Why Venture Capital Doesn't Scale Part 3: How VCs Get Rich, Regardless
Sure, the big wins look far better in a portfolio. But every realistic investor understands that many times, startups don't work out. So they're willing to overlook the occasional fumble. It's all about long-term statistics, accepting that most startups will fail, and the hope that a few of a VC’s investments will become unicorns.
And fumbles happen! Look at the WeWork calamity, for instance. But there are many reasons a startup could fail — even if the business plan is well-thought-out and there's a real need for the solution they bring to the table. Consider:
- The 2020 COVID-19 pandemic is a prime example. While the stock market has performed well enough throughout the pandemic, it's a difficult landscape to grow a young organization.
- Political and legislative changes matter, too. Whether we're talking about a trade war with China or a change in the presiding party, there are plenty of factors that can affect a startup.
But the venture capitalists will be getting richer, regardless. I've mentioned before that VCs will make a living, whether the startups win or lose. And today, I'm going to talk about how VCs get rich despite the outcome. If you're an entrepreneur in cleantech or an aspiring venture capitalist, I think you'll like what you read.
Let's Spell it Out: How VCs Get Rich — Management Fees and Carry
VCs earn a management fee — usually 2%.
Venture capitalists earn a management fee for managing a fund's capital. The bigger the fund, the bigger the fees! There is also carry, and we'll get to that in a moment.
- A venture fund is a pool of capital. It can come from all sorts of places: a few individuals with a high net worth, groups of retirement funds or endowments, or corporations seeking the answers to puzzling technology questions.
- The investors in a venture fund are called Limited Partners (LPs). When a venture fund raises capital, it charges its LPs a fee for having venture investors invest and manage investments in startups.
In a nutshell, the venture capitalist is a middleman (or middlewoman). A VC will raise money from LPs. Then, they take that money and invest in startups. The goal (hope) is that X number of these startups will experience tremendous growth, and then through a liquidity event, the VC will receive much more cash than initially invested. That cash is returned to the initial investors, and the VC makes some considerable money, too.
Traditionally, VCs charge investors 2% of the total value of a fund annually. The task of managing a $10 million fund would earn a VC $200,000 yearly. That money isn't all a paycheck, though. There are overhead costs to be considered: an office, the internet service, a bookkeeper, and so on.
Following that same formula, a $100 million fund would equal a 2 million dollar payday. That's how VCs get rich — but again, some of those funds are needed to pay the bills.
The Typical VC Structure
Here in the US, a typical lifespan of a VC fund is seven to ten years. But twelve years isn't unheard of. In other nations, the lifespan of a fund can be much shorter. In China, for instance, the average VC fund is closer to six years, according to the Thomson Reuters Practical Law website. Keep in mind:
- The term is based on how long it's expected to take to get liquidity on deals.
- In other words, the question is, "How long until this startup is successful enough to be sold or made public?"
- Investors commit to locking up their capital for a set length of time.
- Again, in the US, that can be around ten years.
Now, over those ten years, sometimes investors receive capital back from exits (cash-outs), but the bulk of the significant exits will happen closer to the ten-year mark — or even later!
I think VC Elizabeth Yin has a great example on her website: Dropbox went IPO after 15 years. They sold 36 million shares at $21 and raised $756 million in one swoop. As Yin says, If you were an early-stage investor, you would've made a lot of money, but it took fifteen years to accomplish.
Now, let's cover the concept of carry.
What Is Carry? The 2/20 Rule Is How VCs Get Rich
Here in the United States, a typical VC firm economics structure follows a 2%/20% rule. As mentioned above, the 2% rate represents management fees. 20% represents something called carry.
A Thought Experiment — Making Waves in Energy
Let's imagine it's an ordinary (non-pandemic) year, in 2010, and you're an independently wealthy LP looking to invest in cleantech.
As your VC, I've been vetting a cleantech startup in tidal energy. We'll call it Tide Co. The business model builds and develops tidal energy systems for smaller, undeveloped island nations, attaching them to their current electricity grids (or creating them) and then selling the electricity to them.
A decade passes. Tide Co has done well. The business has been great! Soon, Tide Co will experience a liquidity event in the form of a Mergers and Acquisitions (M&A) transaction or an Initial Public Offering (IPO). Investors will be paid their equity portion of the company's proceeds in cash or stocks at that point of liquidity.
"Carry" Spelled Out
Imagine you invested $10 million in Tide Co, and the return is $20 million. That initial $10 million investment will be paid back to you first. Then, the carry is distributed from the profit. In this case — with $10 million profit — fund managers receive 20% of this profit, or $2 million.
That $2 million is then distributed to the employees and partners of the fund based on whatever agreement they have. So, Tide Co returned 2x at a gross level. The LPs see a return of 1.8x, thanks to the carry. In the end, we see that Tide Co was a small but solid investment — a sweet little winner, but no unicorn.
A VC's job is to raise capital from limited partners, generate returns in five, seven, or ten years, and then do it again. Now, here's another phrase you should know: the power law of startups. You see, to understand how VCs get rich, you need to realize that investing in startups is a numbers game.
The Power Law of Startups
VC funds follow a power law curve. The distribution of returns is heavily skewed. Put plainly, only a few startups will capture a large percentage of industry returns. Sometimes we call those few startups "the unicorns."
So, if a few VC funds take home a large percent of returns, it makes sense that VCs are continually working to make their way into the "winning" part of the curve. I've written a bit more on this topic earlier in this blog series — because VCs thought they were chasing a unicorn with WeWork, for instance, but ended up finding a white whale.
Per the Power Law of Startups, many (if not most) startups will fail, and their value will go to zero. Investors can lose their money entirely. That risk always exists! Some startups, like our imaginary Tide Co, will maybe return 2x or more. And if you have an excellent portfolio, you'll catch a unicorn and capture a 100x-1000x return occasionally.
Final Thoughts: VCs Earn Their Keep
Invention and innovation do more than drive the US economy or make the rich man richer. In a post-pandemic 2021, we'll be looking for advances in healthcare and medical treatments, and we can expect a new focus on clean energy. Above all things, the global population needs to stay healthy and mobile.
VCs exist because of the structure and rules of our capital markets. An entrepreneur with a fresh idea or a brilliant new technology usually has no other institution to turn to for capital. Banks aren't interested in the inherent risks associated with the Power Law of Startups. Even if they were, usury laws limit the interest banks can charge on loans to entrepreneurs. The risk is rarely worth the reward.
Therefore, bankers only finance a startup to the extent that there are hard assets or collateral to secure the debt. And frankly, most startups are shy of hard assets like real estate.
According to the Harvard Business Review (HBR), "Historically, a company could not access the public market without sales of about $15 million, assets of $10 million, and a reasonable profit history."
To put that in perspective, fewer than 2% of the 5 million corporations in the US have $10 million in revenue. The IPO threshold has been lowered recently via the issuance of development-stage company stocks. But still, the financing window for companies with less than $10 million in revenue remains closed to entrepreneurs. That's where VCs come in, and that's how VCs get rich.
If you're a cleantech startup, and you're ready to talk about the next step in funding, check out my other blogs. Then, let's talk.