In Q2 2018, approximately 70 billion VC dollars were deployed across 3,100 deals, bringing yet another year of massive dollar deployments into emerging startups. Most of these dollars came from termed-life (or closed) funds, but an aspiring Harvard Business School entrepreneur can also raise capital from “evergreen funds”. There are only a handful of evergreen funds (or permanent pools of capital) in the PE/VC landscape today, but certain founders may find such vehicles most aligned with their mission. For the potential HBS venture capitalists, the structural difference that evergreen funds operate on can be a differentiating factor to consider as you build your unique investor-brand. The following is a short primer that will highlight the core differences inherent in an evergreen fund compared with the typical closed fund, in relation to distributions and portfolio life spans.
The typical lifecycle of a closed investment fund can vary, but is generally within the range of five to ten years. A fund investing in quickly maturing or relatively liquid investments such as marketable equity securities, or later stage private companies primed for the public markets, will prefer a shorter investment period. A fund investing in more slowly maturing or illiquid categories such as bio-technology, real estate or emerging growth companies will prefer a longer investment period. If we pick a closed fund with a term of 7 years, the first few years will be focused on making new investments with capital raised from Limited Partners (pensions, endowments, family offices, etc), the middle years into harvesting those portfolio companies (helping them grow with strategy, positioning, fundraising, hiring and so forth), and the last few liquidating those assets so returns can be allocated back to the LPs, alongside prepping for the next raise for Fund II. When these liquidations do not occur, the fund will typically decide to sell their stakes in portfolio companies in secondaries or consider side-pockets.
In an evergreen fund, there is no specific timeline as to when the capital raised is deployed and when that capital is recouped in the form of realized proceeds (aka the sale or IPO of your company). This feature makes raising capital from open funds particularly interesting for entrepreneurs who need a longer timeline to realize their vision, which can range from building a sustainable consumer brand to frontier technology platforms. For those entrepreneurs wanting to solve complex issues, create new markets, or just build a business that will take time to get to cash-flow positive, the flexibility of timing provided by an evergreen fund might just be what the founders need. This is not to say evergreen funds are not supportive of exits, but rather the choice of the exit (both in its form and timing) is transferred from the LP requirements to the founder.
Overall, a summary of the benefits in an evergreen structure are:
- Long-term holding of the company, should it be financially more viable to enjoy dividend distributions compounded over time versus the one time exit value. This is essentially the model Berkshire Hathaway approaches their investments with, although of course not using venture as the entry point to pursue durable growth. This is also an emerging trend as we see more and more companies deciding to remain private for the long-term.
- To note: Management looking to take chips off the table can always consider selling their stake in secondaries, should they desire.
- Partnering with companies with modest year-over-year growth but still with outstanding value propositions that only compound over time, generating solid cash flow. This is helpful for those with self-awareness that growth does not need to come at all costs.
- Not leaving money on the table with a premature exit because of an arbitrary forced fund lifecycle timeline or mesh contrasting cultures with non-strategic mergers.
Some challenges (more skewed towards the VC versus the entrepreneur’s perspective):
- It is typical to de-risk an investment with other parties co-investing. It is important to ensure the company, board, and full set of investors are aligned with the evergreen value proposition and company trajectory timeline.
- From the VC side, raising capital from institutional LPs for an evergreen fund tends to be quite difficult. This is because asset allocators are used to specific timelines for receiving distributions (profits on exit of companies), rather than carved out portfolio specific distributions if and when a company is sold or periodic redemptions based on fair value of the portfolio (versus actual realized proceeds). At steady state, however, the hope is for the evergreen fund to eliminate the need to continuously fundraise by re-investing portfolio exit profits or dividends back into the fund.
- Also from the VC side, tax and ownership in the fund changes frequently as the fund and portfolio value grows over time, resulting in higher monitoring and reporting needs.
As founders decide to raise capital, it is incumbent on them to best understand the underlying incentives in both closed and open funds. The structural motivations driving how a fund operates can have a significant impact on the founder’s overall company strategy, for both growth and exit. While there are many instances when closed funds offer the best alternative to entrepreneurs (depending on their goals and time horizon), it is important to internalize which motivations are being realized. I am hopeful the above gives both aspiring founders and VCs at HBS an important factor to include in the decision-matrix of choosing a fund.
Tasnia Huque (HBS ‘2020) hails from Dhaka, Bangladesh and is an aficionado of all things media and tech. Before HBS, she was an Investor with Cue Ball Capital, an evergreen venture and growth equity firm (and remains involved). She also has experience in Investment Banking at Barclays and in Product Management at Toast, a B2B2C restaurant management platform. You can find her on her blog @www.yetanotherview.com or on twitter @tasniahuque.