Venture Capitalists Get Paid Well to Lose Money(blogs.hbr.org)
blogs.hbr.org
Venture Capitalists Get Paid Well to Lose Money
http://blogs.hbr.org/2014/08/venture-capitalists-get-paid-well-to-lose-money/
35 comments
Further I don't think that making it easier to get involved is helping. The ideas of incubators and demo days and all that kind of stuff means really well. But it's along a faulty line of thinking IMO. It goes like this: making it easier to start a company will get more people involved and increase dealflow and that'll increase successful outcomes.
The problem is that as many people have said, tenacity or stubbornness or gumption are highly valued for founding a company. There's the assumption that bringing more people into the startup ecosystem won't substantially change the demographics and thus the statistically likely outcomes. Making it easier doesn't cause everyone to have less gumption but it does lower the bar which allows people with less in and that lowers it on average.
Changing the demographics like that seems to be somewhat self-defeating in a way. It just increases the pool of candidates from which the VC has to successfully winnow down to the ones he/she thinks have the best odds of going ballistic. The game is harder, not easier.
I think a large part of the problem is that the country/world as a whole doesn't change fast enough. In order for a VC to bag a 1000x return it's got to be a national or global scale company. For that to happen the whole world or a substantial fraction thereof must learn about the company and want to avail themselves of the products or services. That's a few billion people you've got to convince; these companies are largely consumer-oriented as of late. But human beings only spend so much leisure time learning about new things to do or buy or what-have-you. It's very, very difficult to convince the whole friggin world to change within the roughly 10 year timeframe of a particular VC fund.
Investing in companies which need more money to have a reasonable chance at success sounds really dumb until you analyze the situation a bit. In those cases, money might well be the real limitation rather than the entire world. As such a VC might have a little more control over the outcome and that's an edge.
The problem is that as many people have said, tenacity or stubbornness or gumption are highly valued for founding a company. There's the assumption that bringing more people into the startup ecosystem won't substantially change the demographics and thus the statistically likely outcomes. Making it easier doesn't cause everyone to have less gumption but it does lower the bar which allows people with less in and that lowers it on average.
Changing the demographics like that seems to be somewhat self-defeating in a way. It just increases the pool of candidates from which the VC has to successfully winnow down to the ones he/she thinks have the best odds of going ballistic. The game is harder, not easier.
I think a large part of the problem is that the country/world as a whole doesn't change fast enough. In order for a VC to bag a 1000x return it's got to be a national or global scale company. For that to happen the whole world or a substantial fraction thereof must learn about the company and want to avail themselves of the products or services. That's a few billion people you've got to convince; these companies are largely consumer-oriented as of late. But human beings only spend so much leisure time learning about new things to do or buy or what-have-you. It's very, very difficult to convince the whole friggin world to change within the roughly 10 year timeframe of a particular VC fund.
Investing in companies which need more money to have a reasonable chance at success sounds really dumb until you analyze the situation a bit. In those cases, money might well be the real limitation rather than the entire world. As such a VC might have a little more control over the outcome and that's an edge.
That all makes sense, but you didn't propose an explanation for why people are choosing to put their money into VC rather than an apparently better-performing investment.
Other responses are "people like to gamble" and "they THINK they'll make more money in VC" and both of those are really good explanations.
I think there are other explanations too. I'm sure there's a lot of prestige that goes with being an LP in a VC fund. It's a diversified investment that isn't going to be as correlated with the market as say GE will be. If the VC fund you invest in under-performs there's really no way out except to wait it out and not invest in the next fund they raise. That sounds like a bug but it might be a feature since money managers are often under pressure to perform and putting money into a VC basically locks it up. That means decisions about what to do with that money don't have to be made regularly which could be a nice little bonus.
> why people are choosing to put their money into VC rather than an apparently better-performing investment.
Basically because the future is unknowable and there are plenty of VCs who do well. I saw some chart where the top x% (I can't remember nor can I find it) of VC get basically all the returns. Because VC is so unevenly distributed there's a small chance that the probably under-performing fund you invest in MIGHT be one of the break-out VCs that'll end up capturing a large portion of industry returns rather than being paid well to lose money. And if your job is to manage money that might be an attractive proposition; prestige, excitement, diversification, a 10 year set-it-and-forget-it investment, and a small chance of making a big return.
