In this section, we’re going to talk about how VC’s actually make money.

Clint: How do you make money as a VC?

Brad: As a VC, I actually have a very simple job. I have LP’s who give me a box
full of money. My job is to give them back a box full of a lot more
money. That’s it. That’s the job.

Along the way, there are a couple of different ways that I make money
and the firm that I’m part of makes money. The first, is through a
management fee. A typical venture firm charges its investors a
management fee on an annual basis for the capital under management.
Typically, the management fee is about 2%.

Sometimes it’s a little bit more. Sometimes it’s a little bit less. That
management fee is paid annually for the first couple of years, up to the
first five years, capital under management. After that, it’s typically
based on a formula of remaining cost basis of investments.

You can get complicated about what that management fee is. It
generally tends to be about 15% of the total fund over the life of the
fund. If you think about that, if you’re an LP or a set of LP’s and a VC
fund raises $100 million, then about $15 million of that is going to go to
their management fee and about 85% of that is going to go to
investments.

The management fee pays for the salaries, the office space, and a bunch
of other things around the operations of the firm. The rest of the money
gets invested in the company. That’s step one. We’re going to come back
to that in a second because there’s a concept of recycling the
management fee. Just keep in mind that 15% number.

The second way VC’s get paid is through what’s called “carried interest”
or “carry.” After we’ve returned 100% of the capital to our investors we
then get to split the profits from that point out 20% to us and 80% to
them.

Remember that that first fund is split between the GP and LP; the VC’s
and their LP’s. If it’s a 1% GP and 99% LP, for the first $100 million a
million of the money invested is from the venture capitalists and $99
million is from their LP’s.
They would get the profits 99 to 1 for the first $100 million that comes
back of returns for money invested. Anything above that they split
80/20. It’s a little nuance, the math’s a little more complicated because
of the way that it all rolls through because you own 99% versus 1%. Just
think about it as 199 to the first $100 million and 80/20 beyond that.
That’s the second way.

The third way is that some of the expenses that a venture firm incurs
they charge back to their portfolio companies. Travel, hotels, and
different types of things that are direct company expenses. These are
reimbursable expenses. These tend to be a relatively small number in
the grand scheme of things. It’s notable because if you’re an
entrepreneur one of the things to expect is that you’re going to pay
some amount of expenses for your VC that your VC incurs coming to your
office for board meetings and things like that.

Let’s go back to the 85%/15%. That was the management fee piece. We
raised $100 million. We’re going to take a $15 million fee over the life of
the fund of ten or twelve years. The rest of that 85% or the $85 million
we’re going to invest in companies.

However, if you’re one of our LP’s you gave us $1 and I’m only investing .
85 cents of the dollar in our companies. This notion of recycling; I can
recycle proceeds that I get.

When I have a company that gets sold and we get $20 million back then
we’ll turn around and we’ll hold on to $15 million of it to reinvest the
management fees so that we actually have invested $100 million and
then we’ll distribute the rest of it out.

What this recycling does is it allows us to actually invest all the dollars.
In some ways, if you actually recycle 100% of your fee, the fee is
essentially just a pre-pay on your profits versus a separate fee.

Some venture firms don’t recycle. They’re trying to get their returns
based on $85 million invested. Others like us recycle more than 100%. In
our case, we recycle up to 115%.

The idea is that if you gave us a dollar as an LP we’re actually investing

$1.15. From that $1.15 the first dollar that goes back to you we split
99/1. Everything after that dollar, we split 80/20.
 If you think about that why would you want to reinvest those proceeds.
The more capital I’m invested of that 100% the higher the probability of
my outcomes. By actually investing $1, I’ve got a better chance of a
bigger outcome than if I only invest .85 cents.

Fundamentally when you think about how a VC and a VC firm makes

money, the real money is made from the profits from the upside, from
the success of the investments in the companies returning the capital
back to the investors. However, some of the reasons that you see funds
get bigger and bigger is because the fee gets bigger and bigger. There
are lots of people who have been in the venture business who have
never seen carry. They’ve never been in a position where they’ve gotten
that big upside check but they still got healthy salaries from those
management fees that they’ve gotten along the way. When we
configured our firm we really focused very much on the upside to us
which was what we were playing for which we felt really tightly aligned
us with the people that we were investing.

