most important things to build, what's the order of it all, it's all just come clear. All the dominoes just clicked into place like I see where we have to go and what we have to do. That's amazing. I think in B2B verticalized markets like this, quite difficult sometimes to wrap your mind around things in short order, especially to come out the backside after six weeks and feel like you have a clear game plan of like what actually makes sense.

I feel like I understand the gaps. I feel I understand priorities and what absolutely has to get done, but we also need to move quickly and speak to customers, speak to prospects, test the market, show prototypes and make sure that we're heading in the right direction and we need to do it really quickly. So we're moving into basically weekly company sprints, where on the Monday we say, what What campaign are we running? What deals are we progressing?

What features or technical support do we need? What are we learning? And then we go off and do that. And then on the Friday, top of funnel, pipe generated, deals advanced, deals won, deals lost.

And what have we learned? And therefore, what are we going to do next week? That's amazing. So the Monday morning, the Friday afternoon, sprint style, right across the entire company, the company is again, 25 people, something like that.

So that sounds like a real drumbeat cadence of focus. It is, and I was like, I still need to speak to our engineering leaders after this to make sure that my idea works, because I was originally thinking about it specifically with GoToMarket, but then I was, like, we're only 25 people and we're so interconnected between the product and the market that I think engineering need to be involved, hear the conversations, understand the learnings. And also, there's always this thing, you don't want to distract engineering with that don't matter, but sometimes they're like, oh.

I can do that. That's like three lines of code, and we need them to be able to be, oh, yeah, I can do that, and that's going to make your life so much easier. And then there's just a lot of friction in the business that's been surfaced. Our demo tenant has messy data, and you have to do a lot to prepare before a demo.

And it's like, we just need a demo that is amazing every single time. We can't have that sales has to worry about free. Prepping it and and everybody needs their own and so somebody changes it, it doesn't mess up somebody else and there's a good thing and a bad thing about the fact that we're coming into Q4 because we can do a huge amount of work to prepare for an awesome start to 2026. We're in the headwinds of everybody's natural energy level.

We're coming from autumn into winter. People start to want to hibernate. Our bodies are more tired. We have loads of energy in the summer.

So I wish we were doing this in Q2, physical, body-wise. We're going to have to work against our energy. So you're right, there's a seasonality effect is there when you're sitting there in the spring heading into the summer. There's a real zeal and energy and kind of more light and more like a capacity and energy, I suppose, to your point.

And then come September, October, it feels, it feels like a grind. And so I'm also thinking about how do I find my energy and then energize the team with the nights closing in. Yeah, so how do you do that? It's interesting, because as a personality type, as you know, I'm not a center of gravity when it comes to charisma.

I'm trying to phrase it exactly. I kind of think about this sometimes coming to the office, like feeling energized, expressing that in some form. You know what I mean? Like giving some people a sense that Brandon's present and energized and focused on the job at hand.

I struggle with the same thing. For me, it's gonna take a tremendous amount of energy and I'm gonna have to find it from somewhere. And then have my energy buoy the rest of the team. Like it's Friday, I wanted the week to finish on Monday.

I don't know where that energy is going to come from, but I have to it. Right now it feels fairly impossible, but I'm sure in another couple of days, like I do tend right now to just. Collapse over the weekend. Like I'm not seeing friends a lot.

I'm just resting. And also I've been sick pretty much for four weeks. Well, that's right. You had a cold last week, didn't you?

So you're better, better-ish. Yeah, there's like a little bit going on, but enough to go back to the gym and, and exercise, but I am just trying to conserve some energy that way. Doing some meditation, I'm back doing my writing class and, although it's hard to find the time for it, it's helpful to process my thoughts with the discipline of it. And in the writing class, it launched last week and it was interesting.

We have four people in it who are working on product. Rather than doing any sort of exercises, because they've graduated and they still come back and they work on the books they're writing and then they read excerpts and get feedback. And so Jules, our teacher was asking them, what specific feedback do you want so that we're a helpful group for their writing? And I basically said to the group, I normally like constructive feedback, I normally liked to learn and better my craft, but I'm not writing for you, I'm writing for me.

And I'm in the class to just have some discipline to write, I just want you to tell me to keep going. I don't need any level of criticism or constructive feedback or how to do things better. I'm not in that space. No, mental.

Capacity to process critique at this stage. No, but it's also really freed my writing because I am literally writing for myself and I'll just read a piece. I'm writing with no audience in mind, which is quite freeing. It's amazing.

I remember when I was doing the acting stuff, we would always freak out before a show. Highly stressful. The butterflies are right in your throat and you're like, all right, 50, 60 people is very intimidating but not very experienced. Our acting teacher at the time, he would take us through all these body movement exercises, breathing exercises to put us in the right state of mind, the right frame of mind.

I've always taken that since then more in the yoga realm, which is if I'm feeling out It's stressed out, not feeling great, and I don't have a lot of time to re-energize myself or figure out how to get back to a regulated state as you characterize it. The yoga sessions are always good for if you have a good yoga session physically and there's some level like breathing exercises involved i can do wonders within an hour or an hour and a half to. Reset you and clear your mind and feel better basically by yourself your situation so outside of the spreads what else are you doing.

