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Venture Model Makeover & Diet Plan—Step Two


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some other fixed figure, which would make vital smaller venture funds uneconomic, a better approach would be negotiated operating budgets. Partnerships should lay out their planned operating expenses for their investors as part of fund-raising. What is really required to run the fund? Reach agreement on that budgetary figure, and make it part of the contract with investors. Investors can eliminate the incentive to raise larger funds purely for the purpose of larger fees and higher salaries, thus better aligning investors and a fund’s managing partners.

Next up, limited partners should drive a harder bargain on when and how they get paid on successful investments. Traditionally, limited partners in a venture fund get 99% of the fund’s returns (these are typically paid quarterly) until they are fully repaid their original investment, at which point the split goes to 80% to investors and 20% to the fund’s partnership. The trouble with that is two-fold. First, it permits the partnership to get paid before it’s obvious that the fund will return its original capital. Second, it ignores the costs of management fees in paying carry.

What would be a better approach? One improvement would be for limited partners to get 100% of a fund’s returns until they are fully repaid their original investment. That way, a fund’s general partners wouldn’t be pre-paid on a fund that may or may not end up performing. Second, once carry is being paid on the fund, it should first have management fees deducted from it. In combination, these two changes would help realign a fund’s partnership with its investors.

There are many other fiduciary changes that prudent limited partners could drive. For example, they could ask that general partners personally invest more of the fund’s total committed capital. Historically that figure has been around 1% of assets, but raising it substantially would further improve alignment between limited and general partners. There could also be more evergreen funds created, in that way reducing the investment timing gamesmanship that goes with overlapping funds and fund lifecycles that is too complicated to go into here. There are still other examples, but the point is that opportunities for improving the relationship and alignment between limited and general partners are legion. It merely requires desire and action from limited partners.

It is time limited partners exercised more influence over their venture capital investees. While that may have been hard in the past, with limited partners skittish about pushing too hard for fear they would be kept out of the best funds, such is no longer the case. Instead, even some formerly high-flying funds will be fund-raising on bended knee over the next year. Conditions have conspired to create a great opportunity for limited partners to drive overdue change in a relationship that has become dated and dysfunctional. It will help make a better and more modern venture capital industry.

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  • 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

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

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