This is the fifth and last blog post in a series on trust.  I’ve written in the past about trust between a VC and an entrepreneur (“When Entrepreneurs and VCs Break Up”), between a VC firm and its investors (here and here) and among Partners in a VC partnership (“When VCs Divorce”).

Today, I’ll write about trust between Partners and non-Partners.  Regarding the latter, I’ll focus on members of the investment staff who are not Partners.

Non-Partner titles vary by firm, but the more common ones include:

• Associate
• Principal
• Vice President
• Venture Partner

When a firm has a good track record, it can raise more funds.  With more investment capital comes a management fee, which can be used to hire more people to the team (for more details, read “How VCs Are Paid”).  That is why a firm hires non-Partners.  They have more capital and need more people to find investments.

Trust isn’t an issue initially, but it can be over time.  Here are some common scenarios:

1. The non-Partner who wants to be promoted.  New staff are hired mainly to source new opportunities.  There is a very tight hiring screen, and the ones who make it are always bright, energetic, and engaging.  And, incredibly ambitious.  They want a promotion to the next title.

Since it takes 8 to 9 years from the initial investment to an exit, it takes a long time to know if an Associate’s sourcing is making the firm money.  So, the most obvious metric for evaluation is this: how many investments has that Associate sourced?  To get promoted, he needs to source and shepherd through a VC investment committee multiple opportunities.

Normally, this isn’t a problem.  But, if the Associate is also doing most of the diligence on a new company, then the Partners have to trust that Associate.  Is the person being objective, or is there bias there given the Associate’s incentive to get the partnership to a “yes” answer?

2. Attribution.  Attribution, or credit for an investment, is huge in VC.  A VC with a strong personal track record has the flexibility to switch firms. When a VC leaves his firm, there can be a prolonged and painful negotiation about attribution.

This dialogue is also complicated.  When an investment does well, a lot of people want to claim credit.  If an investment fails, others run away.  As the old saying goes, “Success has many fathers and failure is an orphan.”  So, when a VC leaves a firm, there may be a dynamic where other Partners want to take credit for that VC’s good investments, and let him take all the blame for the investments that failed.

So, deciding attribution is critical for VC firms and individual VCs–and, it is tricky.  Who gets credit for an investment?  The Associate who finds the opportunity and does all the diligence, or the Partner who sits on the Board?  What if there are two Partners on a Board?  Is credit given 50/50 to each Partner?

Here’s a painful example.  A friend at a large VC firm approached me with a conundrum.  He sourced an opportunity, did all the diligence, negotiated the terms and sat on the company’s board.  At the last minute, there was another board seat available, and the VC firm decided to take two board seats.  The VC firm’s founder took the other seat.

After some ups and downs, the startup eventually did well and went public.  After the IPO, this VC friend of mine heard from another VC firm that the Senior Partner was claiming credit for the investment in the marketplace.  Behind his back.

My friend asked: “What should I do?  Can I trust that guy?”  He was shaken.  I didn’t know what to tell him.  How does he negotiate credibly with a Senior Partner who controls the firm, can cut his pay, and/or fire him?  That felt like an unfair negotiation.

That friend is now making plans to leave his VC firm.  He no longer trusts the Founding Partner.

3. Transparency (or lack thereof).  As I’ve written previously, some Partners are kept in the dark about the firm’s financial statements and are not involved with major hiring and firing decisions (see “Top-Secret VC Economics and Power Unveiled”).  That can make for an awkward dynamic, as this anonymous Quora post mentioned:

Never have I more felt like a second class citizen than when I (and several other “partners”) were not invited to certain meetings around firm governance.  Also no transparency into the firm’s hiring/firing/financials

What’s being discussed on those meetings?  How much money are the senior Partners really making?  Who is “on the bubble”?  What are the firm’s growth plans?

In closing, trust is critical at a VC firm.  As my friend learned, broken trust is very hard to re-forge.

When there’s a great deal of trust, a firm is very stable and can get through ups and downs.  When trust is gone, a firm will experience a great deal of turnover.  Turnover at the Partner level creates complications for everyone:

• For the VC firm: As Partners leave, the remaining Partners have to take over the board seats.  This contributes to board seat overload and a literal case of VC indigestion where experienced investors may each be on 12 to 15 boards (see “The VC and Super-Angel Digestion Problem”).  Partner turnover is also a huge red flag for investors.  They’re committing 10 years’ worth of funds to a VC firm, but who will be there to manage the capital in the end?
• For the entrepreneur: If that sponsoring Partner leaves, someone else will take over the board seat.  This may be a Partner who believes in the company, but usually isn’t.  It may be another Partner, but often a non-Partner is appointed to the seat.
• For the Partner: If he definitely thinks he is leaving, how can he ethically sponsor new investments?  Start-ups take so much time, and is it fair to invest in a company when you know you’re going to quit your VC firm?

