Are VC funds aligned with Investors? Maybe not.
The ideal investment is where the VC firm, the Limited Partners who trust the VC firm with their money, and the founders of the company invested in are all aligned with the same incentives. But the model is broken as can be seen below.
The standard game for a VC is to charge 2 and 20, this means they charge 2% of the fund per annum to run the fund and then charge 20% of any profit that the fund creates. A VC is not penalised if they make bad investments. Incentives create behaviour, as I know in my own company, so let us see how this can manifest itself in a VC firm.
A VC firm is paid fees of 2% per annum of the fund size, for probably 5 years of a fund and then 1% for the remainder of the term of the fund. So what behaviour does this create within a VC firm:
1. Raise a fund larger than they need
2. Raise a new fund every 5 years ( conveniently before the real value of the first fund has been demonstrated )
3. Keep costs low so the General Partners can keep most of the fees ( especially if they have been well paid some where else beforehand and need the cash )
4. Do not do many deals as each deal costs money ( and time )
A VC firm is paid 20% of any profit that a fund makes, so what behaviour does this create within a VC firm:
1. Make it much more worthwhile to make investments that are high risk and may make huge returns ( if partners are already making good cash from VC fees then the upside on exits has to be large enough to make it worthwhile )
2. Reduce the chance of investments into solid business’s
Lets play this out in practice and see how this effects returns for an investor:
– £100 million fund raised with 2% per annum fees for the first 5 years and then say 1% per annum fees for the next 5 years.
– £15 million is split in fees between the partners of the VC firm over the 10 year period of the fund.
– Lets assume the fund is really good ( very few are very good in historical terms ) and makes a 3X return on money invested then the numbers are this:
3 x ( 100 million – 15% ) = £255 million X 80% = £204 million
Thus why do people invest £100 million into Venture Capital firms as this is what you are doing:
– investing into an illiquid asset class that you may never realise
– investing in an asset class with huge risk
– investing in an asset class with poor historical returns
– hoping that you can get a double return on your money
I like many people who are VC’s my concern is how the model works as it is incentivising people to act in a matter that is not alighned with their investors or with interesting startups
My simplistic solution would be the following:
– create a VC that does not charge a 2% fee but a yearly fee based simply on true costs.
– create a VC that has tiered returns on exits ( the more the return the more the VC makes )
– VC’s should publish what the maths model is to their investors and then follow the maths model
Doug