Series on Trust: When VCs Divorce

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.

7 thoughts on “Series on Trust: When VCs Divorce

  1. Hello Jo – Having read the previous posts in the trust series, its delightful to see the relationship VC partners have amongst each other.

    In note of the entire series, the general rules also very much apply to the trust required amongst entrepreneurs themselves. Having co-founded your own fund, I’m quite certain you know this more than many others who will be joining an already established fund.

    A lot of people find it peculiar we look at partnerships as some type of ‘marriage’ and use terms such as “divorce”. Truth be told, its not far from the truth: Two entities “like” each other. They meet, they ‘court’ each other for a while and after much consideration, sign binding contract that bind the two for the sharing of resources – all for the purpose of breathing life into offspring in the hopes they grow and expand the family’s wealth resources. In every aspect, it is just like a family.

    And just like a family, in my view, a strict environment of transparency, solves any impending hardship. If anything, when implemented well, when separation occurs (for any sort of reason) the divorce will be much painless if not constructive to both sides.

    On transparency: I came here trying to do some reconnaissance on figuring out how to get in touch with you guys but stayed in for the reading! I enjoy reading your posts, subscribed!

    Kind Regards,
    David.

  2. Nice one. To spice it up a bit you can also look at the subtleties of why funds stray from the initial social contract. For example: in many firms, “he who controls the fundraising controls the fund”. But what happens when the fundraiser is a poor investor ? And when do you know ? What about uneven performance over long periods of time ?

    I feel that many firms start with a strong bond between founders but that 20 years down the line no one really remembers why the economics were skewed a certain way and strife ensues.

    Whenever you start thinking about this, you know the answers essentially cannot be found (Is X worth more to the firm than Y, and how much ?) so you have to default to the Benchmark model: “We’re a small senior team of General Partners with equal contribution, compensation and authority.”

    You’re either in or out, but if you’re in, you’re all in and all equal.

    1. Hi Fred, thanks for the note. You raise some really important questions, including the one regarding performance evaluation. Returns are so volatile, the lead times to liquidity are so long, and it only takes one new investor to mark-up a company’s valuation (vs. the public markets): all this makes “grading” very hard.

  3. Jo, thank you for sharing these insights. It would be really great if you could also share some thoughts around carried interest. Do all partners have equal share on carry? Or it also goes to management company like the management fees and managing partner(s) decide the carry share for each partner.

    Just to clarify one more point: in a 10 year fund with 2% management fees , 8% hurdle rate and 20% carried interest, will it require 28% (2*10 + 8%) return on the fund size before the carry comes into picture?

    1. Hi Sanjay, how carry is divided is usually a separate negotiation from the management company details. Regarding carried interest, the calculation is usually based on dollars not on return rates. Also, sometimes funds have to pay back the fee before going into the carry zone, whilst others do not–it depends on what was negotiated with the investors.

  4. Sure Jo. It means there is no standard practice as such for carry – some funds calculate it on gross return (excluding management fees) while others do it on net return (including management fees). Given current market situation, I think me-too funds might not actually hit the hurdle rate. Thanks for sharing your views and your blog indeed gives very insightful perspective.

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