A scout fund is a unique instrument that differs from a typical venture capital fund.
It is essentially a large venture capital fund that is then contributed to by an external ‘scout.’
How does a scout fund work?
Scout funds take a portion of their capital and create a sub-fund, which is then invested in by a ‘scout.’ Scouts are non-members of the VC firm; they don’t work for the VC but they are able to write checks on behalf of the firm and put money into startups of their choosing.
The VC firm is still signing off on the deal, but really, the scouts (who are typically famous people in the startup ecosystem and have a lot of deal flow) are the ones making the commitment. Once the scout signs off, then the VC fund funnels the money into the company.
Why are these funds appealing to scouts?
This type of fund is attractive because scouts are people with tremendous deal flow who are probably investing their own money. However, they only have so much money to invest. If you look at your bank account, how many VC or angel investments could you actually make?
Through scout funds, scouts gain access to a bigger pool of capital, meaning they can invest bigger checks into startups while being carried like a normal VC fund would.
How does ‘carry’ work in a VC fund?
Carry in a VC fund is basically the profit-sharing you get when investments work out really well and return more than what was invested in them. This means the scouts get a lot of carry when things go right for a startup with scout fund investment.
The most famous version of a scout fund check really working out is probably Jason Calacanis’ investment in Uber. Calacanis was working with the Sequoia scout fund when he saw Uber and their presentation. It went from around $25,000-$50,000 and turned into around $300 million. Calacanis got a portion of the carry off while Sequoia’s scout fund also made a ton of money.
Check out Kruze Consulting’s video about carry on youtube here.
Why do VC funds Involve scouts?
VC funds are looking for the next great deal and scouts are really well-networked since they are investing in a lot of companies. This means VCs gain great insight from the scouts whose interactions with small startups allow VC firms to look at companies at a much earlier stage than they would usually invest.
Like Calacanis, scouts are able to talk to the two- or three-person startups. Although Sequoia and other VCs do try, it would be really hard for them to cover all of the small companies out there. The scout is like a distributed network that finds the best companies. In order for the VC fund to keep track of what’s happening in the scout fund they can ask for intros to the highest performing companies.
VCs use the scout’s networks and checkbooks to surface the next generation of successful companies.
The downside to scout funds
There is a bit of a downside to scout funds. If you have an investment from some of the scout funds at the bigger VC funds and those big VC funds don’t take a meeting with you or reject you when you do your next round of fundraising, that could be a negative signal indicating:
- Adverse selection
- The creation of asymmetric information
People know they have asymmetric information, and they know they can see what’s happening in that scout portfolio. So, if they’re all saying “No”, that can be a bad sign for your fundraiser.
Most people don’t worry about that possibility too much, but it is something to be aware of.
Who benefits from scout funds?
Overall, scout funds can benefit all parties:
1. Entrepreneurs. Startups will get bigger checks from the angels they wanted to raise money from and, in turn, an indirect path to the best VC funds.
2. Scouts. Scouts can network and invest in startups as they already were but with access to a much larger capital pool and, hopefully, a much larger carried return.
3. Venture capital firms. VCs get the benefits of the scout’s large network of connections, expertise in investing and early-stage insight. In the best of outcomes, they end up having a relationship with the highest performing companies.
If you have any questions about startup accounting, taxes, venture capital, or scout funds please contact us.
You can also follow our youtube channel and keep an eye on our blog for information on accounting, finance, HR and tax for startups!