I think there are other explanations too. I'm sure there's a lot of prestige that goes with being an LP in a VC fund. It's a diversified investment that isn't going to be as correlated with the market as say GE will be. If the VC fund you invest in under-performs there's really no way out except to wait it out and not invest in the next fund they raise. That sounds like a bug but it might be a feature since money managers are often under pressure to perform and putting money into a VC basically locks it up. That means decisions about what to do with that money don't have to be made regularly which could be a nice little bonus.
> why people are choosing to put their money into VC rather than an apparently better-performing investment.
Basically because the future is unknowable and there are plenty of VCs who do well. I saw some chart where the top x% (I can't remember nor can I find it) of VC get basically all the returns. Because VC is so unevenly distributed there's a small chance that the probably under-performing fund you invest in MIGHT be one of the break-out VCs that'll end up capturing a large portion of industry returns rather than being paid well to lose money. And if your job is to manage money that might be an attractive proposition; prestige, excitement, diversification, a 10 year set-it-and-forget-it investment, and a small chance of making a big return.
People like to gamble. GE will never return 5-10x your money over two years, a VC investment just might.
Because they speculate that they will make more money there...
You'd be surprised at how many different careers pay very well to lose a lot of money. Are CEOs really worth 100x a line engineer? Especially when they oversee the gutting or collapse of their company? Probably not. With most employees salary is tied directly to their output: How much can you get done? With higher level employees it seems to be: How much can you get away with?
With the recent revelations of tech company wage cartels and systematic collusion against employees in SV by execs, I feel like the latter statement is somewhat accurate. It pays to take more than you return.
With the recent revelations of tech company wage cartels and systematic collusion against employees in SV by execs, I feel like the latter statement is somewhat accurate. It pays to take more than you return.
If the CEO can make the company lose only 1 billion this year compared to losing 2 billion if another guy had the job... then he's worth 1 billion to the company. Is paying him a few million really that big of a deal?
Another thing:
> Is paying him a few million really that big of a deal?
Paying anyone, anything, is supposed to be a huge deal. Employees get fired for sub performing for even a few weeks to a month! And we're not talking millions of dollars here, we're talking thousands. How can anyone think of "a few million" as an afterthought? That's easily the salary of 50 people. If the CEO deserves it, show us how that he is better than the 50 people we could have hired. And I mean what he specifically did, and not the 10,000 engineers under him.
> Is paying him a few million really that big of a deal?
Paying anyone, anything, is supposed to be a huge deal. Employees get fired for sub performing for even a few weeks to a month! And we're not talking millions of dollars here, we're talking thousands. How can anyone think of "a few million" as an afterthought? That's easily the salary of 50 people. If the CEO deserves it, show us how that he is better than the 50 people we could have hired. And I mean what he specifically did, and not the 10,000 engineers under him.
Where did we get this idea that a CEO is the one earning or losing every dollar that passes through the company? Is everybody insane?
> If an employee only loses their company 50K this year compared to losing 100K if another guy had the job... then he's worth 50K to the company. Is paying him a couple of grand really that big of a deal?
You know what would happen in this situation. The employee would be fired.
You know what would happen in this situation. The employee would be fired.
No. He's worth only a little bit more than how ever much it costs to hire the 2nd best guy.
> he's worth 1 billion to the company.
No, he's worth minus 1 billion, whereas the other guy was worth minus 2 billion. He's worth 1 billion more than the other guy, but that doesn't mean he's worth anything in absolute terms.
Granted, one year is probably too short a time frame to judge; if the CEO has the company making 1 billion a year after, say, three years, then he's presided over a recovery (minus 2 billion to plus 1 billion) and deserves credit (assuming the recovery is stable; even three years is probably not long enough to judge, but I don't want to make this post too long). But if his sole claim to fame is that he lost less money than the other guy, that shouldn't be worth anything.
No, he's worth minus 1 billion, whereas the other guy was worth minus 2 billion. He's worth 1 billion more than the other guy, but that doesn't mean he's worth anything in absolute terms.
