Hi Luke,

Nice article. I think one of the keys will lie with the FDA and its ability to improve its transparency and give industry guidance that is timely vs on a case by case basis. It is amazing how the FDA relies on or cites “non binding recommendations” for years or even decades, and how some divisions of the FDA have never issued a guidance to industry for major therapeutic areas. This would only help start-ups get their preclinical and clinical package together for a Ph1/2 esp in new therapeutic areas where unmet medical need abounds.

You get what you pay for: a good, hard look at 2 and 20

Somewhere along the way, LPs and their investment committees largely abdicated the responsibility for creating and negotiating compensation structures that pay VCs to do what they promise to do: generate returns in excess of public equities. Many LPs state that their minimum target return for venture capital is 300 to 500 basis points above a public benchmark.

Yet, they don’t structure compensation based on that outcome. Instead, institutional investors allow VCs to “charge” them based on the “market
standard” 2 and 20. Here is how a typical 2 and 20 compensation model works:

VC firms earn a 2 percent per year management fee on committed capital during
the first five years of the fund (the investment period);

After the investment period, the annual fee usually steps down but continues
through the fund’s life (e.g., 2 percent on the lower of invested capital or market
value of the portfolio);

The VC firm earns 20 percent of all investment profits on a deal-by-deal basis
when a portfolio company is sold.

This structure has been the industry standard for so long that it’s difficult to trace its origins or rationale. The same 2 and 20 model remains nearly universal today. One study analyzed compensation from ninety-three VC funds raised from 1993–2006 and found that 90 percent of the funds charged a 2 percent or more fee, and 95 percent of funds charged a 20 percent carry.

It’s interesting that VCs have positioned themselves as supporters, financers, and even instigators of innovation, yet there has been so little innovation within the VC industry itself. There have been changes—more funds, more money, bigger funds, and bigger deals—but very little ‘creative destruction’ around how funds are structured, capital is raised, or VCs are paid. For more than twenty years, most LPs have accepted the

following terms:

 A ten-year fund;

 A five-year investment period;

 A 2 percent management fee on committed capital;

 An 80/20 LP/GP split of any profits on investments;

 One percent GP capital commitment invested in their own fund;

 Serial fundraising every twenty-four to thirty-six months.