There appears to be a gap between founder and VC compensation. New VC models are emerging which may change this. Or not. What do you think?

Jonathan Abrams of Nuzzel set off an interesting conversation on Twitter about founder and VC compensation recently. It’s not a topic you see discussed often so I thought some elements were worth highlighting.

The conversation began due to a line from this article in Harvard Business Review titled “VCs get paid very well to lose money” by Diane Mulcahy (holy clickable title):

“Several VCs support the idea that entrepreneurs should be paid $100k (or less) per year until their companies are profitable. What if LPs structured VC compensation that way?”

Within the convo is some more data from Sand Hill Econometrics which found that

“When adjusted for risk, the payoff for an entrepreneur taking venture capital money was no better, on average, than taking a salaried job for a person of similar background.”

Given this apparent dichotomy, it’s been interesting to see some of the newer funds emerge which are trying to do things a bit differently. Think Felicis, which recently said it would vote in-line with its portfolio founders, or Kent Goldman’s Upside Partnership, which is sharing carry with founders.

So we wonder, is the misalignment between VCs and entrepreneurs really as big as suggested above?  And if yes, what models are emerging, if any, to address this? And are these new models real substantive changes or just marketing?

Would love to hear your thoughts in the comments.

  • http://www.camblain.com/ Jerome Camblain

    interesting newsletter

    Sharing carry or voting along with the founders are two different things, …both to attract the best startups:
    1) the clients of the VCs is therefore not the LP anymore, but the entrepreneur….unless VC’s are becoming marketplaces. In which case the chicken and the egg problem is newly resolved by attracting the entrepreneurs first to get the LPs coming- a real change.

    2) sharing the carry is a pressure on margin in a competitive business. You got to love this
    Unless it is a form of discount to attract startups on price, instead of on added value the VC will bring to the party…

    But voting along is a unrealistic commercial move that negates the investor’s added value to his/her LPs

    Congratulations for your business impact

  • Shri Bhashyam

    Great post. As the funds grow larger in size, VCs can continue to get fat off of management fees. But the dichotomy between founders and investors does not stop at cash comp. Consider equity exits as well. VCs want their hits and are often agnostic about which portfolio company delivers the hit, so they may (short-sightedly) push them all towards becoming a unicorn, along the way passing up great exits that would have been much more meaningful for the founder than the VC.

  • http://500startups.com/ Dave McClure

    full disclosure of VC fund performance and compensation would do wonders to improve overall behavior, performance, alignment of VCs & LPs.

    however, most funds hide behind SEC regulatory BS, other poor rationalizations for not disclosing.

    we intend to change that.

  • http://www.4044walnut.com Anand Sanwal

    Dave – love your style. Thanks for the comment.

  • http://www.4044walnut.com Anand Sanwal

    Shri — Thanks for the comment. I’ve heard & seen similar things where friends startups were encouraged to take more money so they could go big. I suppose a lot of this means that the founders need to ensure they know what they’re getting into from an expectations perspective, i.e. $100 million exits don’t do much at all for funds that are hundreds of millions of dollars in size.

    Have you seen any funds (or anecdotally heard of any) that are able to bridge this dichotomy. I imagine it’s easier as a smaller micro VC as the exits are meaningful for both sides, but as funds get larger, it is more difficult. Thoughts?

    Thanks for reading and the note.

  • http://www.4044walnut.com Anand Sanwal

    Thanks Jerome. Your 2nd comment about voting along with founders is one we’ve heard a lot. It will be interesting to see how that plays out when a founder is making a decision the VC completely disagrees with.

    Sharing carry is an interesting idea for sure. If there is carry :)

    Thanks for reading and for the comment.

  • http://www.onceabeekeeper.com/ Kevin Swan

    What I always like to tell an entrepreneur is to not let the size of the fund, and thus, economics of the fund dictate how much you should raise and what a potential exit could look like. As soon as you take that $10-15M Series A from a $300M+ fund you are going to have to figure out how to spend it and achieve an exit in the 100s of millions. Heck, some VCs even write that in the term sheet as a requirement!

    Anand, you are right that raising from smaller funds can create much more alignment for the founder. If it turns out the market opportunity is large enough then you can always raise that larger round down the road.

  • http://www.4044walnut.com Anand Sanwal

    Thanks for reading and the comment Kevin.

    What we’re seeing with smaller funds is that as they have good performance, they almost invariably all go upstream (bigger size funds) where the alignment starts to become tougher.

    This is perhaps natural as LPs throw money at these funds and the management fees become enticing. It will be interesting to see if any of today’s micro-VCs which “kill it” decide to stay small or whether everyone continues to get larger over time.

  • http://www.onceabeekeeper.com/ Kevin Swan

    You are correct. One reason I have a lot of respect for First Round Capital. They have shown restraint in this way and kept each of their funds relatively the same size despite likely being able to raise much more.

