A while back, I wrote an essay on the pitfalls of Entrepreneur In Residence (EIR) arrangements for entrepreneurs. (And I’m now shamelessly recycling bits for blog fodder).

The essential point: EIR arrangements give quasi-exclusivity from the entrepreneur to the venture firm. Entrepreneurs need to make sure getting enough value back for that exclusivity.

For companies seeking additional funding with new investors: watch out! Inter-firm relationships can be “interesting”.

Your existing VC investors frequently have an agenda when they refer new follow-on investors (or steer someone away). Most often, VCs want to expand their relationship with another firm (one way VCs get to know each other is by doing investments together). Or, they’re returning a favor — the other investor helped them with another deal, and they’re giving back.

When you’re steered away, it can sometimes be because of a grudge, or a competitive issue. Maybe your VC felt screwed in some previous deal with the other investor. Or, they feel like it’s a one-way relationship: they show the other group deals, but don’t get anything back. Or, they feel like the investor will hear the pitch just to get competitive info, not with any intent to invest (sometimes, a very legitimate concern).

The key point: the company (usually the CEO) should lead the fund-raising process, not the VCs. The CEO has a clear fiduciary responsibility to act in the best interest of the company. The VCs on the board also have this same responsbility, but sometimes can’t separate that responsiblity from their own firm’s agenda. (NOTE: If the VCs are driving the process, that’s a sign of a weak CEO).

When existing VCs are suggesting leads for follow-on investors, the CEO should do her homework with the VCs:

• Have you done any deals with this firm before? Which partners have you worked with? If so, what was the outcome?
• Has this firm ever referred you deals? Have you referred them deals? How recently? If so, what was the outcome?
• If you haven’t worked with this firm before, why not? How do you know them, and what do you know about them?

Entrepreneurs should understand VC compensation, because it’s occasionally helpful for understanding VC behavior.

The general partners (GPs) at a typical venture firm get paid two ways: management fees and carried interest.

Management fees (typically 2%) get paid per year over the life of the fund, typically 7-10 years, but may decline over time. Carried interest (the “carry”) is a percentage of investment returns shared with the GPs, and is typically around 20-30%. For example, if a $100m fund returns $300m, the GPs would get a percentage of the $200m investment gain. In some funds, the carry may be net of management fees.

For firms with multiple funds, fees stack up. With $2 billion “under management”, GPs could bring in $40m annually. Deducting operating expenses for the firm, you find VCs making several million per year (or more), each, on average — even if all their investments are duds.

The “dirty” secret in venture capital is that industry returns these days are barely beating (if at all) other, less risky, asset classes. The real money is in fees, pushing VCs to raise larger funds and do larger investments. They in turn push entrepreneurs to take more money, sometimes more than they need.

And, the carry only becomes meaningful if a partnership has serious home-runs. As a result, VCs may push entrepreneurs to take more risk and “swing for the fences”, instead of taking a solid double or triple outcome.

One of the costs of raising venture capital is overhead: it takes a lot of energy to navigate the complexity of term sheets, to manage investors, and to navigate follow-on rounds of funding. It gets even worse if you’re dealing with “unique” investor personalities, immaturity, lack of experience, or intra- and inter-firm politics. One CEO friend recently bemoaned that 25% of his time went to “investor stuff” — that’s a typical number.

Venture investing is not a simple business, and investors are adept at adding terms and structures that protect increasingly narrow outcome cases. If getting a home equity loan were like raising venture capital using a FHA loan application, the kick off meeting has 4 people coming to your house and would take all day.

Investors argue this is the cost of doing business: no capital, no company. True, but the overhead has become a real issue in certain sectors (e.g. Internet projects) where the capital requirements are dropping. If you have an idea that needs $500k, and you raise money the “classic” way, you’ll spend 10% of your capital on the legal bill alone. (Remember, the company is paying both sides of the legal bill).

There’s got to be a way to fund capital-efficient ideas with lower overhead (and more time going into creating value in the company). I don’t know what the answer is, but I did think Dave McClure’s rant on the general subject was dead on.