Commitments and Investments
Similar but not the same
Here’s the thing that gets lost to a lot of people: a commitment and an investment is similar but is not the same thing. People wrongly confuse the two terms and use them intergeably. In most cases, it’s fine since it’s similar enough, but it’s not technically right.
Venture funds make investments. That is, if you see a headline saying: “company xyz raises $10M”, it’s very likely that the company received everything in the cash and that the $10M at one point or another, sat in the company’s bank account. There are some exceptions to this (e.g. Biotech companies and tranches, staggered closings etc.), but generally speaking, the investment VCs make, will be wired all in one go to the company.
Limited Partners make commitments. That is, if you see a headline saying “ABC Ventures raise a $10M fund”, what it actually means, is that ABC Ventures raised $10M in commitments. Investors have committed to investing $10M in aggregate. Said differently, LPs have the obligation to invest $10M, but how and if they actually do, is entirely up to the GP. That money will not all be sitting in the GP’s bank account at one time.
At a high level, an investment of $10M means that $10M is out the door. On the other hand, a $10M commitment can mean that no money has been transferred and that in some cases, the $10M will never be fully out the door.
Here’s how the cashflow of a $5M VC investment looks broken down by year. For simplicity, it’s a 5x return in 5 years with no other round of financing. Simple enough.
Before I jump into this next part, I’d encourage you to read what I previously wrote about Committed, Called and Invested Capital, since in a lot of ways, this is a successor piece and reading that will give you a good foundation for this next part.
Below is how a $10M LP commitment could look like: (with the numbers under called being the amount invested by the LP.
Scenario 1: The entire $10M is called and invested over 5 years before $20M is returned in year 6 as a distribution. Here the LP is “out of pocket”, by their entire $10M commitment in year 5, before getting double their cash back in year 6. That is they made a commitment of $10M and invested the entire $10M commitment they made.
Scenario 2: Here the GP calls $8M in capital total from LPs. The $10M commitment is never fully invested. Year 5 sees a distribution to LPs, that is used to offset the capital that would have otherwise been called, hence the 0 in the “Net” column of Scenario 2. As a result of this, the LP is cash out of pocket by $8M at peak even if they committed $10M.
There’s an important simplification I’m making in the above— that the LP commitment is one off and that there is no better use for the cash. The reality is that LPs make a lot of commitments. In other words, any distribution received by a fund that is subsequently put back in, has a real cost to it.
So, LPs make commitments and GPs make investments. Similar but not the same! A commitment is just that: a commitment to invest a certain amount, but not an obligation. The key thing to note is that the GP gets to decide the amount of the obligation— not the LP.
All of this said, this mostly applies to institutional investors. If an individual is making a $50K commitment to a VC fund, chances are that that commitment being made is actually an investment: that $50K commitment is going to be invested at closing. I’ll save the details for another time since I think it deserves it’s own piece but the main reasons are: 1) managing a lot of small capital calls gets annoying 2) people aren’t always good for their commitments.
If you have comments, questions, or criticism, message me on Twitter @Lawrence_Ou and I’m happy to chat and discuss! I do put a lot of time into this so if you found this useful, please consider subscribing.
None of the above should be considered fund advice, investment advice, financial advice, or legal advice. It is strictly for informational purposes and is accurate to the extent of the author(s) knowledge. Generalizations may be made to illustrate ideas and should not be taken literally. The views and writings above are strictly those of the author(s) and do not in any way represent the views of past or present employers.