Yeah. So we're doing the sprints. We have our, the company's never had OKRs. So we are introducing OKR, but it's very light touch because you know how I feel about them anyhow.

But we have three. I won't bore you with what they are because it doesn't matter. Although one of them is become an AI first company. Oh, I love the sprint.

AI first as an OKR. That is amazing. What are you doing on this front? So we have three key results.

One is every employee has, now I'm hesitating here because I pushed that every employee should have five AI employees. The leadership team, we had an offsite this week. This was part of the clarity, was spending a day together, really hashing stuff out. The team had a bit of a freak out about five.

We agreed to two, but when we launch on Monday, I'm gonna go back up to five because we're now. Bye! We've agreed now we're gonna agree to disagree. We're up on the number.

Well, the reason why we're upping the number is also after the offsite, when we agree the OKRs, we were going to do on our company offsite a very traditional, here's a 15-month plan, here are OKR's, work on our companies values, let's do an escape room or, you know, something escape room-esque. And then after the offset, I realized we just have to move faster and people need to know things sooner. So I'm doing the OKRs on Monday, which means that we still have this off-site next week and I'm bringing in Charlie.

The ExaGuess3. To train the team and another guy who's going to be a guest on the podcast coming up called Ryan Fuller. He's an engineer turned CTO turned CEO who had a very successful exit to Microsoft and then stayed in Microsoft for quite a few years. And so I'm going to have him train the engineers because I talked to him and he spent at least 15 minutes explaining to me why he doesn't know anything and he can't teach our engineers anything.

And I was like, yeah, you're the person the engineers will want to listen to. Because you're not telling them anything. He's just like, I can just talk about what I've done. And I was like, that's all I'm looking for, just to open up minds and really understand new techniques and technologies out there.

And so I figure if we're gonna do two days off site, which is AI training and team building, everybody can build their first five AI employees on those two days and or build three and understand what the next two are gonna come. So I don't think it's actually, I don't think two is a stretch and OKR should be a stretch. So we're gonna go for five. So that's our key result for becoming an AI first company.

There's also two other, basically building out, I don't know what to call them, AI automation, smart automations. So there's something on the tech side where you can use linear with something, I can't remember if it's GitHub or Claude code or something, but basically linear and a coding thing can resolve and fix your bugs for you. And so we're going to experiment with that to just get rid of a lot of the bug fixing automated and see if it works. And then on the go-to-market side, do the 24-7 SDR who's constantly scanning the market for people in market, scoring them, writing the emails, sending them out, sticking them in a cadence.

We've actually already built that. So again, we might need to up the key results. We've bought Gitcargo. Our revops guy absolutely loves it and it's just building things overnight.

Like it's really easy to use. I obviously have not used it, but like the feedback is it's amazing. So if anybody wants to have a little look there, yeah, I think it's actually called cargo, but the website is get cargo dot app maybe. And so internally we're calling it get cargo, but when I go on the website, it just says cargo.

So I don't know. It's one of those where they couldn't get the URL clearly and now. It's whether or not their name is get cargo or cargo. Anyhow, going back, so we have three OKRs, one is being an AI first company.

Those are the key results. And then we don't have any set values in the company. It just never happened. And so part of what we were going to do is we talked to Cameron Harrold about it, the mission to Mars, who are the people who are most have the values, blah, blah blah.

And I spoke to the leadership team And I said, should we do that or should I just choose some values that. I think will get us through this. And it was interesting. The team just said, yeah, everybody just wants direction.

They just want to know what to do, where we're going, just choose the values. I was like, cool, I can do that. So then thinking it through, not sleeping a lot, woke up at four in the morning, I think Wednesday night or Wednesday morning, whatever. And I was, like, ah, I know our value.

We have one value. We can do hard things. Simple, very clear. Where does that come from?

When I shared it with my husband, he's like, oh, but that book, I hate that book. And I was like, you don't read Glennon Doyle, what are you talking about? And he was talking about the Andrew Horowitz, the hard thing about hard things. But that wasn't where I came from for me.

So Glennon Doyle, who wrote the book Untamed, has a podcast called We Can Do Hard Things. And that comes from when she was a primary school teacher, and it was a slogan in her room. Yeah, for all the young kiddies, I love that. I just think it probably encapsulates my being.

Like I'm not afraid to have hard conversations. I'm Not afraid of being uncomfortable. I'm, not afraid of big challenges. Yeah, it's such a great way to sum it up.

We can do hard things in particular, given your stage of company and what you're up against that feels like the singular thing to lead on and to reflect on as you work through the next three, six months, because you have a lot of hard things to do for that company to make it work. We know what we need to build great ideas and we just need to ship as quickly as possible get it out there get it tested. On a lighter note, I went to the CEO Roundtable dinner last night at the Zettler.

It was amazingly close to my office. Literally, it was across the street, about a two-minute walk. It was one of those places where I walked by it a thousand times going for lunch. Never took a second glance.

Went in there. And this place is awesome. They get totally vintage, 1930s, 1940s style. And all I can think to myself is like, why do we go to this shitty pub around the corner for drinks after work on Friday sometimes.