I hope you’ve enjoyed this blog series on trust and that the posts have been helpful.  At Kepha, we think trust is everything and we try to shape our behavior through Operating Principles.

This is the fourth post in a blog series on trust. I previously wrote about how trust is critical in the VC-entrepreneur relationship (“When Entrepreneurs and VCs Break Up”). I also wrote two posts on trust between the VC and his investors (the “LPs”), looking at the relationship from each party’s perspective (the posts are here and here).

Today, I’ll write about trust within a VC partnership.

The “Partner” title means different things at different firms. Here, I’m writing about the members of the “General Partner” in a VC firm. This is the legal entity that is formed by the firm’s management company (more below) and which manages a fund on behalf of the LPs.

To be in the GP, you must sign a set of long legal documents. It is a big deal. It is like a joining a club. You spend a lot of time together. A VC fund is 10 years long, and over multiple funds, people can work together for decades.

The relationships, though, can be tested over time. When a VC firm is close and aligned, it can be a very powerful organization. When it isn’t, dysfunction can quickly permeate the firm. A divorce usually happens. Some divorces are done quietly, others are quite public.

I think a few factors complicate trust in a VC partnership:

1. What to do about founders: Founders of a VC firm are the ones who set up the “management company” (read “How Are VCs Paid?” and “Top Secret VC Economics and Power Unveiled”). This is the legal entity that “owns” the franchise, and is where hiring/firing and compensation decisions are made.

It is also the entity that collects the management fees and then pays all others, including other members of the General Partner. What’s left over after paying expenses is divided among the management company owners. It can be a great deal of money. The management company owners can fire other Partners. So, the owners are wealthy and powerful.

Some sticky questions arise for founders who may reduce their roles over time. Since the founders risked their reputations, capital and income to start a firm, shouldn’t they be compensated for that? And, for how long: the first fund only, or the next 10?

What if a founding partner is older and wants to spend more time with his family? What is a solution that is fair for him and the other partners? What if a founding partner becomes sick or dies? Does his family inherit the management company? And, why would the founders ever give up voting control of the management company? That means one day they will be “voted off the island.”

It’s also tricky for the next generation of partners. When are newer partners admitted to the management company, and if so, how much economics and voting are they given? How do both evolve over time? Do new partners buy their management company pieces or get them for free? If new partners have to “buy in,” how do you set the price?

2. Different time horizons: For simplicity, let’s say there are two partners at a firm. Both are members in the General Partner with equal pieces of carried interest, and both are also equal owners in the management company. In other words, it is an equal partnership in every way.

What happens when one partner wants to retire next year, but another partner wants to work for another 20 years. When should the first partner exit the management company? Is it a sudden removal, or is there a “tail” whereby that partner continues to collect fees in future funds, but at a sliding scale? If that second partner in a year’s time will be doing 100% of the new investments and all future fundraising, shouldn’t he get more economics today?

3. The absence of a Board of Directors: The above issues about pay and power are very personal and very complex. When these issues arise at a startup, the Board will weigh in and make a decision. At a VC firm, there is no Board. There is no outside person who can tell the founding partner that he is being unreasonable. There is no outside party that can tell a younger partner that he is being greedy. So, these delicate negotiations in a VC firm can spiral out of control, whereby emotions take over and trust is broken. And, they can drag on for years.

4. Varying incentives: Let’s take an example where one person owns a management company and the firm manages a $1 billion fund. The management company will receive a roughly 2% management fee a year for 10 years. That’s $20 million of fee income each year. Let’s also say that the cost of running the firm, all in and including paying his other partners is a made-up number of $10 million a year. That leaves $10 million of annual “management company profit” a year for the founder.

Now, how much should a firm raise for its next fund? All things being equal, the founder has an incentive to raise a larger fund. Fund 2′s fees will be 100% profit if the firm doesn’t expand headcount. For example, if the second fund is another $1 billion, then that additional $20 million of fee means the management company profit has now tripled to $30 million a year. Over 10 years of a fund’s life, that is $300 million.