Granted, one year is probably too short a time frame to judge; if the CEO has the company making 1 billion a year after, say, three years, then he's presided over a recovery (minus 2 billion to plus 1 billion) and deserves credit (assuming the recovery is stable; even three years is probably not long enough to judge, but I don't want to make this post too long). But if his sole claim to fame is that he lost less money than the other guy, that shouldn't be worth anything.
Technology is very winner take all. Like peter theil says, last mover advantage is high. Google has largely ended the race for the market to develop search, and microsoft was the last enterprise operating system. So the top VCs typically have access to the top entrepreneurs. However, this is a huge industry and the best VCs and the best entrepreneurs are in minority.
So the rest of the companies, most of which are not great or innovative, get funded by finance VCs who want to maximize return, but are not as connected, knowledgeable or high-profile as someone like DFJ or Sequia. Basically the A team entrepreneurs get funded by the A team VCs and everyone lese pretty much get's beaten by them.
Good VCs make money for their LPs which is why it is so hard to get into those funds.
So the rest of the companies, most of which are not great or innovative, get funded by finance VCs who want to maximize return, but are not as connected, knowledgeable or high-profile as someone like DFJ or Sequia. Basically the A team entrepreneurs get funded by the A team VCs and everyone lese pretty much get's beaten by them.
Good VCs make money for their LPs which is why it is so hard to get into those funds.
Relevant: http://www.law.harvard.edu/programs/lwp/Session%20III%20-%20....
Private equity (venture capital and buyouts) hasn't done particularly well over the past few decades. Some big wins, but also some spectacular failures (e.g. $45 billion EFH buyout that ended in bankruptcy). The above analysis shows that there is a huge difference in performance between funds, and the gap is persistent. The problem is, the good funds can't absorb a fraction of the money institutional investors are looking to put in these asset classes.
Why would VC's give up their 2 and 20 when there is just so much money floating around?
Private equity (venture capital and buyouts) hasn't done particularly well over the past few decades. Some big wins, but also some spectacular failures (e.g. $45 billion EFH buyout that ended in bankruptcy). The above analysis shows that there is a huge difference in performance between funds, and the gap is persistent. The problem is, the good funds can't absorb a fraction of the money institutional investors are looking to put in these asset classes.
Why would VC's give up their 2 and 20 when there is just so much money floating around?
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2 and 20 refers to a yearly fee of 2 % of assets, plus 20 % of profits that year.
In fact, the top-performing funds now charge 2.5% and 30%.
Let me guess: "top-performing" means "comparable to an index fund".
Your comment was intended as snark, but in fact asset allocation is more complicated than analyzing year over year returns and comparing them to a benchmark. Investors might put money into an asset class that performs near an index fund, and pay more to do it, simply to have some funds allocated into an asset that isn't correlated with the index. Or the volatility characteristics of the asset classes might be important.
A small remark: thank you for not replying to what you deem to be "snark" with just more snark, but rather instead replying with something that can be replied to with a substantive comment rather than a continual exchange of ad hominems or something.
Ha. That would have been chump change for Stevie Cohen at SAC Capital. He charged 3% and 50%.[1]
Alas for Stevie, a few Debbie Downers at the US Attorney's Office (Southern District of NY) decided that some of Stevie's trades were too well timed for there not to be insider trading. That resulted in criminal convictions and jail time for some of Stevie's portfolio managers (but Stevie was never personally charged with insider trading, he was only charged with "failing to supervise").
So now poor Stevie no longer manages other people's money. Instead his firm only manages the $10 billion or so that is his own money.
[1] http://www.forbes.com/sites/nathanvardi/2013/07/24/the-gover...
Alas for Stevie, a few Debbie Downers at the US Attorney's Office (Southern District of NY) decided that some of Stevie's trades were too well timed for there not to be insider trading. That resulted in criminal convictions and jail time for some of Stevie's portfolio managers (but Stevie was never personally charged with insider trading, he was only charged with "failing to supervise").
So now poor Stevie no longer manages other people's money. Instead his firm only manages the $10 billion or so that is his own money.