    The other thing I find interesting is that when a micro-VC ‘kills it’ and goes out and raises a larger fund they are no longer able to follow the same model that lead to their success as the economics don’t allow it. Same goes from moving from a $150M to $500M fund.

  • http://www.4044walnut.com Anand Sanwal

    Yes indeed – FRC is pretty remarkable in this regard.

    What’s more is that all the research shows that fund size creep correlates negatively with performance. Essentially, the skills to manage $100 million is very different than the skills of managing $500 million.

    But those fees certainly do look enticing :)

  • http://www.sourceasy.co/ Pranay Srinivasan

    I would add Union Square Ventures to this list who have raised almost every fund to be ~$85M – aside from their sidecar late stage follow on fund which has no management fees.

    Its truly interesting to see micro VCs who’ve traditionally written $200k cheques struggle with wanting to write $750k-$1M cheques because their fund size has tripled..

    Perhaps an article on what the optimum size for a micro-VC fund would be to manage LP / Founder expectations would be awesome?

  • http://jimshook.tumblr.com/ Jim Shook

    If I were an LP, I wouldn’t mind paying the fee as long as it was clear there was quality effort and thought put into investment decisions. Anyone can take money and give it to people. As long as there is transparency in what is being done and the thought process (a high bar though) put into investments, I’d be fine with however they decide to spend the fee.

  • http://teten.com dteten

    One way to analyze this based on public data is to estimate the financial model of a given VC. You can
    do this with probably ~80% accuracy by collecting: AUM (relatively easy to find) ; returns data (somewhat publicly available, e.g., on preqin and I think CB Insights); headcount (easy to find on linkedin); approximate compensation for different levels of staff (easy for people below the Partner level, on glassdoor.com , Salary.com, glocap.com (via relationship), etc.). You can reasonably assume most compensation after paying non-Partner staff, taxes, and overhead either goes to Partners, or is reinvested in the business. In my research on VCs with a portfolio operations model (see http://teten.com/VC-consulting ), it was striking that such VCs (OpenView Partners, ff Venture Capital, Andreesen Horowitz, First Round Capital, etc.) typically have much larger headcount for a given level of AUM than do traditional VCs. Anand, contact me offline if you want to dive deeper into this
    research topic; we’d be glad to help.

  • Shri Bhashyam

    I think 500 Startups (full disclosure, they’re one of my investors) falls in the category of Micro VC that bridges the dichotomy. @davemcclure:disqus has been vocal about being happy with “doubles” if it makes sense for the company and not pushing each portfolio company to a homerun exit.

  • http://www.sourceasy.co/ Pranay Srinivasan

    Yea and their fund size has actually tripled :-)

    PS full disclosure: they’re one of my investors too :-)

  • philjeudy

    Vcs do not play in the same courtyard than entrepreneurs. Managing P&L issues for a guy who get money to create a product is one thing, and the effect is a control of the investment made on his head. I’m not sure you will have many VCs going for their own funding knowing the fact they have to wait for profitability before being decently paid (we’re not talking about kids-Tshirt-flipflop on their 25 here). There might be some ways maybe of giving additional incentives to entrepreneurs bringing profitability to their VCs fund. Or maybe I’m wrong.

  • http://captainkinnard.com/ Ben Kinnard

    For better alignment, why not set the management fee in dollars instead of %? If you need $2m a year for offices, travelling, salaries etc. with a $100m fund, there’s not a strong argument for this doubling alongside your AUM – you are still doing the same amount of work, and your carry should be bigger anyway. Too naive?

  • http://www.4044walnut.com Anand Sanwal

    Jim – Thanks for reading and for the comment. Those are pretty subjective measures unfortunately. I’m sure most anyone can dress up a crappy process to make it look high quality and thoughtful at the time? The real test is when the exits and associated results occur which is very time-lagged.

  • http://www.4044walnut.com Anand Sanwal

    Ben – good idea. I suspect that as fund sizes grow, the team and other things grow accordingly. That said, your point is a good one as I’m not sure the 2nd $100 million requires 2% as much as perhaps the 1st $100 million. I think some funds do offer management fee structures like this but probably the exception more than the rule.

    Disclaimer: I’m not a VC. Just a poorly paid founder :)

  • http://www.4044walnut.com Anand Sanwal

    Pranay – thx for reading and great comment. All the research actually shows that fund size creep is correlated with poor performance for the exact reason you highlight. Writing checks out of a $10 million fund requires different skills than a $100 million fund vs a $1 billion fund.