Clint: These different ways that you make money, do they create incentives or
motivations that are important for entrepreneurs to understand?

Brad: Very much so. The incentives and the nuances around how the money
works varies from firm to firm. For example, in some firms like ours all
four partners are equal. It doesn’t matter whether Jason finds an
investment and sits on the board, or I find an investment and sit on the
board, or I find an investment and Seth sits on the board. The four of us
are all sharing whatever the profits are equally.

In other firms, you have individual partners who get paid differently.
They get paid based on the performance of their own investments or
they might get different amounts of the profits based on tenure or
seniority in the firm.

Also, a newer investor in a fund might behave differently than an

investor who has been around for a while and has been very successful.
The investor who has been very successful might have more latitude to
make decisions. He might be able to make a co-investment or a follow-
on investment decision more easily than a newer partner that’s getting a
lot of scrutiny.

You could get in a situation where a partner might actually not be

performing very well and all of a sudden his or her ability to actually
 make new investments or make follow-on investments is severely limited
by the other partners in the firm. It does matter a lot the dynamics
internally. It varies partner by partner and firm by firm.

Clint: Questions on how Brad makes money?

Student: Those that hear that VC firms don’t make any money or a very small
amount of money. Can you talk about that?

Brad: There’s a lot of noise around what the actual performance of VC firms
are. One thing that you have to recognize is that the interesting number
to look at it over time, especially for early stage investors.

When you’re investing in a company you don’t expect to see a

realization for five or ten years. The measurement that any particular
moment in time is often sketchy because it’s not a consistent thing that
you’re dealing with.

In addition, the venture capital industry has for sure the Lake Wobegon
effect. It’s not that everybody is above average. It’s that everybody is in
the top cortile. You have this situation where firms are constantly trying
to adjust what’s being measured to demonstrate that their performance
is as good or better than most of the other people, which of course is
illogical as well.

Last, the numbers are fairly opaque. There are some publicly reported
data because of public pension funds. An awful lot of the data is private
or is not fully reported. As a result, it’s hard to actually match up
numbers very carefully.

That said, there’s no question that there are both firms and funds that
don’t return capital. There are periods of time, if you look for example
of any fund that was raised in 1999 or 2000, which was the very
beginning of the internet bubble. Not the beginning of the bubble but
the sort of peak of it just as things were starting to fall apart in 2001,
2002, or maybe 2003. Funds that were raised in 1999 and 2000 and
started making investments in companies at that stage, many of the
companies they invested in failed in 2001, 2002, and 2003.

Many of those funds from 1999 and 2000 are called vintage 1999 or
vintage 2000. Oftentimes, people talk about the fund as the vintage
year. We name our foundry 2007, foundry 2010. That’s the year that they
were started.
 Many of those funds, not only did they not return capital, but they
returned .50 cents on the dollar, .30 cents on the dollar, .10 cents on the
dollar. A $100 million fund might have only returned $10 million. In that
funds case, the management fee was likely paid. The VC’s got some
portion or all of their management fee but they didn’t get any of the
upside. They didn’t get any of the 80/20, the 20%.

What’s the implication if you don’t have a successful fund? You might be
able to get away with one unsuccessful fund. If a venture firm has
multiple unsuccessful funds then it’s LP’s won’t fund the next fund.
Ultimately, if you’re not being successful as a firm then you won’t be
able to get your existing investors or new investors to fund you and your
firm will shut down. You saw a lot of that happen in the last six or seven
years.

Student: As an entrepreneur, what’s the best way to judge a track record?

Brad: One is look for the history and the tenure of the individual partners.
Some venture firms are very dynamic and there has been a lot of
generational change of the partners over time.

It’s also useful to ask when the last fund they raised was. Sometimes you
can figure that out. Other times you can’t. It’s not as clear. If the firm
hasn’t raised a fund in at least five years then it’s probably getting
essentially old in the tooth or long in the tooth as a fund.

Most venture firms raise a new fund every three to five years. If a firm is
in year seven and it hasn’t raised a fund, it likely means that it’s having
difficulty raising a new fund.