Monday Note

by Jean-Louis Gassée

As promised last week, let’s dig into a venture fund’s key numbers.

Limited Partners, LP, institutions or individuals put money into the fund. We, the General Partners, GP, make and manage the investments and we split the profits with the LP as the sole compensation for our services.
Over time, the split has varied with the industry’s prosperity and the fund’s reputation, it went as high as 35% of the profits for the GP but, as this WSJ story belatedly explains, is now back to about 20%. In our vernacular, that number is called the Carried Interest or, for short, Carry.
A second number, the Management Fee, needs a bit more elaboration.
As the Carry did, it varied and went up to 2.5% of the fund’s capital; it is now pegged at a fairly standard 2% per year. The Management Fee provides the money needed to run the firm’s operations, pay the rent, associates’ salaries, travel expenses and the like. It also provides fodder for misunderstandings.

The Management Fee is a loan, not a stipend. For the GP to get its 20% of the fund’s profits, both the capital, the money invested by the LP and the Management Fee must be repaid first.
When funds become very large, say a billion dollars or more, the Management Fee gets correspondingly large and can encourage spending habits, thus generating criticism the GP is more interested in the fee than in making money for its investors.
But, you’ll object, the advance must be repaid before profit-sharing kicks in. Yes…, and what happens if the fund doesn’t make money? Are the LP losing money while the VC enjoys a good time, living off the Management Fee? The answer depends upon the way the fund agreement is written. If it contains a Clawback clause, the GP is obligated to return the “unearned” fee. As you can imagine, this leads to interesting exchanges during the fund’s formation and, much later, if it turns out it loses money.

To summarize: profit sharing (Carry) of 20%, a yearly advance of 2% of committed capital (Management Fee), to be repaid before profit sharing kicks in.

Let’s move to the heart of the matter: making investments. Here, let’s focus on a basic, oversimplified but usable formula:

We like to invest between $3M and $15M to end up with 20% of a company worth $250M when it “exits”.
“Exit” can mean going public through an IPO (Initial Public Offering). IPOs are rare these days, they’ll come back when the economy does. In the meantime, exits are achieved through M&A (Mergers and Acquisitions) deals, that is the company is sold to a larger one such as Cisco, Google and countless others who thus get access to valuable technology and/or people. In may respects, we, the VC, have become an engine of “externalized” R&D, of technical innovation for larger companies. We make and manage speculative investments in riskier technologies on the big companies’ behalf. This is a meaty topic all unto itself, maybe for a future Monday Note.

Going back to the numbers, they need three qualifications. First, they’re only valid for a mid-size fund, in the $200 to $400M range. Larger funds, billion of dollars, can’t make “small” $5M investments, they deal with bigger projects requiring larger amounts of capital such as infrastructure investments, semiconductors or biotech.
Second, the $3M to $15M bracket covers the total amount poured in over the life of the investment, that is 2, 3 or more rounds, over 3, 5 or more years.
(Add to this we never invest alone, for financial reasons, more capitak, and psychological, we don’t want to “fall in love”, a small (2 to 5) group of investors, called a syndicate, provides more viewpoints, more objectivity.)

Lastly, the $3M, $5M, 20%, $250M set of numbers is a neat simplification, reality gets much more complicated, from outright failures, to so-so, middling results, to the occasional “out-of-the-park” success. It’s not called venture capital (capital risque in French) for nothing.
If we invest “only” $3M and get 20% of $250M, that is $50M, this is more than 15 times our investment. If we risk the “full” $15M, we get about 3 times our money. Either way, it looks good, even if you keep in mind a few hard failures.
But you need to introduce time: how many years did the adventure take? 3 times your money over 7 years yields “only” 17% in compound interest, but 44% if the exits happens after 3 years. (Readers interested in geekier Excel simulations of cash-flows can go back to the May 17th, 2009 and May 24th, 2009 Monday Notes.)

The permutations, the possibilities for success and failure are, pardon the bromide, endless; they make our profession so fulfilling as it engages so many dimensions of human endeavor, from technology to psychology, from the fleeting desires of customers to the hard realities of time-expiring cash.

Finally, on job creation as a result of venture investments:

• A study by the North American Venture Association (NVCA).
• Research by the European Venture Capital Association (EVCA)
• US Census Bureau data analyzed by the Kauffman Foundation showing the net positive impact of startups on jobs while more mature industries lay off tens of thousands.

In Europe and in the US, venture investments are the engine of job creation.

— JLG@mondaynote.com

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