Venture is a two-sided business matching great entrepreneurs with capital. But where does the capital come from?

While the “front” or entrepreneur-facing side of the venture industry has been demystified over the last 10 years, the back-end of the business, or how venture firms emerge and raise funds from limited partners (“LPs”), remains opaque.

I’ve been fundraising at venture funds for more than twelve years, starting with Founders Fund’s third fund. Since then I’ve worked with LPs large and small and have taken an active role in raising Initialized’s last four funds. I often get questions about how to raise new venture funds, and coming on the heels of Initialized’s close of its fifth core fund last week (which had all of the headline attributes one aims for – “one close!” “over-subscribed!” “top LPs!”), I’m sharing some best practices and tips.

Advice for just starting out:

For first-time fund managers, the easiest way to get started is to put together a small amount of money and start writing checks. I’d advise putting it into a pooled legal structure even if the size is $50,000. You can be an angel investor and write $5,000 checks. This provides a liability shield and starts building a brand for your firm.

What you need to prove:

With each fund, assuming that you have ambitions to grow, you should be: 1) building relationships with institutional investors, 2) demonstrating your track record, and 3) cultivating a great reputation with founders and other VCs.

I have more on LP relationships below. But overall, it’s best to start meeting them as soon as possible and regularly.

As for your track record, aim for having several successful, well-known companies in your portfolio and a track record that shows either extreme strength (5X+ and exits) or a great deal of promise (getting into exclusive deals with follow-on rounds done by top-tier firms). Reputation-wise, institutional LPs, which include university endowments, foundations or public pension funds, sometimes conduct 30 to 50 diligence calls and you want those calls to come back strong with comments like, “They were the #1 or #2 investor on my cap table,” or “We always take their intros.”

Different types of LPs:

If you decide you’d like to raise a larger fund and build out a firm, you will need to engage a variety of limited partners, from friends and family investors to endowments and pension plans. This list is generally ordered from smaller checks to larger, and in reverse order of decision-making timeframe. If you’re aiming for a bigger fund from the start, I would recommend giving it at least a year to raise a fund and to expect many closes.

  1. Friends and family: They’re fast and they already know you! They generally can write only smaller checks, though.
  2. Rich individuals: You can tap accredited investors (which means that they have made more than $200,000 a year for the last two years). These could be ultra high-net worth individuals or they could be high-income professionals, even a dentist or doctor.
  3. Family offices: Extremely wealthy individuals who have made enough sometimes hire a group of professionals to manage their investments, also known as a family office. They often operate similarly to institutional investors in terms of diligence and their level of financial conservatism.
  4. Wealth managers: These managers aggregate the money of category #2 people. You should try to find ones that have discretion over their client’s assets or have created a blind pool to invest.
  5. Fund of funds: These are funds that invest in other funds. Fees on top of fees are not optimal, but that means they are paid to get to the best managers. Since it is hard to get into the best managers — when everyone knows they are good — they are more open to talking to new managers. Some have emerging manager programs like Top Tier’s Alpha Manager program and are willing to back first-time managers like Trusted Insight or Horsley Bridge.
  6. Endowments: Endowments, which manage capital for universities, foundations and other institutions, tend to be more conservative. They are unlikely to do a first time fund unless you have had a great track record from another big name fund and they have followed you for while. That said, they are more consistent. They understand that if they invest, they are making a two or three fund commitment.
  7. Sovereign Wealth Funds: Owned by governments, these funds are actively making investments across all asset classes. If they are active in fund investing, they are also probably making direct investments, and therefore would like access to your later-stage direct deal flow. These groups will have requirements related to taxes, CFIUS laws, and other country-specific regulations.
  8. Pension Plans: These entities also have higher regulatory and legal requirements. For example, if you take too much pension fund money (or more than 25 percent of your fund), you could be treated as a retirement plan. Or, they may have restrictions on types of investments (such as no alcohol or tobacco). If they are U.S.-based and public, taking their investment could subject your fund’s returns to public disclosure, and your fund’s employees could be restricted from making certain campaign contributions. However, these pension plans often have tens of billions if not hundreds of billions under management and large investment therefore their minimum investment size might be $50M or more.

Over time, the goal is to create a stable LP base that understands it takes many years to generate returns, and even longer for distributions — one close and oversubscribed fund will allow you to better dictate terms and be choosy about who your LP partners.

Common mistakes first-time managers make:

Network and hustle are table stakes. You have fifty thousand Twitter followers? Join the club. Maybe you were a partner at a great firm for several years or co-founded a company that is now a unicorn. All of these things are great, but without capital, you don’t have a fund.

Don’t ignore the boring stuff. Think about terms, portfolio construction, follow-on investments, record-keeping. Smaller fund sizes are generally easier to return. Initialized started off as a $7M fund. There’s no shame in starting small. Start filling out your back office infrastructure that can support an institutional LP base, such as a head of finance or operations. Get a reputable auditor, administrator, and legal counsel. You’ll also need to start adding structure or processes to your investing approach by assembling a valuation policy or compliance manual.

Start talking to LPs and building relationships. Don’t think you can meet someone and ask for money right away. Some family offices prefer to co-invest with you for a while before they invest in your fund. For institutions such as endowments, sovereign wealth funds, or pension plans, it can take a year or more to get them comfortable. Share information and keep the lines of communication open, but expect lots of diligence and meetings before you get to yes.

Don’t enter into a partnership for convenience. I sometimes joke that a hack for raising a fund is to partner with the son or daughter of a billionaire. But truthfully, who you partner with reflects on you and has long lasting dynamics that should be carefully considered.

Everything you do contributes to your reputation. Act with integrity to create a foundation for a long-lasting institution.