Venture Model Makeover & Diet Plan—Step Two

10/8/09Follow @pkedrosky

The venture capital model is being remade. It must happen from the ground up, via its relationship with entrepreneurs, as Daphne Zohar has previously described here. But it must also happen from the top down, via its relationship with limited partners (the investors in venture funds).

Limited partners in venture capital funds aren’t very happy these days. After a decade of indifferent performance, 10-year returns for venture capital as an asset class are set to turn negative this year when the last of the dot-com exits disappear from the rolls. When that happens, the industry’s main performance peg will no longer hold up the venture capital marketing tent. Limited partners will find it even harder to allocate money to venture capital, and funds will find it more difficult than ever to raise money.

[Editor’s note: This article by San Diego Xconomist Paul Kedrosky continues the thread started last month by Boston Xconomist Daphne Zohar in Venture Model Makeover & Diet Plan---Step One]

Of course, that doesn’t mean that investors should abandon venture capital. There will always be good performance available from skilled investors adept at making early investments in illiquid private companies in emerging growth markets. The venture capital industry is not disappearing, nor is investor interest in the asset class. There is, however, an opportunity for investors to force change on a broken industry— there are specific changes that limited partners should force on partners at venture funds.

One perennial problem at venture funds flows from the compensation system. The standard compensation model for venture capitalists is “2 and 20”: Partners get a management fee of 2% of the assets under management, and then earn 20% (the “carry”) of any investing gains. To understand one reason why that model needs to change, it helps to take a walk through the math. On a $100-million fund, a 2% management fee provides $2 million in annual income for the partners, come good investing or bad. Given a reasonable numbers of partners, associates, administrative personnel, and office expenses, that isn’t anywhere near penury, but it isn’t entirely unreasonable either.

If you scale the fund size up, however, the same cannot be said. A 2% fee on a $500 million venture fund means $10 million in annual fees for the partnership. But you don’t have five times the operating expenses on a $500 million fund that you do on a $100 million fund. Costs go up, but nowhere near that much. What happens to the extra money? It typically turns into higher salaries for the partners, with it being common for senior partners at some of the largest venture funds to receive seven-figure incomes from fees alone. That is, of course, egregious and wrong, enabling partners to become at least moderately wealthy without making a single successful investment. It is a serious misalignment of incentives between limited and general partners.

What is the solution? Rather than shrinking the management fee percentage from 2% to … Next Page »

Paul Kedrosky, a senior fellow at the Kauffman Foundation, is an investor, essayist, technology analyst, and entrepreneur. Follow @pkedrosky

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  • http://www.KangasAdvisors.com Stephen Kangas

    Wow, well said, Paul! Long overdue change ideas.
    However, there is a potential sticking point: recruiting and retaining experienced entreprenurial talent as General Managers has historically been a real problem IMO, and that is particularly true today as I’ve witnessed some of the best ones I know bail out of VC firms, leaving the wheel spinning on deck or left to the new MBAs & big-co financial types who have little feel for what it really takes to help a new venture succeed. If/when these new ideas come to pass, it may mean that General Manager profiles have to migrate more toward those who love the work, have been successful as entrepreneurs, are accustomed to and enjoy the “high risk, high reward” compensation model, and/or want to “give back” to an industry that made them successful. I wonder what size of that type of talent pool can be drawn from?

  • Michael Elconin

    Good article, Paul. On the face of it, a valid comparison is that VC’s wouldn’t fund a startup that paid is executives $400K annually on the theory that management should profit only when investors do.

    Stephen Kangas raises some valid concerns (that this model might mean VC’s would be run by recent MBAs and financial types) but I predict this is an unlikely result simply because the limiteds won’t buy it. What has really changed is supply and demand. Investors are in a position to call all shots.

  • Krassen Dimitrov kr

    Stephen Kangas:
    quite contrary, I think. The MBAs will be turned off by the idea of having to perform for a living. they are mostly moochers whose only skill is to sell themsleves and to BS their way to a fat salary without having to deliver.

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  • Tim Rueth

    VC fund terms have classically been “shoved down the throat” of the LP. I don’t expect this will change unless a) GPs really do have to go down on bended knees to ask for $$, and b) large LPs read your article and say “Yah, you’re right, this has to change.” Oh, and keep the newbie MBAs out of the board room.

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  • Azzouzi

    As a VC manager, I just want to correct something brought in the article.The 2% of management fees are calculated on the committed funds,i.e, indexed on the amount of funds really invested.Which makes a big difference between 2% of the fund size and funds actually committed.

  • Krassen Dimitrov kras

    Azzouzi,
    What do you mean? Capital committed = fund size. Are you trying to say fees are only on called capital?

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