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Living off the Fees

There has been a lot written lately about VCs living off their management fees (I mentioned it here).  This is a side-effect of large fund sizes which throw off 2+% management fees per year.  The bigger the fund, the larger the fee.  And, the VC partners of large funds tend to keep any 'excess' fees (beyond operating expenses) as a 'bonus.'  The problem is that VCs make a lot of money each year from their fees, significantly lowering their motivation to drive value in their investments (which would reward the VC in carried interest).  This is an even bigger problem in buyout funds, although they have had good performance lately.

This morning at breakfast, an entrepreneur told me that he felt that a lot of start-up executives were inheriting the 'living off the fee' mindset from their VCs.  Because many serial entrepreneurs have not made money from their equity in their recent companies, or have had their equity squeezed from multiple rounds of capital, executives are focusing more on getting 'market' salaries and on having job perks (flying business class, etc.).  They also see the lifestyle that the high VC fees have provided for their board members.

To me, this totally destroys the start-up model.  One of the main advantages that a start-up has is a highly motivated workforce.  You really can't afford to pay in cash to compensate a start-up executive for the high-level of work they have to do.  But, if their equity pays off, they could end up doing very well.

The key is to make a lot of progress on a little capital.  That's the only model that ensures that the VC gets a good multiple on their money (which they and their limited partners require) and the entrepreneurs still have a lot of value left over to divide up between them.

If a company can generate an exit value of $100M on $8M of total invested capital, that's a 12.5x multiple on capital.  If the VCs owned 67% of the company for their $8M, the VC would make just over 8x on their money (they're happy) and the entrepreneurs still have $33M to divide up between them (they should be happy).  This is a simple analysis assuming no bells and whistles on the VC terms.

It's much worse if the company has to raise $25M to get the same result.  By this time, the VC's probably own 80% of the company.  So, they make just over 3x while the entrepreneurs and employees (and there are likely many more of them for a company that has raised and spent this much money) will split up $20M.  This might seem like a lot of money, but chances are that this kind of deal also has some VC bells and whistles which suck another $5M out of the entrepreneurs pockets.  Not much of a payout for a $100M exit.

The lessons: Clean deals.  Simple terms.  Raise only what you really need.  Be frugal.  Stretch your cash.  Get to break-even as quickly as you can.  And we should all have our compensation dependent on the upside.


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Sorry for the delay in posting your comment, chirpy. Movable Type was set up to let me know when someone commented, but for some reason your comment was put in the Junk pile. I didn't discover it until just now. Thanks for commenting.

Here's the thing, Mike. You know the drill -- in a GOOD VC fund:
- 20% of VC investments return 10x+;
- 60% return 1-4x;
- 20% get written off.

When the return is sub 2x, it's likely the preferences wipe out the common. And of course the entrepreneurs share of the company is divided among a lot of people --- the execs and the option pool. If there's been 2-3 rounds, the founders are most likely down to a small single-digit percentage of ownership. If there's been 3 rounds, there's a high probability there's a new management team in place (vs. the start), who are now the ones fully-incented to make the company succeed.

So, *now* look at the payout potential:
- Get funded, and your odds look ok; you've got a 50/50 chance of *some* exit;
- But you've only got a 10-20% chance it'll be big. If it isn't, you've got a 80% chance that the pool the entrepreneurs get is sub $10M. That pool has to be split up a lot of ways.
- And that's if you still have an interest if/when the exit happens.

There is now WAYYY too much case history that shows personal wealth probability is pretty darn low for the entrepreneurs. Only the rare entrepreneurs will walk away with BIG money. Most of the rest will get little (except for whatever CEO happens to pull the acquisition rabbit out of the hat in the end.) The VCs can make a reasonable return off the 20/60/20 rule; but the entrepreneur is all-in; it's all or nothing.

When you look at the alternatives available to entrepreneurs (other than starting a company), some of them look like they have some appeal; better salaries, better retirement plans, etc.

So I think what you're seeing is that Entrepreneurs are looking for is to shift the balance a little bit. We're less willing to suffer for ONLY the too-remote remote chance of a wealthy exit. We want a little more payoff NOW for killing ourselves to get the company build. We're not looking for riches in salary; just a bit more compensation for the value we're providing in trying to build wealth for the investors.

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