By Saksham Sharma | 10 September 2024
The decision-making process behind venture capital funding often appears enigmatic and opaque to those outside the industry. Founders may sometimes perceive rejection as a personal failure or a dismissal of their innovative ideas. While many of these rejections stem from common factors such as market size, team composition, and competition, there are deeper, less transparent reasons that can leave entrepreneurs puzzled and sometimes even discouraged. However, some of these reasons also sprout from a thoughtfully designed portfolio construct that guides a venture capital fund’s investment strategies, aiming to maximise returns while mitigating certain risks.
The actions of a fund are governed by their Private Placement Memorandum (PPM, our guide). Right from carry percentages, management fees to the type of bets a fund plans to take in a specified period of time, Private Placement Memorandum is the playbook that makes funds inflexible at times as investors. This discipline is critical for steering a chartered path and creating successful outcomes.
Understanding Portfolio Construct
In the vibrant landscape of venture capital, portfolio construction is similar to building a world-cup winning team. The approach involves several key strategies:
Identifying Focus Areas: A venture capital firm establishes a clear investment focus. Whether it's “spray and pray” or make “high conviction” bets, this clarity enables a fund to identify promising startups that align with strategic goals, whether they are just getting started or looking to scale.
Diversification: Just like a cricket team needs a balanced set of players to win, venture capital firms need to invest in a mix of different companies. By investing in companies from varied industries at different stages of growth, a fund can spread out its risk. This means that if a few companies fail, the fund won't lose all their money and their overall investment performance, measured by MOIC (Multiple on Invested Capital), will still be good.
Scenario Planning: Before investing in a company, venture capital firms conduct a thorough analysis to predict how the market might change and what potential outcomes could happen. This helps them estimate how well their investment might perform and how they might eventually sell their shares for a profit, making money for their investors (Limited Partners) and themselves.
A portfolio construct model is like a blueprint that guides how a venture capital firm invests its money. It shows how they'll spread their investments across different companies to balance risk and reward. Here’s a sample construct for a USD 10 Million fund:
| Factors | Value |
|---|---|
| Fund size | 10 Million |
| Investments to be made | 15 |
| Average cheque size | $250k-$600k |
| Target shareholding (@ 1st ch) | 10%-15% |
| Follow-on reserve | 20% |
| Stage | Pre-seed/Seed |
| Theme | B2C, B2B2C |
| Sectors | Consumer, Healthcare, Media, Fintech |
| Valuation cap($) | 4-5 Million |
| Target return for the fund | 5x |
Outside of the above, there are multiple other elements that go into a portfolio construct, from sectoral and stage diversification to follow-on investments and exit modelling.
In summary, there is more to VC decision making than meets the eye. Founders, industry, traction, etc., are all important factors, but funds are at all times constrained by their portfolio construct strategy too. Hence, a rejection might sometimes have nothing to do with the capabilities or performance of a company but simply a fallout of the limitations a fund has to work with.
At Merak Ventures, we use a strategic approach, careful management, and a focus on innovation to navigate this dynamic environment. Saying this, we are always ears to impactful new ideas that help us make this world a better place. If you are a founder with one such idea, write to us at investments@merakventures.com.