JWZ had some choice words for VCs the other day:
When a VC tells you what’s good for you, check your wallet, then count your fingers.
I did make a bunch of money by winning the Netscape Startup Lottery, it’s true. So did most of the early engineers. But the people who made 100x as much as the engineers did? I can tell you for a fact that none of them slept under their desk.
So if your goal is to enrich the (VCs) of the world while maybe, if you win the lottery, scooping some of the groundscore that they overlooked, then by all means, bust your ass while the bankers and speculators cheer you on.
I don’t know Jamie’s history with VCs, so I won’t speculate. But his post got me thinking about the contrast in perception vs. the reality of VC economics.
The underlying assertion Jamie makes is that VCs stand to make far more money than certain employees when and if a company has a positive liquidity event (acquisition or IPO). So, let’s test that assertion with a simple sample case for today’s market.
Let’s say a company raises $5M in two rounds of funding from 2 VC firms and is acquired for $100M.
Now, let’s say that each of the two VC firms put in $2.5M and owned 20% of the company at the time it was acquired ($5M total investment 40% of equity owned by VCs).
Founders, early employees and executives each own between 10% and 1% of the remaining 60%. The founder who owned 10% comes away with $10M, the Executive who owned 3% comes away with $3M and the early engineer who owned 1% comes away with $1M. Fairly simple math.
Each VC firm in this transaction brings in $20M (remember, they both owned 20% of a $100M acquisition). On the surface, it appears they’ve made out much better than the founders. But there is other math involved in a VC partnership that needs to play out before the final score is posted.
Let’s assume each firm has a standard fee structure of 20% carried interest, i.e. 80% of profits go to back to their investors, 20% of the profits go to the VCs. Now, the actual dollars going back to the VCs is actually $4M (20% carried interest on $20M).
Still following?
‘Cause it’s a bout to get a little more inside baseball.
A fairly standard VC term is that firms can’t dip into carried interest profits until they’ve returned all committed capital. So, in the sample case above, the VCs would only get to take that $4M in profit IF AND ONLY IF they’d returned all paid in capital.
Let’s say this acquisition came out of a $100M fund. This $20M acquisition only retured 20% of their fund, so there’s a scenario where the VCs wouldn’t see any of the profit on this exit, it would simply be returning 20% of the committed capital of the fund to the investors.
But, let’s keep is simple and say they’ve paid back the whole fund before this sample case acquisition happens and $4M in profit is coming back to the partnership.
Now, each firm splits this profit among their partners very differently. Just as companies have different cap table structures, so do VCs. In some firms, one partner takes the majority of the carry, while other partnerships have flat/equal carry distribution.
For the sake of simplicity, let’s assume a flat carry structure and a 3 person partnership. That would mean that each partner would receive 33.3% of the $4M coming back to the firm or roughly $1.3M.
That puts the VC’s outcome on par with the early engineer.
Not bad!
But, not exactly the windfall Jamie berates in his rant against those greedy, good fer nothin’ freeloading VCs who are only passing along table scraps to the founders and employees of the companies they back.
I’m sure there are some bad actors out there, and Jamie has every right to be cynical of the VC industry while avoiding it like the plague.
But there are some good VCs out there who work hard to be valued partners from the very earliest days of company formation. Hopefully casting a little light on their economics can bring a some persecutive to the rewards they receive.