Why do not come to this very stylish nineteen thirties ask vintage place to have a drink and seems like such a better place to go is it twice the price yeah probably that's the answer. So the round table is fun so we had to as usual introduce ourselves but she added a plot twist to the introduction which is we had two talk about a story from each of us around what creates a good life and the lesson behind it. Oh my god. So I didn't realize this until I got there looking at the cue card in front of me.

So instantly you're like, Oh fuck. It's like, what am I going to say? What is my story? And then she cut it into two halves, 14 people, the first seven went, right?

So all the stories for the most part, I might be slightly over exaggerating, but they were all like deadly, serious, you know, very serious consequences of family situations, this, that, and the other, and there's nothing wrong with that and you know they can be quite meaningful stories, but having seven of them back to back, like I'm like, oh my God, I feel just like I feel terrible about these people. So I went into this story around having fun experiences in the workplace.

I gave this quick story. We had our Christmas party, this is back in 2014, 15, roughly a hundred people having dinner, at that point later in the evening, everyone was asking like, where are we going for the kind of like after drinks? I live two blocks away. I have a two bedroom flat.

So this handful of people at my table, I'm like, yeah, we should go to my place. That'd be amazing. So next thing I know, The board gets out across the entire rest of the company. We all go to my flat, it's three floors up.

Everyone traipses up the stairs. I'm leading the pack, get to the top, and in my head, I'm like, oh shit, my roommate. I walk in, knock on her door, like, hey, is it cool if I have a couple friends over? She's like, okay, yeah, that's fine.

Everyone's in, floods the flat. I'm not even joking, two bedroom flat, 80 people, we had maybe, I want to say roughly half inside the actual flat itself, there's a rooftop with a ladder on the backside of my flat. It's not particularly well bolted in. All these drunk people like climbing up to the rooftop, which probably wasn't the safest thing to do.

And then I could see once there was like, I don't know, let's say 40 people up there, I could the roof flexing, right? Because it's one of those older built buildings that I was like holy shit. So they all come pouring through your roommate's ceiling. Half of SwiftKey can be wiped out in one fell swoop because of my actions in this case.

Later on in the evening, the chief marketing officer, it's always the marketing person, my roommate had a beautiful African horn. He grabs the horn, blows on it, and because it's an African horn, it was pretty fucking loud. Wake her up my roommates her horn she freaks out comes out so that point the party's over ever leaves fast forward ten years we had a swifty reunion and john and the founders of the company when they're giving their talk around the highlights of the swifty experience they brought this up as one of their highlights saying what amazing party was i was like yes.

Fun experience, people remember, it was awesome, despite obviously pissing off my roommate. And it's like once in a while, you need to cut loose and have a good time with people. And fun is important as part of company experiences. It is, and the problem is you can't schedule fun and you can mandate fun.

It just happens, and it's a special moment. Completely unpredictable. Yeah, that was definitely was not planned. I'll tell you that much Yeah, it's always the best thing because when you plan it, expectations are high.

You force it and it's just almost like de facto isn't fun. Exactly, it's the manufactured force fund that we all do in companies. Yeah, the escape rooms versus the random party at somebody's house around the corner. So we've got a great topic for today which is the economics of VC funds.

We have an amazing guest for this which is Edward Barrow. He's the co-founder and CEO of Cloud Capital and the former Notion Capital, a resident expert on financial strategy, M&A, and market mapping. That is a mouthful. So before we get to Ed, just wanted to ask you three questions on the economics of VC Funds.

So he said that there are three important questions that a CEO should ask of existing investors. The three questions are, when did they raise the fund, meaning that if the fund is in its latter stages when they have invested, it means that they need to get a return on capital fairly soon, which means they're putting pressure on their portfolio to return cash sooner or later effectively. So that question of when did the raise the funds, where do you sit in that timeframe, that's an important question to ask to understand that.

The second one was, what is the size of the fund? So the funds a hundred million pound. Fund and you're in a position where ultimately you can deliver a 300 million exit for the company, which is possible, that is a fabulous return for a hundred million pound fund. If it is a three billion dollar fund from SoftBank, your chump change and your importance to that company may be a lot less in that case.

So the size of the fund is useful. And then the third one, which I never really thought about is where do we rank in the one's performance, your ranking, which they do. Really means how much time and attention are they gonna pay to you as a potential bet that's gonna pay off. And again, going back to that notion of if you're later in the fund cycle and they're looking for liquidity and maybe you're not a top performer, but there's a realistic path to exit, there might be additional pressure put on you as a mid-tier performer to basically get the company sold or get some kind of liquidity event.

So with those three questions for the CEO, what do you make of that? And what's your experience, I guess, in? Those kinds of questions and I guess your investigations that you've done. I'm trying to think of like what an interesting answer is other than it's very wise and he explains it very well.

Yeah, it's a pretty clear three-question set, I think, isn't it? So Ed talked about secondaries becoming super common these days. What should CEOs know about this secondary situation? Because I think there's a couple red flags in my head around this in terms of your reality as a CEO and why this matters.

That you can actually exercise your options as they vest, rather than you can vest them, but have to exercise in some other moment. So basically if there is a secondary, you can cash in some of the shares that you've earned, turn the options that are vested, exercise them, sell them in secondaries and take some cash. Exactly, because I think this idea that if there's not a lot of M&A's ability for VCs to get a return of capital based on exits that are actually happening, and that's dried up to a certain extent, the way they're actually getting liquidity is kind of like the secondary kind of side of things.

