« swipe left for tags/categories
swipe right to go back »
I’m an investor in a bunch of VC funds. Some of them recycle their management fees; others don’t. I’ve never really understood why funds don’t recycle their management fees.
Understanding what “recycling management fees” means is a fundamental part of understanding the economics of a venture firm. Here’s how it works.
Let’s assume a $100 million VC fund that charges a 2% management fee and a 20% carry. In the typical case, a fund will get an annual management fee of 2% of “committed capital” (the $100 million) for the “investment period” (usually the first five years, or until a new fund is raised) and then an annual management fee of 2% of “invested capital” (whatever the fund has invested in companies that are still active) over the remaining life of the fund, which is usually 10 years.
Now, there are lots of minor variations on this, but the average “fee load” on a fund over its life is 15%, or $15m paid out over 10 years on the $100m fund.
So – if $15m gets paid out in fees, that only leaves $85m to invest in companies.
That’s where recycling comes in. When a fund has an exit, it can either distribute the money to its investors (the LPs) or it can “recycle it” and invest it in new and existing companies in the fund.
Now, assume that by year three the $100m fund has invested $50m. During this year, it sells a company and gets a realization of $20m. At this point, it would have taken $6m of management fees (2% * 3 years) so it could recycle the $6m (hence, reinvesting it) while distributing $14m to the LPs.
By managing recycling this way, the fund could end up investing the full $100m, instead of just the $85m. The advantage, for all the investors (the VCs and their LPs), is that $100m gets put to work as invested capital, rather than just $85m.
Our view as a firm is that a successful VC fund has a net return of at least 3x to the LPs. That means that if an LP invests $1 in the fund, they get back $3 over time.
Now we get to do the fun math, including the impact of carry on return.
If I’ve only put $85m to work, I have to generate $100m to get to a point where I’ve returned capital, which puts me in a position to get carry. Then for every $100m of additional returns, $20m goes to the VCs and $80m goes to the LPs. To generate an incremental $200m to the LPs, I have to return a total of $250m. So – my $85m needs to generate $350m to get a net 3x return. On a gross basis, my $85m has to generate a 4.1x return to accomplish my “net 3x return to LPs.”
On the other hand, if I recycle my management fee, then I put $100m to work. I’ve reinvested $15m over the life of the fund, so I’ve had to generate this $15m plus the $100m to get to carry and the $250m to get to a net 3x return. In this case, I have to generate a total of $365m (instead of $350m), but I now have $100m at work to do that. In this case, my $100m has to generate a 3.65x return to accomplish my “net 3x return to LPs.”
That’s an 11% difference just by recycling my $15m fee. It’s better for the LPs and better for the VCs.
A few weeks ago Hunter Walk and Satya Patel of Homebrew, a one year old seed-stage VC firm that my partners and I are investors in, came and spent the day in Boulder. This wasn’t the typical “hey – I want to come see you for a meal when I’m in town” kind of meeting that happens with a lot of VCs. In this case, the firm (Homebrew) came by, committed a full 24 hours to being in Boulder, and went deep with me and my partners.
I’ve known Hunter for a while although our relationship is mostly from a distance – email, blogs, and twitter. He went to GSB with my partner Ryan’s wife Katherine so they’ve known each other for a while and have a handful of entertaining stories from their time together at The Lobby Conference. This was the first time I recall meeting Satya Patel although I’ve also known him from a distance.
Hunter’s blog, 99% Humble, 1% Brag, is outstanding. If it’s not part of your daily reading, it should be.
Hunter, Satya, Ryan, Seth, Jason and I spent two hours in a conference room with a white board. Hunter and Satya tossed a bunch of things they wanted to discuss up on the board and we went through the topics one by one. We shared our view about how we address them, they added some of their thoughts, asked some questions, and we cycled more on the topics. We got through most of them and then went to dinner at Oak for a few more hours of discussion, this time more casual, but just as deep and wide ranging.