    That said, we see funds chasing larger fund sizes increasingly because those management fees are sweet :)

    Union Square Ventures and First Round Capital (Kevin Swan mentions) are great examples of those who’ve stuck to their core size with some alterations to ensure they participate in upside (USV with their Opportunities fund)

    More on USV here in case you’re interested – https://www.cbinsights.com/blog/union-square-ventures-teardown/

    And Fred’s teardown of our teardown here – http://avc.com/2014/08/tearing-down-the-teardown/

  • http://www.4044walnut.com Anand Sanwal

    David – VC performance data kinda blows though, right? Dan Primack and others have pointed this out recently although it’s been known for a while.

    https://www.cbinsights.com/blog/venture-capital-performance-data/

  • http://teten.com dteten

    Yes, of course the data available is incomplete. However, this analysis is still feasible, with a higher level of accuracy for those funds for which performance data is possible. For all other funds, you would just assume the VC earned median returns (which are mediocre as noted).

    That said, the ideal way to do this analysis is partner with some institutional VC fund of funds, and negotiate for them to share with you anonymously their real time-stamped cash in/cash out activity with each VC.

  • http://www.4044walnut.com Anand Sanwal

    That’d be the way to go. Any volunteers?

  • http://www.sourceasy.co/ Pranay Srinivasan

    I happened to read Fred’s teardown of your teardown first! :) Great research based on public / anecdotal data though..

    I think its also interesting that 500 has 8-10 investing partners across the world, whereas most micro-VC funds have 2-3. I do think that fund size : no of investing partners is a huge signal as well as fund size grows.

    Might be something there.

  • http://jimshook.tumblr.com/ Jim Shook

    Agree, but there is a large luck component to returns as well, realistically. Just because a VC found themselves in a huge success doesn’t necessarily make them a good VC going forward. So I’d just dive deep into their process/mindset. Which is why I think its so important for VCs to blog/be transparent, etc.

  • http://www.4044walnut.com Anand Sanwal

    Jim – luck is def important, but the reality is that in VC, performance persists. In other words, past returns do indicate future returns. It’s not like public markets for any # of reasons (information asymmetry being a big one).

    There may be a handful of funds who get lucky with 1 big exit, but as we’ve shown before [1], there are very few who are consistently good at getting into venture’s black swans.

    [1] https://www.cbinsights.com/blog/billion-dollar-exit-venture-capital/

  • http://teten.com dteten

    I’ll contact you offline.

  • Tom Cannon

    Founders should be aligned with their first investors at minimum and terms of any follow on rounds post seed and post start up, should reflect a vesting of stock ownership. This is reasonable and fair to all. If there is Stock (equity) paid or considered as part of the ‘deal’ then it should be stated as such in writing as a condition of investment. part cash comp part incentive stock participation.
    Investors do not want any founder member to walk with the stock that the investors made of value by investing capital.

    I have seen many companies collapse from dumb deals with founders –too much too soon and to the detriment of all. I have fought other founders members as their being unreasonable and not fair minded. If you want someone’s money, then be prepared and offer to risk you getting yours or go away.
    No freebies guys and gals.

    As for VCs ~ they will make their payday(s) on % carry, Success Carry split and each round marks up anyway, so they cash in sooner than the company does.
    It is the VCs’ problem to determine what is fair for them. if their LTD investors disagree, then change, or do no invest in this fund. The broad compass of compensation is tricky and perhaps the most vital determinant of any start up. Not one # is fair and making a # to apply to all is irrelevant. However, for sure, bonuses should not come from investor dollars any more than dividends should be paid to convertible/subordinated debt or coupon yielding is to be paid annually from a company that is not profitable or at least cash flow positive. Vesting periods is a responsible quid pro quo method of compensation. rare, but it happens that a flyer entrepreneur is able to keep it all no strings. fine. rare — do not let your judgment get clouded by your own myopia toward the bigger picture

  • CB Insights

    A comment we received from a former LP who wished to remain anonymous is below.

    I wanted to shoot you a quick note with a thought related to your post on Founder vs. VC Comp. You mention (particularly in the comment section) the temptation of VCs to raise larger funds due to increased management fees – I would respectfully contend this is a secondary motivation for moving up the food-chain for many venture capitalists. What I always worried about from the perspective of an institutional limited partner evaluating funds was the impact on risk tolerance of investments – the larger a fund size, the lower the return required to generate the same dollar amount of carry. Simplistically, if a fund doubles in size, it can generate the same carry pool ($ value) with a 50% lower return. This incentive to raise larger funds is often obscured behind additional management fee, but I actually think it is economically more relevant to LPs, and potentially has a more adverse affect on a firm sticking to its strategy.

    Frankly, I was always surprised that there wasn’t more innovation around fee terms in partnership agreements – more aggressive sliding hurdles? percentage carry reduction with larger AUM? I think LPs are pushing back on fees more aggressively now, and there are certainly some more creative structures out there, but the 2/20 standard is still dominant and frequently unquestioned.