Successful entrepreneurs often end up investing in VC firms (usually the ones that backed them) and get insight into how it works at that point, but first-time founders often have no idea. There’s a natural human curiosity level to this but I think it’s also important to understand the business model of venture because it casts light on the incentives that drive firms and the individuals they employ. For the purpose of simplicity, this post is aimed at a ‘classic’ venture capital firm that raises one or more closed funds in series over time. There are many other models — not least those used by corporate VCs (like Google, Intel, Salesforce and more) — and I’ll try to cover some of those in a future post.
While a venture ‘firm’ is an enduring corporate structure (usually a partnership), a lot of the dynamic in VC firms is actually built around each individual fund. The Fund is governed by what is usually called the Limited Partner Agreement (or LPA). The LPA is struck between the purely financial investors in a venture fund (the LPs — usually pension funds, high net worth families, university endowments and more) and the active fund managers of the fund (the GPs — these are the folk you interact with at the firm, and as well as making and managing investments they often invest personal capital too, though usually, this represents a tiny fraction of the overall fund size).
The LPA defines many things but, for the purposes of this post, the key thing to note are the two-income/value streams:
Any good CEO or CFO should be able to tell from the description above that one income stream is guaranteed, consistent and low-risk (the fees!) and the other is volatile, of uncertain timing and runs the risk of actually never materialising (the carry!). As a result, fees are used as the core ‘revenue’ for a firm and its day to day P&L.
For example, here at Balderton, like pretty much all other firms, our biggest cost by far is our team. As well as the partners we have Principals, Associates and Analysts, we have a CFO and a General Counsel, large finance, legal, marketing and talent teams, a community team, administrative professionals and so on —it is a big team and, I should say, an awesome team. Being a relatively small organisation we are able to have a very high bar on who we hire and we do.
The second biggest cost is rent (we have a great office, if you haven’t visited, you should!) and then, after that, there are smaller buckets for data, marketing, travel and so on. All of this comes from our fee income. This way we can make long-term commitments to our team (another reason we get amazing people to work with us) and suppliers, we have consistency in what we can do and provide to our portfolio company. As an ex-entrepreneur myself I can share that the consistent, predictable fee income means that the level of emotional distraction/stress on ‘making payroll’ is very low. Most firms will run this part of their business at break-even. If there is a surplus, it usually gets rolled over just in case one day there’s a deficit — both are relatively small in the grand scheme of things because you have such great visibility on both income and costs.
While running a company with amazing people at break-even is absolutely fine, it’s not the key financial incentive for most VCs. The reason for doing business is the bit where we take the risk: carry. Depending on the firm, carried interest may be paid only to partners (in some jurisdictions tax/legal structures make it hard to avoid this) but many firms will also have some form of carry pool that is paid to the firm and then distributed to other employees in the firm. Even within a partnership, carry is not necessarily equally distributed — some firms do it based on seniority or tenure while others focus on who made the most successful investments.
If the fee income is more consistent and lower stress than a regular company’s revenue, carry is even less predictable and dependable than a bonus scheme. Most bonus schemes have clear KPIs that an individual can affect. In the case of carry, the numbers depend on aggregate investments — your partner may make an amazing investment that returns a large profit, but if you blow it by backing a number of failed investments then those will eat into the profit. Timing is also highly unpredictable — sometimes a company is sold very quickly, leading to rapid profits and carry, sometimes a great fund can have multiple unicorns or decacorns that just take a long time to get to a stage where any equity can actually be sold. To give you a rough idea on this, when I first became a VC, the accepted wisdom was that it would likely take 7–8 years to get your first ‘carry cheque’. The bull market of the last few years may have reduced this a bit but I think the lengthening time companies stay private and given how early some investors invest (pre-pre-pre-seed, etc!) means that that rule of thumb is probably still accurate.
Financial incentives are not the only incentives in life (there’s a good post for a future day!). However, financial incentives can be powerful and understanding this business model may help you understand VC behaviour. Here are some insights:
When trying to understand someone or something, I think the old cliche is still a strong one: follow the money. Hopefully this post starts you on that journey with regard to the venture capital industry.
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