November 14, 2004
Reverse Engineering Venture Economics
Most entrepreneurs don’t really understand how their VC investors actually make money, so I thought I’d take a shot at explaining it in general terms.
Let’s say a venture firm raises $100 million from a series of what they call Limited Partners, or LPs. LPs can be anything from diversified institutional investors like pension funds or banks to high net worth individuals. The partners in the venture firm, or General Partners (GPs) typically derive money from two sources.
First, they receive a small percentage of their fund as an annual management fee to pay basic operating expenses. These fees range in size, but a typical one is 2% per year. So on the $100 million fund, the GPs will take $2 million per year to pay their salaries, staff, and office expenses.
Second, they receive a percentage of what’s called the carry, or the profits from their investments. Carry percentages have a range as well, but again a typical one is 20%. Here’s where the math starts to get interesting.
Let’s say the GPs invest $4 million in your company at a $12 million pre-money valuation, so they buy 1/4 of the company. You end up selling the company for $40 million a couple years later without taking in additional capital (good for you!), so their 1/4 stake in the company is now worth $10 million. They’ve made a 2.5x return on their invested capital, bringing back a profit of $6 million to their LPs, and they’re entitled to keep 20% of it, or $1.2 million, for themselves.
Fred Wilson talks about the rule of 1/3 in Valuation, where, from a VC’s perspective, 1/3 of deals go really well, 1/3 go sideways (he defines sideways as a 1x-2x return), and 1/3 go badly and they lose most or all of their money.
So based on this rule, let’s say a "good" VC will generate an average return of 2.5x on their LPs’ money over a 5-year period (an IRR of 20%). Now let’s say on average, the GPs make 22 investments of $4 million each to fill out their $100 million fund (less the $10-12 million spent on management fees over the life of the fund), and, again on average, each returns 2.5x (recognizing that many will return zero and a few will return 10x). The VCs will have returned $220 million to their LPs on $100 million invested, for a gain of $120 million (good for them!). The GPs get to keep 20% of that, or $24 million, to split among themselves. Not a bad bonus, on top of their salaries, for 5 years of work across a small number of partners and associates.
Let’s attempt now to compare those earnings to the earnings of an entrepreneur, assuming equal annual cash compensation. An average entrepreneur of a venture-funded company probably owns somewhere between 5-10% of the company by the time the company is sold. In this same average case above, the company is sold for $40 million, so the entrepreneur’s equity will be worth between $2 and $4 million for the same 5 years of work. In this simple case, the GPs in the venture firm have earned a collective $1.2 million, much less on a per-person basis than the entrepreneur. However, in the 5 year period of time where the entrepreneur is working solely on one business, the GPs are working on 25 businesses, earning a collective $30 million. A senior partner in a small firm will end up with $10-12 million. A junior partner maybe more like $2-4 million, comparable to the entrepreneur. However, and this is an important point, most entrepreneurs probably operate at the "seinor partner" level.
So on average, I think the economics probably work out in favor of VCs over entrepreneurs in the long run, mostly because VCs operate a diversified portfolio of companies and entrepreneurs are putting all their eggs in one basket. But on any given deal, I’d rather be the entrepreneur any day of the week – you have more control over value creation, and more of a personal win if things go well. And in the 1/3 of deals that are home runs for the VC, it’s better to be the entrepreneur, since you’re much further along the risk/reward curve and have that chance of seeing your equity turn into $20 million or more in that one shot.