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.
Great blog, and important for all entrepreneurs to understand. Venture capital funds used to be small ($25 to $75 million). The fee income barely covered expenses, and all of their incentive was on the “carry,” or profit, on the invested capital. And with a smaller fund, a venture firm often would invest a fairly small amount ($1-3 million) in a company. Its successful investments could easily return all of the capital in the fund, and then some. now, with funds of several hundred million dollars, it takes a substantial gain to “move the needle” in the fund. Investing $1 million and returning $10 million would seem like a great investment, but wouldn’t be material to a large fund’s performance. So they look for situations where they can invest $10 to $20 million, with a strategy/chance/hope of returning 5x or more on the investment. And the fee agreement they have with their Limited Partners means that they have a big incentive to make bigger investments (often far beyond what a company really needs).
The shame of the economics of venture is that it gives venture capitalists the wrong incentives. In the past, they would invest small amounts of money, not over-fund sectors, and really push companies to achieve a lot on modest financial resources (which, in turn, helped companies build operating discipline). Now, their mission is all too often to shove lots of money into their investments, and hope that one becomes the next Google, Skype, or Facebook.
So did this happen because there’s more money available for venture funds? (the pressure to make bigger, riskier bets). If VCs have moved away from making smaller, smarter bets because they can make more money at the high end, who’s to blame them?
So what are the low-capital-requirement entrepreneurs to do? Especially in this age of rapid, inexpensive software development? It seems there is an opportunity to meet this need using a model that differs from the current VC setup. What construct would create the right incentives to drive capital into smaller, smarter bets? On a large scale, that is. How can investors more efficiently fund these smaller projects?
Since VCs make more money per hour of effort at the high end, the solution would seem to be to make them more efficient at the low end:
1. Reduce transaction costs of funding a new company
2. Reduce amount of time required to shepherd a company to success
3. Reduce costs / time required to vet good ideas
Now how to do that….
great post & comments… altho i tend to disagree with Greg a bit, tho perhaps not with his final suggestions.
i think you *can* blame VC firms for going after too much money, and not for keeping aligned with entrepreneur interests. of course, ultimately the market will speak about how well VC firms with large funds perform… but it may take several years if not decades (possibly never) for entrepreneurs and LPs to realize that only a very few whopper-size VC firms can do well operating at that size.
another point where VCs tend to be misaligned with startups: a lot of exits are happening at between $25-75m, and VCs that want to invest $5-10M or more for 20-30% are already placing $25-35M post-money valuations on the companies they put money into, which makes it much tougher to do exits anywhere south of $100M for any reasonable rate of return (perhaps this is as much a problem created by the entrepreneur who accepts this kind of deal too).
i think this is again why smaller funds feel more aligned with entrepreneurs, in that $25-75M exits are more acceptable to funds that are only that large themselves.