The term “cash drag” sounds contradictory, because how could cash be a problem for venture capital funds? But cash drag is actually a negative thing. A VC fund collects funding from a variety of investors, and then uses those dollars to invest in startup companies. When the startups are successful, the VC fund investors get to participate in that success and get a return on their investment. One note: this has nothing to do with startup cash management, which is how individual startups take care of the dollars on their balance sheet, manage their cash inflows and outflows, and get yield on their bank balances.
When the VC firm needs money to invest, it makes a capital call, and the investors that have agreed to supply funds are required to make their investments. Once those investors write the check, though, they start measuring the internal rate of return (IRR) on their investment. That measurement is one of the big ways that the investors judge the VC firm’s success.
The clock is ticking for the VC fund - cash drag starts immediately
Cash drag refers to cash the VC firm has on hand that’s not being invested in startup companies. Those funds are earning little or no return, and IRR is time-sensitive. So once the VCs issue a capital call, the pressure is on the VC fund to get the investors’ money invested in startups. If the dollars are just sitting in an account, it’s bringing down the average return on those funds.
While cash drag is a negative for a VC fund, an even bigger negative is missing a strong startup investment opportunity because the fund doesn’t have enough investable capital on hand.
The VC juggling act
So the partners in the venture capital firm have to carefully balance having investment dollars on hand to fund investments against being nimble enough to invest quickly in good opportunities. Too much cash on hand creates cash drag, but not enough can affect the fund’s ability to invest. If you have other questions about venture capital funds, VC investments, or startup accounting, please contact us.