The next morning Hunter and Satya hung out at Techstars and did office hours with a few of the seed stage companies in Boulder.
I had a great time and learned a lot. Hunter and Satya both sent thoughtful debriefs around which caused some additional discussion on our end about a couple of topics we felt we could learn more from. And we developed a deeper relationship, outside of a specific deal context, which will help us in anything we do together going forward.
This was so much more enjoyable, satisfying, and useful than a flyby. Hunter / Satya – thanks for making the effort to come see us.
I often get asked how I ended up becoming a venture capitalist. When people ask me how they can become a VC, I point them to my partner Seth Levine’s excellent blog posts How to become a venture capitalist and How to get a job in venture capital (revisited). But it occurred to me today – after getting another email asking me how I’d become a VC, that I wasn’t really answering the question.
Amy likes to remind me that when I was an entrepreneur, I used to regularly give talks at MIT about entrepreneurship. I’d say – very bluntly – “stay away from VCs.” I bootstrapped my first company and, while we did a lot of work for VCs, I liked taking money from them as “revenue” (where they paid Feld Technologies for our services) rather than as investment.
Feld Technologies was acquired in November 1993. Over the next two years, I made 40 angel investments with the money I made from the sale of the company. At one point in the process, I was down to under $100,000 in the bank – with the vast majority of our net worth tied up in these angel investments and a house that we bought in Boulder. Fortunately, Amy was mellow about this – we had enough current income to live the way we wanted, we were young (30), and generally weren’t anxious about how much liquid cash we had.
Along the way, a number of the companies I had invested in as an angel investor raised money from VCs. Some were tough experiences for me, like NetGenesis, which was the first angel investment I made. I was chairman from inception until shortly after the $4m VC round the company raised two years into its life. Shortly after that VC investment, the VCs hired a new “professional” CEO who lasted less than a year before being replaced by a CEO who then did a great job building the company. During this period, the founding CEO left and I decided to resign from the board because I didn’t support the process of replacing this CEO, felt like I no longer had any influence on the company, and wasn’t having any fun.
But I still wasn’t a VC at this point. I was making angel investments with my own money and working my ass off helping get a few companies that I’d co-founded, like Interliant and Email Publishing, off the ground. I was living in Boulder at this point, but traveling continuously to Boston, New York, San Francisco, and Seattle where I was making most of my investments. During this time, I started to get pulled into more conversations with VCs, helping a few do some diligence on new investments, encouraging some to look at my angel investments, and investing small amounts in some VC funds whenever I was invited to invest in their “side funds for entrepreneurs.”
One of the VCs I overlapped with while in Boston was Charley Lax. Charley was a partner at a firm called VIMAC and was looking at some Internet stuff. I was one of the most prolific Internet angel investors in Boston at this point (1994 – 1995) so our paths crossed periodically. We never invested in anything together, but after I moved to Boulder, I got a call from Charley one day in early 1996. It went something like:
“Hey – I just joined this Japanese company called SOFTBANK and we are going to invest $500 million in Internet companies in the next year. Do you want to help out?”
Um – ok – sure. I didn’t really know what help out meant, but on my next trip to San Francisco I had a breakfast meeting with Gary Rieschel and Jerry Yang. SOFTBANK had recently invested in Yahoo! and presumably the breakfast was to vet me. I remember it being pleasant and ending with Gary saying something like “welcome to the team.”
I still didn’t really have any idea what was going on, but I was making angel investments and having fun. Charley proposed being a “SOFTBANK Affiliate” which had a small monthly retainer, a deal fee for anything I brought in, and a carry on the performance of any investments I sourced. Informal enough for me to play around with it for a while.
I was in Boston the following week so Charley emailed me and said “can you go check out this company Yoyodyne and tell me what you think?” So I went to a generic office park near Boston and met with two people who would become close friends to this day. The first was Fred Wilson, who had just started Flatiron Partners (SOFTBANK was an investor in Fred’s fund) and the other was Seth Godin, the CEO of Yoyodyne. I vaguely remember a fun, energetic chat as we met a few people at Yoyodyne, ran through the products, and talked about how amazing the Internet and email was going to be as a marketing tool.
