How are VCs paid?Mar 2
[4.7.12 Addendum: Many of the management company details are now available on a SEC web site. More details here.]
Here’s how VC firms are paid.
When VCs raise funds, they are paid in two ways. First, they get a commission on gains they produce for the fund, which is usually 20 percent and is called “carried interest.” Second, VCs receive a set fee, to run the business, while they and their investors await a future good payday from investment gains. Usually, a VC firm collects annual fees that amount to 2% to 2.5% of every dollar it manages (after 10 years, those funds end and the fees stop).
What many don’t know (including many VCs) is that these fees are transferred to a separate legal entity, called a management company. This is the entity that pays out expenses (salaries, rent, travel, legal, etc.), hires and fires employees, and owns “the franchise.” It is where the power is.
What is left over after expenses is the management company’s profit. The “franchise owners” of the firm divide this up among themselves. Usually, a small group of partners are the franchise owners, and often, it is just one or two individuals (usually, the founders). Very important to know is that usually one person has voting control of the management company; that person is truly the “Chief Partner”. This person usually owns the firm’s trademark.
The management company financials are a closely guarded secret. Very few partners get to see it. Most are kept in the dark. It sounds odd, but there is a top-secret “firm within the firm.”
The existence of the management company has a few implications. First, the Chief Partner cannot be fired without his/her consent. Every other partner at a VC firm can be, including the ones who have worked hard to earn pieces of the management company. So, a partner at a venture firm is usually an employee-at-will. They can be fired at any time.
So, why does this all matter to entrepreneurs? Well, we’re living in a time when it is very hard to raise new funds, unless a VC is in Facebook or another very exciting and already-large company. And, that fact affects start-ups in two ways.
First, if a firm cannot raise more money, then that firm obviously will not be able to make new investments. So, entrepreneurs should try to understand where VCs are in their current fund. Ask the VC how much of their current fund has been invested and reserved for existing investments.
Second, the lack of a fresh fund can complicate life for start-ups already backed by a VC firm. An entrepreneur’s Board member may leave his/her VC firm, or get fired. Here’s why. Without a new fund, fees to the management company decline as old funds’ fees expire. So, a Chief Partner may want to trim expenses. The most expensive cost? Partners. So, a firm may lay off partners. In other situations, the next-gen partners may leave and start a new firm, knowing that it is nearly impossible to restructure the management company since the Chief Partner doesn’t have to comply.
So, an entrepreneur can suddenly find that his/her sponsor at a VC firm is no longer there.
Entrepreneurs can overcome this reality in two main ways. They can out-perform, so that even if their champion is no longer on their Board, they can point to clear metrics. Another way is to build good relationships with other partners at that VC firm, particularly the Chief Partner.
Now, a VC firm’s culture varies from one to another. The Chief Partner may delegate authority so that all partners have a voice in an investment decision–or, he may allow input from others, but in reality, is the one making the decisions. Entrepreneurs need to know that when they pitch a firm. Who is the Chief Partner and do the other partners have power? The best way to find about both is to speak with other entrepreneurs who have pitched that firm. In my opinion, 80% of venture firms have a collegial decision-making process.
I want to point out that this type of ownership structure is usually the norm in other asset classes. LBO firms, hedge funds and funds-of-funds (firms that raise a fund to invest in other funds) nearly always are structured like this, too. So, founders at VC firms haven’t come up with a new structure. This is the standard which their lawyers tell them to adopt.
Last, I want to share why we at Kepha have tried to simplify our system. This is admittedly self-serving, but I think it’s important for entrepreneurs to know about it. Eric and I are equal partners on the carried interest, the management company profit, and the management company votes. We’ve assigned zero economic value to the management company, and so, when Eric joined the management company, he received his shares for free. So, we are equal partners and equal owners.
Why did we decide on equality? First, we believe the entrepreneur is our customer. It is one of our Operating Principles. We think the best way to serve entrepreneurs is with the best people possible. The best people, in turn, demand and deserve great economics. So, we want to offer a great compensation package to field the best team we can for our entrepreneurs and investors.
Second, we believe early stage investing is best practiced as a team sport. By having shared economics, we together have a strong incentive to have all of our companies succeed. So, an entrepreneur doesn’t get just one person’s set of contacts and energy–he/she gets the entire partnership.
Note that our CFO is a Partner–he receives a piece of the carried interest and management company profit. Among VC firms, a small number of CFOs get the former and only a select handful get the latter. So, he too very much wants our companies and Kepha to succeed.
We certainly don’t have a perfect system, and only time will tell if ours works. But, we like how our compensation helps us focus as a team on the entrepreneur. It also makes for a very collegial firm culture.
Last, if you’re an entrepreneur or a VC who would like to engage further on this off-line, just give me a shout. Always happy to try and help.