So if you are an existing investor and you need to get capital know participating in a secondary sale to the new lead investors coming in as part of that package and I think the key question for. A CEO is just making sure that you can actually participate in the secondary itself. And I've had, two companies ago, a very clear experience where, for whatever reason, I still cannot understand to this day, in the articles of association and the resolutions, in what I don't quite know, the employee base with vested shares was unable to participate in the secondary sale itself.

And they were caught out with that and they were surprised by that. That's not a good outcome. So I think this idea that. Very clearly joining an organization, can you participate in secondary sales, should they occur, is a very important question to ask because if secondaries are becoming super common these days, it's such a clear, more short-term duration possible way to get cash in the bank that could be fairly substantial depending on the valuation jump of the company instead of having to wait.

I feel like in one of my investments right now, I'm gonna be waiting for what feels like a decade to get a payback. And it's also because there's a few ways for secondaries. Sometimes people come in and buy secondaries for your pence on the pound or pennies on the dollar to get into companies and, you know, like their current valuation, but it would still be an uplift for early investors based on what they invested. And they just buy some of the secondaries and they're not actually buying a majority stake in the business.

But then you also have these deals. Where they get pushed as new investments. Look, blah, blah came in and invested an insane amount of money, but they're not actually VC investments. They're in effect buying 80, 90% of the business for that investment.

They are now really the owners, but it's not a total transaction. If you cancel your secondaries in that, you might never really see an exit. You know what's fascinating? So literally as of this week, this was kind of a big deal to me.

Signal AI, my former company, basically completed a fundraising round with battery ventures. It was characterized not as a Series E, which is a venture round, but characterized as an equity round effectively. So they're repositioning from venture over to private equity effectively. And the investment was 165 million US going into the company with a majority stake, Basically, which means that they now effectively own the company, and they're now prepping it, I think, for kind of a P2P swap at some later stage.

Being a P kind of play now, it's probably another five years before there's going to be like an actual proper P2 P sale at this point. I think what ended up happening, and I don't know this, but with that majority investment, to your point, I thing what they've done is probably cleared out some of the existing investors by purchasing their allocations with some of that 165 million U.S. And unfortunately, for people like me, they haven't gone into the individuals, as it were, that hold shares in the company, angel investors and so on.

I suspect they've actually just gone after some of the blocks allocated to some of these earlier investors that had more substantial blocks, but not other folks like myself. So to your point, at least in this kind of, I don't know, secondary situation, sometimes unclear what they're going to do, but at least, in this case, I'm not getting my payoff at least for another five years. Very frustrating. I'm sure all our listeners are crying for me right now.

Last question I wanted to ask you would be simply the acceleration of vesting and how important this is because if the lead investor in your company is looking for a return in let's say two years and you've got a four year option grant cycle, you're not aware of this, then that can be problematic because at the end of the day, you want your four year options grant presumably to vest fully and if they're wanting to have the business exit within two years as an example. Then you might get jacked just in terms of like not getting your four but potentially getting half of that.

Well, so I actually have an answer for this one, or a new piece of information I learned recently, is the UK are an anomaly when it comes to acceleration as an offer. In the US, it is pretty much considered bad practice and is almost never offered, and you have to negotiate hard to get acceleration. In the UK, something like 85% of companies used to offer acceleration, but with... Maybe u.

s. Influence is dropped down to sixty something and it's trending down and in europe it's only thirty percent of companies are option plans that offer acceleration. So actually now is the time to negotiate it because it's going to come off the plate in the u.k.

And it already pretty much is off in the u.s. Unless you push really hard and as an exact like ceos ceos. CROs are in a good position to negotiate individually for acceleration because they need to be motivated for the sale, but across standard packages, the acceleration is not the default in America at all, and in the UK, it's rapidly declining.

There's no skin off the back of the company or the acquire really outside of like a bit of dilution i guess but yeah. Well, that's what it is. So like, who's going to pay for this acceleration? And it's the investors.

And so now that the market's switched and they're like, why should we pay? People are lucky to have jobs. And then the other part is it makes you in some ways more expensive to buy for the acquirer because they have to invest to tie you in, in a way that it's easier to kind of like flip. Rest of your money into their shares in effect.

Yeah, that's fascinating. So just to give the audience a bit of a broader perspective. So the idea essentially is if the company exits before your options fully vest that they accelerate whereby the entire four-year grant. Is fully vested as part of the acquisition itself for the exit event and the whole purpose of that is to tell the employer of the senior executive like look.

You know we need to create value in the business as fast as humanly possible getting to an exit point earlier the later is better for everyone so you're incentivized to make that happen is as quickly as we possibly can and you don't have to sit there brandon and wait for four years for you to fully best to get your your your payout because at the end of the day what i don't want to the point doesn't want Is to be sitting there. Thinking themselves i don't want this company to exit in a year i don't want the next two years i wanna like not by my time to make sure.

Angle my way to ensure the company kind of doesn't exist until like little bit later essentially and as a company i think you don't what that we want is people flat out value creating from day one as fast as they possibly can. Yeah, so as an exec negotiate it and look for it because more and more are going to default not have it. We will pause here and we will move on with Mr. Ed Barrow.

