complicated concepts

Offering the right to co-invest

Here it is, people! The much anticipated part 3 of the "attracting more LPs" series.

This is the last in this series, although I pinky promise to share any new gems I gather on this topic

Quick moment of gratitude to Sam Loui from Sydecar for her help on this series. Sam is genuinely fascinated by all things venture-capital, including the (seemingly) boring stuff. Her patience in answering alllllll my stupid questions was astonishing. If you're looking for help setting up your fund or SPV, I highly recommend checking out Sydecar (they are not a sponsor, I just love them).

And now... onto the thrilling world of co-investing!

Why do people invest in venture capital?

The people who invest in VC funds are called limited partners, or LPs.

Often LPs are high-net worth individuals (angel investors), family offices, or institutions (like a bank or a university).

They might invest in a VC for a number of reasons. But a big reason is to diversify their capital.

See, VCs raise a fund to invest in a bunch of different startups. Depending on the size of the fund and the size of the checks they write, a VC might build a portfolio of 10 to 100+ startups through each fund.

This is attractive to an LP because startups are a high-risk investment. So rather than putting all their eggs into one startup's basket, they invest in a VC, which scatters those eggs into a dozen (or more) companies.  

Being an LP also gives investors the opportunity to invest in startups without the obligation of building dealflow channels, or doing a bunch of due diligence, or supporting founders.

But some LPs want more

Many LPs are content to let VCs do all the work. And that is totally wonderful.

But other LPs want to get more involved in investing.

And this is where the right to co-invest comes in.

Let's say you find a promising startup and decide to invest into the company through your fund.

If the company exits, an LP in your fund might see 1% of the profits of that investment. That number depends on their check size into your fund, your check size into the company, valuation, allocation, etc.

But let's say one of your LPs sees that deal before it's finalized and is excited about the company. Offering the right to co-invest means that this LP can invest directly into the company through an SPV that you put together.

(note: SPV means "special purpose vehicle" and allows investors to collectively back a company as a unified entity.)

The benefit to the LP is that they would get a larger percentage of the proceeds in the event of an exit.

And since many funds set up SPVs for their LPs with reduced or waived carry, the LP has the potential to take home even more of the profit.

It's also great for warming up leads

Chances are that when you fundraise for Fund I, some LPs you pitch will say no.

But they may want to be added to your newsletter so they can keep tabs on your progress... presumably so they can decide if they want to invest in your next fund.

Offering those prospective LPs the right to co-invest is a huge benefit of this strategy.

Let's pretend I'm a super wealthy angel investor. I'm not yet an LP in your fund, but you give me the right to co-invest. I might end up co-investing in so many of your deals that it's a no-brainer to become an LP in your next fund.

This strategy doesn't only prove your skill at selecting great companies, but also gives me a taste of what it's like to work with you.

How to position this

When you're fundraising, you'll definitely want to mention the right to co-invest in your conversations with LPs.

Especially if those LPs are active angel investors, or want to become active angel investors.

Some funds offer the right to co-invest on every single deal they do.

Other funds cherry pick the best deals – usually the ones with the best terms, or the highest allocation – for their LPs.

Others make note of their LPs' personal preferences and offer the right to co-invest based on those preferences.

The important thing here is that it makes your fund more attractive to LPs because they get the opportunity to get more involved in great deals... often with reduced or waived carry.