Now, let’s say you’re a junior partner. You get a paid a flat salary and a bonus that that will not change with a new fund. Since you have carried interest in the new fund, though, your incentive is to raise a smaller fund. It is much easier to generate a 3x return on a $100 million fund than it is on a $1 billion fund.

So, the different incentives in the firm will create debate on how big or small a new fund should be. Suddenly, there’s real dis-alignment among the partners.

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I can continue, but I think you get the idea. A VC partnership is a very unique, self-managing entity. Trust can tightly bind together a firm. Dis-trust will lead to divorce over time.

At Kepha, we’ve tried to create a trusting culture. The management company financials are open to all in the firm. Eric and I are equal partners, in that we have equal carried interest in the General Partnership, and we also have equal economics and voting in the management company. There is no management fee “tail” in the future for me, the founder. No system is perfect, but ours fits our personalities and our mission as a firm.

Next week, I’ll write about trust between the partners and non-partners at a VC firm.

I’ve been writing a blog series about trust.  I started with a post on how VC is a “trust business” and I highlighted why trust between an entrepreneur and a VC is important (more here for a post on “When Entrepreneurs and VCs Break Up”).

Last week, I wrote about why investors (called “LPs”)  in VC firms find trust as a must-have before they invest (more here on “The LP and the VC”).

Today, I’d like to write that trust goes both ways: the VC must trust his investors–or shouldn’t take their money.

It’s very important that a VC’s investors have a long term horizon and can tolerate the ups and downs that exist in a VC portfolio.  Here’s why:

• VC is a high risk business.  We’ve seen data that shows that over 60% of venture-backed start-ups return less than 1x capital raised.  Less than 10% of start-ups generate returns of 5x or more.  (I’ll blog about this in the future).
• VC is a long-term business.  The median time to liquidity is about nine years today.  That’s right, from first VC funding to exit is almost a decade!
• LP support creates scarcity.  It is critical that a VC has investors who want to back the next fund.  That’s because it’s very hard to create scarcity.  Many LPs do not want to be more than 10% of a VC fund, and so, a VC must find at least 10 investors for a new fund.  A start-up entrepreneur will need for a Series A usually just one major investor, and so, scarcity is easier for a start-up.  It is much harder for a VC fund.
• Scarcity is even harder today.  Robin Painter, a foremost expert on VC funds formation, tells us that five years ago a new VC fund needed about 70% of its dollars to come from existing investors before it was deemed a “respectable” fundraising.  These days, that number has dropped to about 30% to 40%.  It is now very difficult to raise VC money.
• A loyal LP base is critical to getting a new fund.  If not, new LPs will wonder: “If this VC firm is so good, why aren’t most previous investors re-upping?”

Why does all this matter?  Well, when a VC closes a new investor, he is doing so not just for the current fund, but with the hope that the LP will commit to future funds.  So, there is a real opportunity cost to a bad fit.

This dynamic is further complicated when a fund is over-subscribed.  Which LPs does the VC firm pick for the fund?  If you say no to someone who has done a lot of work, it’s very difficult to re-build a relationship for the next fund.  But, if a LP comes into one fund but drops out of the next, all LPs talk and this could taint the next fundraising.  So, these are delicate decisions.

Unfortunately, in today’s market, the situation is more complicated.  There is a lot of turnover at LP entities.  I’ve heard that up to 40% of LP personnel are switching jobs.  For example, many great LPs work at public pension funds and, usually, at relatively low salaries.  Once a LP has a great personal track record, he may be tempted to switch firms to receive a significant pay increase.

So, the VC may spend years building a personal and trusted relationship with a LP, only to find that person gone.  Someone else takes over the relationship with that VC.  Since this new LP didn’t make the original investment in the VC, he may not be emotionally committed.  It’s pretty tough to “speed date” to a good relationship with someone.

Moreover, the LP that is taking over faces a tough situation.  If the VC succeeds, the other LP will get the credit for it.  If the VC fails, the new LP can always blame his former colleague for it.  So, there is little personal upside and much downside.

This dynamic unfortunately encourages VC firms to generate more demand than their fund can accommodate, and then cut back LPs’ allocations.  So, if you’re raising a $200MM fund, you try to generate $600MM of demand.  If each LP is asking for $20MM, you cut each back to $10MM.  You thereby diversify your LP base.  If a few LPs drop out for the next fund, it’s manageable.