What should COOs know or think about before they join the business? Well, I think it's actually really important to understand the cap table of any company that you're coming into, particularly in the COO position, you're going to have a fairly sizable responsibility around fundraising, around preparing the business to scale and ultimately to exit through any of those sort of different exit routes. And how the cap tables are structured, how people get their money back eventually at the end of this journey is incredibly important.

And then behind that actually the different funds and the different motivations behind those. So I think a cap table, you can say, okay, you know, 20% belongs to this VC and 20% to this VCE. But actually, there's a huge difference in the motivations and requirements of different investors based on when they invested, how much they invested, the rights that they got, but then also where they are in their fund lifecycle. How large are they as a VC fund?

How much have they raised? How much of they been able to return to their underlying investors? And where do you stack in the distribution of performance within that investment fund? So I think you start by needing to just understand who those investors are, but there's a good amount that is really valuable to know about their motivations in turn.

If you can do that, then I think you can really start to understand how all the different parties align and what pressures you're going to face over the next three to five years as the business scales and you raise more capital, you look for exits. Who's going to be enthusiastic for an exit at $50 million, who's going be enthusiastic for an access at $500 million, and who's gonna be enthusiastic to an exit of $5 billion. And obviously, as you're scaling the business, it's really valuable to know that.

Could you maybe just pull out, I think you just said it, but pull out the three or four questions that I should be asking the existing investors at some point, probably in subtle ways, I suspect, but to get to those answers that you just talked about, like what are like the key questions? And also the why behind them. So I think, as you maybe set back, venture capital, if you think about the basics of it, VCs are what you call capital allocators. So they raise money from underlying investors called LTs, limited partners.

Those can be angels or institutional investors, pension funds, endowments. They go and raise that money and they, over the lifespan of a venture capital firm, they might raise multiple pots or funds. And their job is to go and invest that money into companies and then return that capital and ideally significantly more to those underlying LPs on an expected. Typically an expected 10-year lifespan.

So what that looks like in practice is if a BC fund raised money from LPs, they might have raised $100 million, let's say, in 2020. They ultimately need to return, ideally, three to $500 billion, so three to five times return, by 2030. So they have a roughly 10-year cycle to invest capital, to allow those businesses to grow and support them on that journey, and then to return that capital. So it's valuable, first of all, to understand when they raised that money and when did they actually have their, what's it close that LP capital, because they will be at somewhere along that journey.

So in the first three years, so in that scenario from 2020 to 2023, they would have been deploying that capital fairly quickly, prudently, ideally, but fairly quickly to invest that money. They will have reserved some of that investment capital for what's called follow-on investments. So maybe half of the capital, 50 of that 100 million, would have being to deploy to initially enter new investments and then some capital reserve to participate in subsequent investment rounds. But as they're getting into year seven, year eight, so that's in a few years time, 2027, 2028, they're going to start to think, okay, how can I start to return some of this money to my LPs?

And as I said, by 2030, they are meant to returning all that capital and more. Often, and as is frequently happening in Europe, you can have several extension years. So funds can continue to operate into year 11 and year 12 with the approval of LPs. But what this obviously means is if you've got two different funds invested in your business, one that was a 2020 vintage fund and one that was a 2017 vintage fund.

They're going to have different timelines. By now, your 2017 fund, 2025, where we are now, that fund is going to be looking for returns already. Whereas the 2020 fund is quite happy to continue to see growth and performance before they start to drive liquidity. So, actually, any startup has, as I said, typically got multiple different investors.

Often they have different fund vintage, the year that they raise the capital, and but just the timelines of when they're expecting to get capital back from you. Will be very different, and understanding and aligning that, I think, is very important. Another thing to mention, I think, Ed, for people who don't understand is the consequences of not having a successful return for the VC fund. Like, why do they care?

What happens if they don't do it? Ultimately, a VC fund makes their money in two ways. One is on management fees. So if you raise a $100 million fund, typically you're allowed to take about 2% of the value of the fund each year during the life cycle of the funds as management fees, your fees for operating that fund.

So a $10 million fund roughly generates about $10m in fees. Now, most VCs don't work for management fees. Most of them are looking for returns, and they make money. Obviously, when you sell your startup, and if that performs well, they will make some money.

The way that works is they typically make 20% upside from every investment once they've returned the original capital. So again, if we're talking about a $100 million fund, they They make 20%. Once they've returned the first 100 billion, often actually a little bit more. So they have to, you know, have reached what's called a hurdle.

So it might be 110 million, 115 million, and then they make their money. So first of all, they are looking to have successful performance because obviously they want to make money. No good VC is sat there simply making a living off the 2% management fees each year, they're looking to actually... Generate money for themselves and see that performance.

The longer they have to wait for that capital, obviously, they are delaying gratification on that fund. I think the other point, which is really important, is obviously every VC or every successful VC is looking to raise their next fund. So a typical VC is raising a new investment fund every three years. Sometimes faster, particularly during COVID, people were raising very, very quickly, but typically kind of a three-year life cycle.

