We are in business for one reason: to make returns for our customers, our Limited Partners. We love our companies, but, in the end, we have a fiduciary duty to generate returns for our investors. If we don’t, we won’t be in business anymore.
For our investors to be happy, we need to generate dollar returns. Venture capital is a yield game. As harsh as it sounds, it is. Not every company that forms is successful and not every company that is venture-backed is successful. We will and should spend our time where it will generate the highest returns.
How does this fit into the amount of capital a VC needs to invest? Well, it doesn’t. At least is shouldn’t. We get paid two ways: management fees and carried interest (for those of you unfamiliar with carried interest or, simply, “carry”, it is where the VC receives a certain percentage of the profits that are generated from an investment). The typical terms for a venture firm is 2% management fee (2% of the total capital committed by LP’s) and 20% carried interest. Over the past few years, these economics have provided the incentive for larger funds (more management fees and more carried interest on a dollar basis) and the incentive for a VC to have a larger fund has driven the need for larger investments in companies.
While fund sizes increased, in technology-based companies, the dynamics of internet connectivity and low cost computing platforms has enabled companies to grow faster and consume far less capital than ever before. In short, our market drivers got out of sync with the entrepreneur’s market drivers.
This is a long-winded way of saying, we should not require you to take as much money as we want or suffer dilution that we require. But, on the other hand, we are here to make money for our investors and we are going to invest our time where we can generate the most dollar profits for our customers. That means that we need to either have a large amount of capital at risk so a small percentage returns can drive large dollar returns or smaller investment that can drive large percentage returns (and, consequently large dollar returns). We can tell you that everyone is equally important, but they are not. You are most important immediately after the investment when we feel we can make the most impact and when the potential value of the investment is high (of course it is – otherwise we would not have made the investment!!!), when you are cratering and we have a load of money in you and we are trying to save our bacon, and, last, when you are riding to the moon with success and the value of our investment is growing. Is this truth pretty? Maybe not, but it is one thing that is very important to know: it’s the truth! And anyone who tells you differently is not telling it to you…