Reverse Engineering Venture Economics
First, they receive a small percentage of their fund as an annual management fee to pay basic operating expenses. These fees range in size, but a typical one is 2% per year. So on the $100 million fund, the GPs will take $2 million per year to pay their salaries, staff, and office expenses.
Second, they receive a percentage of what’s called the carry, or the profits from their investments. Carry percentages have a range as well, but again a typical one is 20%. Here’s where the math starts to get interesting.
Let’s say the GPs invest $4 million in your company at a $12 million pre-money valuation, so they buy 1/4 of the company. You end up selling the company for $40 million a couple years later without taking in additional capital (good for you!), so their 1/4 stake in the company is now worth $10 million. They’ve made a 2.5x return on their invested capital, bringing back a profit of $6 million to their LPs, and they’re entitled to keep 20% of it, or $1.2 million, for themselves.
Fred Wilson talks about the rule of 1/3 in Valuation, where, from a VC’s perspective, 1/3 of deals go really well, 1/3 go sideways (he defines sideways as a 1x-2x return), and 1/3 go badly and they lose most or all of their money.
So based on this rule, let’s say a "good" VC will generate an average return of 2.5x on their LPs’ money over a 5-year period (an IRR of 20%). Now let’s say on average, the GPs make 22 investments of $4 million each to fill out their $100 million fund (less the $10-12 million spent on management fees over the life of the fund), and, again on average, each returns 2.5x (recognizing that many will return zero and a few will return 10x). The VCs will have returned $220 million to their LPs on $100 million invested, for a gain of $120 million (good for them!). The GPs get to keep 20% of that, or $24 million, to split among themselves. Not a bad bonus, on top of their salaries, for 5 years of work across a small number of partners and associates.
Let’s attempt now to compare those earnings to the earnings of an entrepreneur, assuming equal annual cash compensation. An average entrepreneur of a venture-funded company probably owns somewhere between 5-10% of the company by the time the company is sold. In this same average case above, the company is sold for $40 million, so the entrepreneur’s equity will be worth between $2 and $4 million for the same 5 years of work. In this simple case, the GPs in the venture firm have earned a collective $1.2 million, much less on a per-person basis than the entrepreneur. However, in the 5 year period of time where the entrepreneur is working solely on one business, the GPs are working on 25 businesses, earning a collective $30 million. A senior partner in a small firm will end up with $10-12 million. A junior partner maybe more like $2-4 million, comparable to the entrepreneur. However, and this is an important point, most entrepreneurs probably operate at the "seinor partner" level.
So on average, I think the economics probably work out in favor of VCs over entrepreneurs in the long run, mostly because VCs operate a diversified portfolio of companies and entrepreneurs are putting all their eggs in one basket. But on any given deal, I’d rather be the entrepreneur any day of the week – you have more control over value creation, and more of a personal win if things go well. And in the 1/3 of deals that are home runs for the VC, it’s better to be the entrepreneur, since you’re much further along the risk/reward curve and have that chance of seeing your equity turn into $20 million or more in that one shot.