(Note: At Kepha, we do the opposite.  We like having a small group of LPs, as we think we can better build a trusting relationship with each of them).

So, trust goes both ways between a LP and a VC.  Funds are 10-year long entities.  It’s important that both parties sign the documents with the intent of being true long-term partners.

Next week, I’ll write about trust within a VC partnership.

This is the second post in a blog series on trust.

Last week, I wrote that VC is a “trust business” and I highlighted why trust between an entrepreneur and a VC is important (called “When Entrepreneurs and VCs Break Up” and is here). This week, I’d like to write about trust between a VC firm and its investors.

In 2006, I left a venture capital firm, where I had been a partner for 8 years, to start a new VC firm. To get funded, I met with a lot of institutional investors, called “Limited Partners” or “LPs.” That inaugural fundraising was very interesting. Unaffiliated with an existing firm, many LPs were very up front and shared their thoughts about VC.

A few were very happy with some of their VC managers. But, most were not. I paraphrase one LP who said: the VC industry is guilty until proven otherwise.

For example, one of our major investors has many VCs in their portfolio, but now supports only two: Kepha and a VC firm in China. A major foundation has cut their VC roster from 30+ firms to just five. A leading university endowment has dropped most of their VCs and instead is thinking of bypassing VC firms and investing directly in innovation. More stories like this abound.

Common frustrations I heard from LPs during our inaugural fundraising included:

• “Scope creep”: VC were expanding their efforts into new areas or geographies where they had no prior expertise. Some were doing well, but most were not. Some LPs felt that they received portfolio exposure to areas for which they had not signed up.
• “Inconsistent strategies”: LPs keep all presentations that a VC firm pitches, includes ones from decades ago. So, they can easily call up the old documents and compare the new one to prior versions. If there are inconsistencies, the LPs know
• “Lack of transparency”: Some LPs were very frustrated with the lack of detail on the management companies (more on that here). Others didn’t like how VC quarterly reports to their investors often say the bare minimum
• “The stiff price of success”: One investor told us that when a firm has a successful hit, it often then raises a very large subsequent fund (for reasons on why this may be challenging, click here). The LP feared that VCs would drift away from early stage strategies that created success in the first place
• “Complicated stories”: One of our investors recently commented about another VC firm.  He said they had “a lot of baggage” and it was unclear if LPs would re-up with their next fund.  In other words, it was a complicated story.  LPs cover a lot of ground: public stocks, bonds, hedge funds, real estate, natural resources, leveraged buy-outs, and venture capital (all of which include both domestic and international).  As of May, in VC alone, there are 369 VC firms officially fundraising.  That figure likely excludes firms that are “pre-marketing” a new fund (informal discussions that start a dialogue).  When you include real estate, growth equity, buyouts and VC together, there are over 1,900 private equity firms fundraising right now.  So, complicated stories are hard to assess amid this sea of firms.  As one LP told me, “We just don’t have the time to research everybody, so we just pass on most.”

I think part of the frustration comes from the nature of a VC fund. You see, when a LP invests in a fund, it is empowering a VC with a 10 year-long open checkbook. Funds last a decade and a VC has tremendous freedom with how he invests it. There are limits usually on how much a fund can put into a single investment, but for the most part, the VC has tremendous latitude.

Moreover, if a fund isn’t doing well, the LP has limited recourse. One option is that they can renege on their investment commitment to the VC fund, but this usually triggers a “default” clause whereby that LP will give up 50% of the dollars they’ve invested to-date. These dollars are then allocated to the remaining LPs. So, in practice, I’ve never heard of a LP defaulting.

A second option is to sell their investment in what is called the secondary market. Other institutional investors will bid for that LP’s investment and assume the obligation for the remaining unfunded dollars. Unfortunately, buyers usually bid with a discount to fair market value. So, if a LP has $100 invested in a VC and wants to sell it, bids can come in at $50 or less.

Third, fund documents usually include a “no fault divorce” clause, where a group of the LPs can together vote to hire a new manager to take over the investments. However, the clause often requires 80% or more of the LPs dollars to vote “yes” on replacing a manager, and that is a high number. And, many LPs wonder how easy and practical it is to find, hire and retain a new VC firm to manage a portfolio they don’t know well. So, in practice, these divorces almost never happen.