My formal report back to Charley was short – something like “Seth’s cool, the business is neat, I like it.” SOFTBANK and Flatiron closed an investment in Yoyodyne a few weeks late.
Suddenly I was a VC. An accidental one. And it’s been very interesting since that point back in 1996.
VCs love to say things like “we are entrepreneur friendly.” It’s trendy, catchy, and looks good on a blog post. But, as I’ve said in my post Your Words Should Match Your Actions, one can “damage their reputations by having their words not match up with their actions.”
Now – this post isn’t about responding to emails. Nor am I trying to be preachy. I’m not trying to explain a new behavior. Rather, I’m making an observation about something I’ve experienced – both as an entrepreneur and investor – since my first angel investment in 1994.
Here’s the situation, as reported this morning by an experienced CEO of a company we are investors in.
“We’re raising money. I have a good intro session. Prospective investor wants to meet in person, see a demo. We have a good 2nd meeting. We agree on action items. I go away and follow up.
Follow up again.
Radio silence still.
The first time it happened I was inclined to think it was the investor and that they just couldn’t find the time to send an email response saying, “sorry – no longer interested”. Then, it happened again this month.”
Now – initial non-responsiveness – whatever. Lots of people don’t respond to emails, intros, or requests for meetings. But after two in-person meetings, to be non-responsive is just plain rude.
How hard would be it be to say “Hey – great spending time with you – but this isn’t something I want to pursue.” Or maybe “Sorry for being slow – I’ve been swamped – I don’t have time for doing this right now.” Or – well – anything.
I’ve had this situation come up so many times that I’m immune to it. I assume that the VC isn’t interested. But I’m amazed at how the reputational damage follows the person around. And then – at some point in the future – that VC is looking for a response for something. Hmmm …
I’ve had this happen with LPs. When we went and raised our first fund in 2007, plenty of people wouldn’t meet with us. That’s fine. Lots said they weren’t interested after a first meeting. Totally cool. But some met with us but then were completely non-responsive after the meeting. Ok – whatever. But when those non-responsive LPs call me today asking for something – whether it’s to get together to “get to know me better”, or to get a reference on someone else they are looking at, or to learn more about what I think about the market for hardware investments, it’s really hard to get on the phone and spend time with them. I do – because that’s my nature – but I always remember their non-responsiveness.
I hear – and say – “No thank you” all the time. Every day. 50 times a day. That’s just part of the role I play in business. But I always try to say “No thank you.” It’s just not that hard. Especially when I know someone, or have engaged with them in some way.
Are you the guy the experienced CEO just encountered? How would you feel if your name – and your firm’s name – just went out via email to 60 CEOs attached to this story? Maybe you don’t care, but if your message is “we are entrepreneur-friendly VCs” you just undermined the reputation of your firm in a major way.
Some of my favorite VC posts are ones that say what the VC posts that say what the VC thinks about how it all works. And – importantly – how it impacts the entrepreneur, his choices, and the dynamics between the entrepreneur and the VC.
Fred Wilson does this regularly. For example, see his post today on Valuation vs. Ownership.
My partner Jason Mendelson does the same. See his recent post The “VC Bargain”. Of course, Jason and I aspired to do the ultimate version of this in our book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist.
You don’t have to agree with them. That’s what the comments are for. But they each say what is on their mind, why, how they think about it, and what the implications are for them.
If you want another example, take a look at my partner Seth’s post from last year titled I’m getting sick of the bullshit. And then reflect on the post from the anonymous entrepreneur that I highlighted yesterday titled My Startup has 30 Days to Live.
This shit is really hard and really complicated. It’s easy to have a surface view of it, to romanticize it, or to fall in love with the idea of it. Don’t. Do it because you love it. And find partners who want to go on the journey with you.