So they will start to deploy investments from one fund in the first few years, but in order to raise their next fund, they really kind of need to return some money from the previous one. The ideal scenario for any VC is make a bunch of investments from fund one, see great performance out of that fund. Generate, have some great exits and great liquidity, have a big pot of cash ready to return to their LPs, and then be able to turn around to those LPs and say, actually, rather than me give you this money, would you love to deploy this into our next fund?

And they recycle that capital into their next fund. And obviously, they're going to make more management fees and more performance fees off that fund. So actually... Their ability to be successful as a venture capital firm and their ability to raise more money is very much driven, not surprisingly, by exits and performance of previous funds.

So there's obviously a timing to that if you're looking at your VCs and understanding when is their next fundraise and when would they ideally be able to turn the great valuation you've got on paper into reality. That's also a very useful data point to understand so that you can see how their motivations align. Are they doing really well raising this new fund or are they struggling? Would it be great if they had some capital to recycle into that new fund, or be able to demonstrate they can return capital so they can raise more money?

So if one of the companies in the portfolio goes past the 10-year mark, and they just consider it like a write-off, it's just like, whatever. If they return some cash, normally fine. If they don't, fine. How do they view companies that seem to go on for some time?

Particularly, Europe, the first serious VC funds started to scale up sort of 2010, 2012 and so actually we're seeing a lot of funds you know now sort of sat in the position in Europe looking to return capital who have blown past that 10-year life cycle. In year 12, sometimes year 13, there's even years 14 and 15 out there obviously. The motivations of the venture capital fund in that kind of 10 year plus environment really depends on the performance of the company. So if you are a star performer, if you're doing really, really well, then actually venture capital funds and the LPs underlying the funds are often quite motivated to roll the dice and to continue and see if day's further performance and further upside.

So in that scenario. You can do what's called a continuity fund. So essentially you can carve out that investment from the fund and put it into a new separate pot, a new, separate vehicle. And essentially allow that investment to continue on.

So we're seeing that now a fair amount with top-performing investments in a fund, the top one or two investments, where they might be now serious scale with the potential of an IPO or a very large exit in a few years' time. No one necessarily wants to get out just yet because of the potential upside from that. If you're not one of those star performers and the VC world really does work on a power law, so VC's economics mean that they are highly motivated by an investment that can return the value of the fund.

If you are outside of that, if you're in that top cohort, if you are in the second quartile or third quartile, then they're going to look for liquidity. They're going say, okay, let's find some way to get money back. Obviously, one option is to encourage the company to look at exit opportunities. So you'll often have investors at a board meeting saying, let's think about our strategic options.

When we're coming to a fundraise, let us explore other things than just raising another round of funding. Are there opportunities to sell the company? Are there opportunities to get what are called secondaries. The other option is that the VC Fund themselves can work with secondary investors.

So there are specialist investors who will come in and buy out and invest them. So they can buy out a VC fund from a particular investment. They could buy out the VC fund from their entire portfolio. They can actually buy out just one underlying LP.

So if there's one investor, one limited partner behind the VC funds that for whatever reason really needs all their money back, then someone can come in and step into their shoes. So there are ways to exit that without actually directly kind of evolving. Or requiring the company to do a lot of work, but they will definitely at that point be looking for exit routes for their stake at the very least. So if we go back to the questions that either coming in as a CEO or if you haven't asked the questions and now you're there, what are the ones to ask?

So one is the timeline. Definitely on timeline. I think the other is actually what is the size of the funds that you invested from because that will help set some guidelines for what is expected. If it was a $100 million fund and they invested for 10% of the company, that 10% the company needs to ideally be worth $100 billion.

So the company needs to be a billion dollar for that to be achieved if the funds were 500 million. Or a billion-dollar fund, and there's obviously a lot of large-scale, particularly kind of multi-stage investors, that really changes just the absolute quantum that they would be looking to return. If they had invested, let's say they are one of these massive funds, so half a billion, billion, three billion, and they put 20 million in, are they actually expecting their whole fund to be returned?

I can't imagine they are. They are expecting a very sizable return even at that stage. I think it is important to understand specifically what pot you're being kind of funded out of because a large three billion dollar fund is actually typically kind of subdivided into different pots. But certainly if they are investing out of the flagship pot from your funds, they are going to be expecting very, sizable returns.

Their support for you and frankly their attention to you as a portfolio company will in large part be determined by the likelihood that you're going to be able to deliver on that. We have got a lot of large-scale funds that invested with. Big expectations of very, very sizable returns, because obviously a $3 billion fund doesn't need to return $3. It needs to return 9 to $15 billion in order to perform well.

And so you can definitely start to think quite carefully about what is the reality of you as a portfolio company actually delivering on those expectations. I suppose if you're a smaller fund, those carries matter a lot to your point, but if it's a larger fund where it's $3 billion or something like that, your management fees are astronomical. So the balance of power between the carry influence versus the management flee influence, it seems to me that to Bethany's question and these massive billion dollar funds, the carry side of it is obviously very, very important, but the management fees are so high at that point that I can imagine there is a bit of a trade off in the mindset of the GPs.

I think that's definitely something to be concerned about and I think it is valuable where possible to raise capital from investors who are really motivated to see the outcome that you're looking for and that you think you can deliver because if you are raising from a large fund and say you've raised from a multi-billion dollar multi-stage fund but they've only put one or two billion dollars in at an early stage into your business. You have to recognize that you are just not going to materially impact the economics in terms of that return.