So, you see, the typical LP is very leery about having his money locked up for 10 years. They must trust that VC. And, trust takes time. Broken trust takes even longer to re-forge.

So, how does all this affect Kepha? We believe transparency is the answer. It helps us earn trust with a LP.

We are a new firm. We have a lot to prove. We know we are one of the new kids on the block with nothing to brag about. But, I’m glad that some of our investors have told us that we have the most honest reporting in the business.

So, trust is important between a VC and an investor. Investors sign up for a 10-year checkbook. It is tough to tell your investors the bad news, but it is the right thing to do. In the end, the bad news will be discovered anyways.

Next week, I’ll write about the other side of this trust factor: why a VC must trust a LP, or not take their money.

We met with some of our large investors recently, and one of them mentioned: “VC is a trust business.”  He was saying that he trusted us.

I’ve been thinking a great deal about what he said.  I think trust in venture capital is critical, and it is something that covers multiple dimensions.  So, I’d like to write a blog series about trust.

For starters, we think that VC is a business just like any other.  As such, it has stakeholders:

• The entrepreneur: we think they are a VC’s customers
• The investors in the fund: they are called “Limited Partners”
• Partners in the VC firm: these are the folks in the legal docs and are named as part of the “General Partner.”
• Non-partners in the VC firm: they may include Venture Partners, Partners, Principals, Associates, finance executives, office managers and executive assistants.  Some of these folks have investing roles, and are hugely valuable, but they’re not partners if they’re not in the legal documents

We think that stakeholders are like legs in a chair.  When one is wobbly, the entire structure is de-stabilized.  One major wobble factor: dis-trust.

In this post, I’ll cover the importance of trust between an entrepreneur and a VC.

First, let’s look at trust from a VC’s standpoint.  When he invests in a start-up, he needs to have a lot of trust in the entrepreneur.  That’s because the VC is there for board meetings and assistance, but is essentially an outsider.  An entrepreneur can lie to the VC.  Lies will eventually be discovered, but it will take a long time.

For example, one founder I know started a company, received a lot of venture backing, and later, secretly started a new business and shopped around for a financing.  I know this because I am the first VC he approached.

You see, I had invested in his earlier company, and left that board when I started Kepha (which is the customary protocol in VC).  He later approached me a few times in secret about his new idea.  I told him I was uncomfortable.  I did not want to betray the management team, whom I had worked hard to recruit to that venture.

So, I told him I would start diligence only after he came clean with his current board and colleagues that he wanted to leave.  He wasn’t willing to do so.  He then approached me a few more times, and I continued to stick to my guns.  I told him I didn’t understand why he wouldn’t tell the truth.

In the end, he approached other firms, received funding, and then quit from his original start-up.  His previous management team was completely shocked, disappointed and hurt.  No executive from his old team joined him at his “new” venture.  He lost their trust.

Now, let’s look at trust from an entrepreneur’s standpoint.  Trust here is critical.  The VC can fire the entrepreneur, but the entrepreneur cannot fire the VC.  It is an assymetrical power relationship.  Yes, the VC’s reputation is at stake if he behaves badly.  But, the reality is that he can fire the entrepreneur, or decide not to invest in the next round, which is a negative signal to any prospective new investor.

So, it’s very important that start-ups can truly trust the VC.  Here’s a very real example.   One CEO, hired by a founder, was raising money for a start-up.  My partner Eric really liked the idea but told him that he did not think he was the leader for the start-up.  The CEO was insulted and shopped the financing elsewhere.

Three VCs at well-known firms decided to invest.  They too thought the CEO was not back-able.  But, they decided together not to tell him that, as they didn’t want to lose out on the investment.  So, they invested.  One month later, they fired the CEO and appointed the founder to lead the company.  Unfortunately, the CEO had moved his entire family to be closer to the start-up.

Now, I think 99% of the VCs I know will be very honest about their thinking.  So, this isn’t an indictment of VC “bad behavior”.  Bad behavior exists everywhere, in all circles.

But, I want to emphasize that it’s very important for the entrepreneur to get to know a VC.  Take your time and get to know someone.  Do a lot of reference checking.  Understand who the VC is and why he is working as a VC.  Don’t be overly enamored with a firm’s brand.  Then, trust your gut.  I always tell my entrepreneurs: it isn’t about a firm’s brand, it’s about that individual VC.

So, it’s about trust.

In next week’s post, I’ll write about why institutional investors need to trust their VC.