How VCs Make Money: the 2 and 20

In downturns in the economy, it’s then that Venture Capital Funds really come to the forefront of our startup communities because it’s then that entrepreneurship shifts from a buyers market to a sellers market.

Buyers vs. Seller.

Some time ago, I got a little bit of s*** for suggesting that founders think of Venture Capitalists as customers. Lambasted a bit because noble, wealthy people really took some offense at being called customers, the fact is, the underlying notion has merit because Venture Capitalists are exchanging capital for a product of value (that being equity in your venture).

We can draw from a conventional wisdom of Real Estate an appreciation of how entrepreneurship goes through Buyers and Sellers Markets and thus, it’s the “Buyers Market” (in which we find ourselves now) that smart investors get involved.

“A buyer’s market occurs when the supply (available homes for sale) exceeds demand (the number of buyers seeking to purchase homes). If you’re buying a new home, a buyer’s market is the ideal time to make your move. You might be able to buy a great home for a lower cost than you would in a seller’s market.

A seller’s market occurs when demand exceeds supply, or there are more buyers seeking to purchase homes than there are available homes on the market. This often leads to multiple buyers interested in a single property, resulting in bidding wars.”

– Redfin chief economist, Daryl Fairweather

The “buyer” being a startup investor, a few things happen in a difficult economy:

• More people endeavor on an idea, resulting in a greater supply
• Costs in the market overall plummet, reducing the costs of starting and operating a venture
• Founders and teams are psychologically attuned to being more flexible on terms and expectations

All of that equates to a “Buyers Market,” making this really a time when society can identify and uncover Venture Capital investors because a second bit of conventional wisdom, this from Wall Street, always holds true for anyone in finance: buy low and sell high.

Now is the time to seek capital and now is the time to develop meaningful relationships with Venture Capitalists because now is when venture capital wants to help.

And we need only look at some of the popular content in startup communities in the last few weeks to see that there are Venture Capital Funds really ready to get to work with you:

• Wondering if venture capital is open for business? A new initiative has investors saying yes
• Private equity eyes industries crippled by coronavirus: ‘They have been waiting for this’
• Venture Capital Firm General Catalyst Raises $2.3 Billion Amid Coronavirus Crisis.

Don’t get me wrong! I’m not saying venture capital investing won’t slow and even dip; I want to encourage you think differently and that you use this time to appreciate HOW Venture Capital Firms work and that, as I’ve alluded, it’s now when you might really uncover WHO is important to you in the capital market.

A Fund is a fund and presuming you have a venture fundable, the circumstances of the economy wouldn’t change [much] the interest a fund has in what you’re doing.

Starting those conversations and considerations doesn’t actually start with your pitch, it starts with knowing how Venture Capital Funds operate and get paid; so that you can discern which firms are “in business” funding entrepreneurs.

Venture Capital Funds are Businesses

…and the Partners get paid

When raising venture capital this fact may be the most important thing for all entrepreneurs to know: How the VCs Make Money

Before you jump to the often advised conclusion that Venture Capital Funds seek exits or only big opportunities, appreciate first that Partners get paid.

Venture Capital Funds are businesses.

The typical structure is what’s referred to as 2 and 20 and knowing if/that/how/who operate as such, really changes the expectations both parties (you and them) have in exploring opportunities.

 2 and 20 refers to the business model that compensates VCs for running their funds

• 2 – 2% of the capital in the fund is charged to the fund as an annual management fee. That fee is used to cover the cost of running the VC fund – salaries, rent, resources, and other overhead.
• 20 – refers to a participation on profits: 20%. This is called carried interest (or often, just, “carry). After the investors in the fund get a return of their capital invested, under whatever terms are in place, then the VC(s) get 20% of any profits.

That’s a Venture Capital Fund’s business and what it means to you as a founder, is that you want to KNOW (and appreciate) IF a source of capital operates that way because the SIZE of the fund then establishes the kind of operating capital they have to work with, how much they could invest, and whether the fund is paying (employing) people that can help you (or not).

Let’s back up because that model can really be confusing and it’s rather transformative when you know how it works and why.

You might have noticed from time to time that I can be a bit of a stickler about what the word “Venture Capitalist” means and how that word is not the same as Angel Investor, Business Investor, etc. It’s always been my experience that Venture Capitalist refers to the Partners in such Funds.

Venture Capitalists raise money.

See, I told you knowing this might be transformative. Venture Capitalists raise the capital that they use to invest in startups.

Investors, in a sense, as such, are not “Venture Capitalists;” the investors are referred to as limited partners (“LPs”). Funds usually form as a limited partnership with the VC being the general partner (“GP”) managing the fund.

Why the Size of a Venture Fund Matters

Let’s say a “Venture Capital Firm” has a $100 million fund.

What that means is that the General Partner(s) have raised $100MM from investors and sources of capital, usually high net worth individuals (“accredited investors”), pension funds, foundations, and endowments. A 2% management fee is charged as a percentage capital meaning that each year, $2,000,000 is what the Fund/Firm has to work with to pay people, hire, and operate other resources

Note that there are technicalities, circumstances, and variations in which this isn’t exactly how it works and certainly not always how it works. For the sake of keeping it simple and upskilling everyone, let’s stick with the basics (should you be someone who knows this stuff better)

That fee is charged over the length of time General Partner(s) need the money to operate the business of managing the investments.

Meaning, say our $100MM fund invests into 10 companies over 10 years…

That’s $20MM (twenty million) that goes to just running the business. And $80MM in fact available for the investments. Thus, a glimpse into how much the Fund can actually invest in anything. Appreciating that any good startup investor is investing in at least 10 things (hoping to hit one good return), we’re looking at a firm that is likely little more or less than $8MM in any investment.

In time, the startups exit and let’s say the Firm ends up with $100MM PROFIT from the exits. As it comes back to the fund, over time, the LPs (the “investors”) get 100% of any cash until they get back whatever they have invested to date. Eventually, in our case, there is $100 million of profits to split. The General Partners get 20% of that, and the LPs get 80%.

Why this matter so much to understanding from where and how to raise capital?

That fund size matters.

The life of the fund (over what time frame they’ll invest), matters.

The investment thesis (in what and when/how) they invest, matters.

Their operating budget matters because a Venture Capital Firm is a business that should have resources available to help you!

A $10MM Fund under the same circumstances, would only have an operating budget of about $200k per year. That’s essentially just paying one person. And for 10 investments, we’re talking about $900k. Such a fund is genuinely a seed stage fund, more of an Angel Investor, and certainly not something you’d want to think of as the same as a Venture Capital Firm as in First Round Capital.

A $300MM Fund under the same circumstances is understandably structured as a business to be more involved in all that you do and to capably fund later rounds and/or follow previous rounds of funding. We’re working with an operating budget of $6MM a year in this case; that means Executives, EIRs, and other resources, such as their own PR firm, which you could (should) expect are part of the value of what they’re bringing to the table.

These questions and structures matter. Venture Capitalist is a JOB and a job means you can have expectations of the people doing that work; raising capital isn’t just a matter of you pitching, they’re raising capital too, let me know if I can help.