And maybe they are, as you said, more motivated by being able to invest money quickly, mark up those investments. To a new great valuation such that they can go and raise another bigger fund. And obviously, there are two very different ways of looking at the performance of an investment fund. One is the potential.

Returns and what is the actual return. So there's a thing called TVPI, total value to paid in capital, but essentially that's the what's the on paper valuation of all of the investments that have been made. And then there is DPI, which is the how much money have we actually returned. Now, as a VC fund, you invest your money.

When those portfolio companies then raise their next investment round, hopefully, and obviously, typically, that's at a higher valuation. Once that higher valuation comes in, you can, as a VC fund, mark up your investments. You can say, actually, this company and this investment I made is worth a lot more. And typically, it's off that potential value that you may well be raising your next fund as a VC.

So we have a CEO asking questions of existing investors we got a duration time we have size of the fund what are the other key questions and why. Where do you rank in the performance of this fund? So when they are deploying capital, they're obviously deploying capital across multiple different companies. And to a degree, those companies are competing in that portfolio to deliver on the outcome that the VC is looking for.

If you as a portfolio investment are viewed as one of the performers who are most likely to deliver. You know, the big return, then obviously you're going to get more attention and more support. But there are other motivations. Maybe you're a company in the portfolio that can see an exit sooner.

That actually may be really beneficial as we've spoken about in terms of enabling them to support the next fundraise that they're doing. So once you understand what has already happened with this fund and all the portfolio companies. You might have a much better understanding of their motivations. Obviously that can be an awkward conversation.

You might have walked in to a company that maybe isn't the top performer and you're maybe aware of that from the outside, but actually going and having that honest conversation may be something that you as a COO can have that maybe the founders can struggle a little bit to have that conversation with some of their best is. Understanding the reality of where the investors are at in their life cycle, in the returns they've generated and where you bank at that can be incredibly helpful for you to try and craft that path forward.

And obviously, if you're demonstrating your alignment, they're going to be very, very happy too. And I think there's one more important question, and I'm always surprised at how few people understand the pref stack and what has to return before they see any money. Yes, I think it's very easy to look at a company and say, Oh, you've raised X amount of money. So you just need to give that back plus some percentage return and everyone's going to be happy.

And it's really easy to get a cap table and go, Oh investors own 40% of this company. Therefore, if we sell for X, they're going to get 40%. That is really not the case in 99% of the time. The reality is that venture capital investors, particularly institutional investors, very often get additional rights when they invest.

Some of those are basic. They get information rights, basically means they get to see the board pack or the periodic update that you send out. Others are consent rights. They get the approval, yes, no, on major things like fundraising or exits or even hiring and budgets and so on.

But probably the most significant is liquidity rights or liquidity preference rights. So typically, when a VC invests, say they invest $10 million, typically they have a liquidity right that says... They will get back at least $10 million. So that's called a non-participating preference.

That is, if they invested, let's say, 10 million for 10% of the company, if you're exiting for 100 million or more, they will be getting 10%. But actually, if you are exiting for less than 100 million, i.e. That means their stake is worth less than the 10 million they put in, they get at least 10 million back.

So they'll get that first 10 million off the top and then the rest will be distributed out and so that kind of sets a minimum bar for them and often you you know and most common now is to have a 1x non-participating so essentially whatever money they put in they get to return that first and they get that us as a minimum hurdle. That's very common, but there are all sorts of other structures. So some investors don't have a one-times return. They might have a one and a half or two times.

Or you get to see what's called participating preference. So it's a, I don't get, you know, a minimum of 10 million. I definitely get 10 million and I get to participate pro rata in the rest. So that's almost like a double dip.

Where, in essence, their initial investment acts a bit like debt. It sits on top of the cap table. It gets paid back to them first before anyone else gets to participate in the rest. And when you're thinking about planning for those strategic options and having those conversations, and certainly when you are then into negotiation on the deal, that can have a huge impact on who's really excited.

To see that exit now and who of them would really prefer to roll with ice and go bigger. And it also makes secondaries that much more valuable. Why don't we talk about vesting and what you should be looking at in terms of your own options and the types of schemes you should be looking out. Well, I think, first of all, it's worth noting that most non-institutional investors don't have any of those liquidity rights.

So if you've had any early-stage angel investors, often they don't have any of those things. But certainly management, founders, and option holders, employees, don't have those liquidity preference rights. And then in terms of vesting, obviously... Understanding the timelines and expectations of your investors is really important to understand.

Obviously, in a number of scenarios, there's what's called an acceleration clause on your option investing. So that means that maybe you have a four-year investing cycle on your equity. But in the event of an exit or change of control, actually, that vesting schedule can get accelerated and you get the full equity. So it's definitely worth understanding if you're coming in with a five-year time.

Then maybe you make sure that that is either aligned in terms of the vesting schedule overall or certainly that if they push for an exit sooner that you're going to see that acceleration and see your return. And then there's also, if your shares, hopefully they're time vesting, and nobody has a cliff anymore, like the market has definitely moved to time and they vest over time and you can exercise them, make sure that you can actually take part in any sort of secondary sale because that's a way to take money off the table.

