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May 01, 2005

Venture Capital 101: Decision-Making and Economics at a VC

How do VCs make investment decisions, personnel decisions and work through other critical issues?  Well, first you need to understand VC economics before the murky decision-making process can be teased out.

So what's the VC business model?  Raise a fund, get paid 2.0-2.5% annually in fees to manage that fund, and make investments that you hope will generate capital gains.  When those returns are generated, the VC funds typically get 20-25% of "carried interest" or "carry" in the capital gains.

Let's walk through a simple example.  Let's say there's a $150 million fund and the VCs are getting 2% in annual fees and 20% in carried interest.  Then, the firm takes in $3.0 million in annual revenue.  If the fund returns 2x the capital, or $300 million, over the 10-year life of the fund, then $150 million is considered capital gains and the VCs get 20% of that amount, or $30 million, to be divided up between the partners according to who has how much of the carried interest.  If the fund doesn't generate any capital gains, the VCs get nothing beyond their salaries paid out of the annual revenue.  Once the VC is finished investing their fund, they need to raise another fund from Limited Partners (LPs), typically universitiy endowments, pension funds, fund of funds, wealthy families or corporations.

Why does this help shed light on VC decision-making?

Because decisions within a firm typically get made depending on who has the most carry, not based on title, as you would assume coming from a real company (VP Sales - oh, I guess they sell...).  Partner or General Partner titles can be misleading.  A 29 year-old, green General Partner may have a tiny sliver of carry as compared to the 50 year-old General Partner who's been a successful investor for 20 years.  Guess whose opinion matters more?

In VC firms where the carry is divided unevenly, decision-making is typically unevenly made.  VC firms where cary is divided evenly are more consensus-driven.

So, if you find yourself pitching a VC firm and wondering how they'll make their decision, there are a few important questions to get answers to while you're fundraising:

1) Who is the partner who would serve as the deal champion?  Associates and Principals don't typically have carry, so they can't make investment decisions without a partner's support.  Junior partners with small slivers of carry may need senior partners to closely oversee the diligence and decision-making process.

2) How long has that partner been with the VC firm?  Are they on an equal footing in terms of carried interest (i.e., ownership) to the other partners?  If not, they may not be able to "speak for the firm" when it's time to make tough decisions about follow-on rounds and M&A transactions.  If so, they will still need to get to consensus, but it's a very different dynamic when your "deal champion" isn't a subordinate within the VC firm.

3) When is the last time that partner made an investment and what other deals are they working on?  If a partner is out of capacity, conventional wisdow nowadays suggests sitting on 8-10 boards at any given time is the max, then they are far less likely to take on a new project than if they have recently sold off or shut down a bunch of their portfolio.

4) Where is the VC fund in their fundraising cycle?  If they are at the tail end of a fund, they may be more selective in their investments...or more rash.  If their current fund is strong, they may be more willing to roll the dice with the final few investments in terms of risk/reward profile.  If their current fund is weak, they may need a few short-term, safer hits to make up for poor historical performance.

VCs are great at asking entrepreneurs dozens of probing questions about their state of affairs - so in theory turnabout should be fair play!


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Isn't the mgmt fee on committed capital?

Great posting. I have been reading a few blogs as of late and most of them talk about esoteric business and technology issues.

You seem to hit on practical issues and show some personality at the same time!

That is very insightful. The old wisdom is that a junior partner only has the authority to say no. So what's an entrepreneur to do? I've been working with these two junior partners at a respectable firm for almost two months now. To me, that's simply too long. Only a seasoned GP can pull the trigger and make it happen within 45 days.

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