Recycling: The challenge and the opportunity for a Seed stage VC

My recent post gave rise to a host of questions around the issue of recycling. What does it mean? How do you do it? And what are the implications for venture investors? I attempted to respond in a Tweetstorm, but recycling is a complicated issue that warrants a more thorough discussion.

When Limited Partners (LPs) invest in a venture fund, they agree to pay an annual Management Fee on committed capital, usually on a declining scale over a 10 year period. In total, these fees amount to around 20% of an investors’ commitment, which implies that LPs only get to put 80% of their investment dollars to work because of management fees. This makes most LPs pretty unhappy – and it should. LPs generally expect to have 100% of their investment working for them, and best practice is to invest up to around 120% of committed capital when possible. Enter concept of recycling.

Recycling can happen when a fund exits an investment, and rather than distributing the proceeds to LPs, reinvests all or part of the funds in portfolio companies. This sounds pretty easy, but in practice is quite hard, especially for Seed stage venture funds. By definition, Seed stage funds invest very early in a company’s life, meaning that time to exit can be 7-10 years, or more. Further, as a seed fund with higher cash-on-cash return expectations than later stage funds, IA Ventures doesn’t have much time for a company to exit before its other successful investments become too high-priced to warrant later stage capital. This is because a successful seed company often grows into an attractive Series A and perhaps Series B investment from the seed investor perspective, meaning a potential return on a new investment of 5-10x capital invested at each stage. We reserve for this likelihood, and this represents one of the bedrocks of our life-cycle approach to investing. But beyond the Series B, it is often challenging to get comfortable with 5-10x upside from that point, especially for “hot” companies that may be priced in the hundreds of millions of dollars by the Series C round.

So what generally supports recycling in seed stage funds are either companies that: (a) exit early because they get a great offer that is life-changing for founders but so-so for venture investors; or (b) exit early because it is apparent that the “big idea” won’t be realized and the founders and investors want to sell. And if these liquidity events happen early enough in a fund’s life, the proceeds can be deployed into fast-growth, highly attractive companies within the portfolio that still have 5-10x upside potential. These reinvested proceeds count towards recycling, and help to repay the management fees that were burdening the amount of capital available for investment. We had the good fortune of having two exits, ThinkNear’s sale to TeleNav and Simple’s sale to BBVA, early enough in Fund I’s life that we were able to effectively redeploy the proceeds into a set of attractive investments, including The Trade Desk Series B round. We ended up Fund I being around 116% invested, meaning that we invested $58M against $50M of committed capital. This is exactly where we wanted to be.

Hopefully this provides a flavor for how recycling fits into the seed stage venture firm’s portfolio construction and decision logic. A bunch of stuff has to go right in order to achieve a fund’s recycling goals (while remaining true to its return objectives), but we believe it is important to have this mind-set when embarking on a new fund. It is respectful and fair to one’s LPs, and, when used prudently, can amplify the gains available to LPs as well as the GP through carry.