It is, I'm not sure of the statistic, but it's depressingly small percentages of employees actually exercise their share options, which is basically as your vesting schedule progresses, some of your options are no longer essentially options, they are in theory yours if you purchase them. And hopefully if your CFO has done a good job, the valuation of those options is kept as low as possible and it's possible to purchase those at a reasonable price. What that basically means is then they switch from options into actual shares.

And then absolutely when it comes to the next funding round, then there might be secondaries or new investors coming in and buying equity from existing investors, then, there's an opportunity as a actual shareholder to participate in those. So as an operator, one of the increasingly likely options for you to get money back is through those secondary transactions. Those themselves are the app that exploded in the last few years. There's a lot more of these.

Obviously we see sort of headline secondary transactions from people like OpenAI and Revolut. Very nice multiples and actually that is providing liquidity and value for a lot of employees, but it's actually happening across the board. So definitely, if you've got options that are vested at a reasonable share price that you can afford to buy, it makes a lot of sense to do so. Unfortunately, a lot employees either don't do that or don't exercise those when they leave.

And if you don't exercise those and leave, then after, typically a 90 day. Window that equity returns to the company to give out to the next employee. So if you can, obviously there's an affordability to that, but if you believe in the upside of the business and the potential for secondaries or exits, then it's a really good investment. So a two-part question, just a bit of a tail end on the secondaries, is there a special reason why it's exploded in popularity as an actual thing now where secondaries is now happening across the board?

The second question is, let's pretend I'm a CO just about to raise a Series B and we're gonna talk to investors. What are the questions I should be asking of these prospective VCs in terms of their funds and their fund economics? That is useful for me to understand as part of trying to figure out which VCs are the more attractive ones to us. So secondaries have exploded, I guess, in kind of two ways in the last few years.

One way is there is more capital wanting to get into really hot AI startups than the AI startups actually want to raise. So if you're a shit hot AI company and you're going out to raise $100 million seed round, which is kind of average size for seed round with some of these things, maybe you've determined that you only want 100 million, just 100 million. But there's 200 million on the table and people clamoring to get in, then actually one option is to actually sell second groups.

And so we've seen a big uptick in secondaries in some of these big, very hot AI start-ups. Where there's more money chasing the company than the company actually wants to raise. Outside of that, actually, in the normal world, the secondary's explosion has really actually been driven by two factors. One is the lack of exit opportunities that has been, there was for quite some time a lull in the M&A markets and as I think we've all seen, there has been until relatively recently a very very quiet IPO market.

So not much opportunity to exit in the traditional sense of the word. And at the same time, as we've spoken about, a lot of VC funds getting to the end of that 10-year life cycle, keen to get their money back, or maybe even earlier, as I said, if they're trying to raise their next fund. And so there's been a lot capital locked up in startups and locked up, in growth stage companies in particular, where investors are keen to getting their money back and maybe prepared to do a deal, to take a discount on the last share valuation.

And so it's a great market if you're an investor who's prepared to buy existing equity from previous investors or employees or a combination of the two and you see great upside in a particular company or portfolio of companies. It's been a great investment opportunity. So we've seen a large growth in secondary investors, specialist investors or pots of money dedicated to this strategy in the last few years. And it's really because...

We are, again, particularly here in Europe, seeing a wave of VC funds get towards the end of that lifecycle. The first proper generation of venture capital funds in Europe is now really at the end of that life cycle. That has driven demand for secondaries on that side and it's great that as an employee, you can participate in that wave. To your second question what should you do when talking to new investors?

Actually, some of the questions are very similar. So if I have a conversation with a VC fund and they're making their five-minute pitch on who they are as a fund and why they're amazing and going to make you incredibly successful, a good question to ask is, what vintage is this fund? When did you raise this fund, how much did you raised, how much of that is being deployed into primary investments, into new investments versus follow on investments. How much of that fund have you already deployed?

How much is left to deploy? What is your typical investment size? So if you've got a $100 million fund and you're deploying half of that into primary investments, and your typical check size is $5 million, then it's much clearer to understand how many investments there will be in the portfolio. How many of those they've already made and how many they've got yet to make.

Maybe they've actually only got a couple of slots left in this fund that they want to deploy into. But if they're already five years into the funds, you have a pretty good idea that actually they're going to probably want some money back relatively soon. Typically, when you're raising capital, what they won't know is what's the stat rank of companies already in that fund. They're often, as should be, they're in the first few years of deployment.

So they're focused on investing into those. They're not really sure who are going to be the runners and the riders just yet. But you can certainly understand that if you've got funds already on your cap table that are already in year five and year six, and you're bringing in a fund now that is right at the beginning of its life cycle, and with a much bigger fund size, you're going to have different motivations. So, Ed, final question is, if our listeners can only take one thing away from the conversation today, what is that?

That your cap table and your group of investors is not as simple as it may appear. And if you actually want to have a productive relationship with those investors and want to get to a great outcome that everyone is aligned on, then it's worth having those conversations now with your existing investors, understand where they are in their journey, and have perhaps some empathy For the VCs on your cap table and their job and what they're, you know, tasked with doing. So if you can understand what is driving them and motivating them, then you're going to have a much, much easier time as an operator.

Thank you Ed Barrow for joining us and please subscribe or leave us a comment and we will see you next week.