Venture capital Limited Partner Agreements look very similar. The formula goes something like this: 10 year fund, 4 year investing period, 2% management fee and 20% carried interest. The implications of these terms can help explain why venture capitalists work the way they do, and help founders ask the right questions of their investors.
After the 4-year investing period, the 2% management fee, which otherwise kicks in every year, ratchets down to 2% of the invested capital, meaning that investors tend to fundraise for a subsequent fund before the end of the 4-year period, so they can ensure they can continue deploying capital, paying themselves, and keeping the lights on at their organization. Under these circumstances, a venture investor will pitch their next fund before they have fully invested the fund before it, much less realized all of the gains in the first set of investments.
What it means for the investor: Investors pitch LPs on the ‘markups’ and IRR of the previous fund – has there been follow-on investing, at a higher valuation, from their investment? Any acquisitions, mergers, or public offerings?
What it means for you: If the fund manager has yet to prove herself, and is still early in building out her portfolio, she has a very strong vested interest in your raising subsequent funding at a higher valuation, ideally soon after her funding comes in.
An investor will deploy all of the principal and reserves in the first four years, which means that the companies which have a long road ahead of them, or which are very experimental, might be better investments at the beginning of a fund, so that they have time to mature.
What it means for the investor: Consequently, those companies that are somewhat later stage, or are in a period of high valuation but also high revenue / defensibility, might be more appropriate for the end of a fund, where the investor has fewer years to show a return to the LPs.
What it means for you: If you are doing something very ambitious, highly experimental, or not very viral, you may be better off working with investors who are at the beginning of their fund life, because they are willing to ride for a longer time than investors who are making only a few more new investments before they raise their next fund.
Most investors have an expected return of 3-5x over at most 10 years, with a preference towards 7 or even 5 years. This fund structure forces liquidity in a timeframe that is almost always sub optimal for the business.
A business should exit based on one of the following:
- When they have an amazing opportunity to combine forces with another team (like Youtube and Google, or Vine and Twitter)
- When the market (IPO or private) is commanding a premium and the management wants to take advantage of it
The last reason to exit should be when the venture investor needs liquidity, or when its fund life is ending. That reason is ultimately a random decision based on a decades-old custom, but is not actually aligned with anything relevant to the company.
We are working on ways to address this misalignment, but perhaps this is a helpful reminder to founders about what investors have to think about as they make investments.