[1] http://www.forbes.com/sites/nathanvardi/2013/07/24/the-gover...
the link is 404
Works for me at least. Try this shortened URL though: http://preview.tinyurl.com/lm57wd6
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This explains the crazy valuations we are seeing now. I've always been wondering who is benefiting from the huge valuations: definitely not the employees and to some extent, the founders, as all their worth are not liquid. So the ones benefiting from the high valuations are VCs, who has incentives to raise bigger and bigger funds.
"A VC firm is, first and foremost, an investment vehicle created to generate returns for investors that exceed those available in the fully liquid, low cost public equity markets. If that objective is persistently left unaccomplished, investors will allocate their capital elsewhere."
Presumably the level of returns in the equity market is somewhat dependent on the amount of new business entering the equity market and therefore the on the amount of VC capital available, so it doesn't necessarily follow that you do expect to see massive profits from your overall VC investment if you are a large enough investor to consider it to be part of safeguarding your equity investments.
Presumably the level of returns in the equity market is somewhat dependent on the amount of new business entering the equity market and therefore the on the amount of VC capital available, so it doesn't necessarily follow that you do expect to see massive profits from your overall VC investment if you are a large enough investor to consider it to be part of safeguarding your equity investments.
They also get paid exceptionally well to generate exceptional returns, so they make money either way. There is a relatively common saying in finance that 2 & 20 is the best business model that exists.
As for LP returns, if you're not investing in a top quartile (or decile) fund, you're wasting your time. There is still some turnover in which firms perform but it's relatively consistent.
Edit: I've skimmed the article, the other thing that isn't mentioned is that the 2% management fee is generally paid back to investors out of profits (if there are any).
As for LP returns, if you're not investing in a top quartile (or decile) fund, you're wasting your time. There is still some turnover in which firms perform but it's relatively consistent.
Edit: I've skimmed the article, the other thing that isn't mentioned is that the 2% management fee is generally paid back to investors out of profits (if there are any).
The incentives are setup that way.
If I were a VC with money from clients with me, telling them that I'm holding out for a good investment is a great way to lose them next year.
Money un-invested is stale capital that will definitely not earn anything back. That money could be lost on a venture - but nothing ventured, nothing gained.
In some sense, they're really paid well to not hold back on investing it - only to be penalized if they do not assume risk on behalf of the client.
If I were a VC with money from clients with me, telling them that I'm holding out for a good investment is a great way to lose them next year.
Money un-invested is stale capital that will definitely not earn anything back. That money could be lost on a venture - but nothing ventured, nothing gained.
In some sense, they're really paid well to not hold back on investing it - only to be penalized if they do not assume risk on behalf of the client.
> If I were a VC with money from clients with me, telling them that I'm holding out for a good investment is a great way to lose them next year.
VC inflows tend to be locked in after the fund has been raised.
VC inflows tend to be locked in after the fund has been raised.
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VCs provide access to small growth businesses and will never have a lack of passive investors because that sector "should be" a great profit engine. When one set of passive investors tires out due to the funds' mediocre performance, there'll be another set of suckers coming down the line.
The most underreported self-dealing by the VC class isn't the 2-and-20, but the revolving door between VC firms and overpaid executive positions at VC-funded companies. Being a partner at a VC means you get a lot of executive positions to hand out to your B-school friends who turned out to be underachievers. This means that a bunch of people will owe you favors, 10 years down the line. This type of personal draw-out (funding suboptimal businesses to win future favors from founders and other VCs, rather than the best) is also impossible to prove or even measure.
VCs draw a decent salary for themselves, but the personal career benefits of being a king-maker (which are impossible to track) are even bigger. The savvy ones essentially assure that they'll become two- or three-digit millionaires (billions is unpredictable and hard to assure; you typically have to go all-in on your own company) in the next bubble cycle. You can't not get rich if you're a VC, and for 95-99% of these guys, I could do their jobs better and I'm a 31-year-old relative nobody.
For better or worse, they're the main (and perhaps the only reliable one) valve between top talent and the ocean of passive capital seeking better returns than what index funds offer, and they're not going to give that up.
It's a Cheap Votes Problem. Why is it illegal to sell one's vote? Because, even if the statistical power of one vote is low, the statistical power of a bloc of votes can be quite high (voting blocs grow quadratically in contribution to variance). If you allow vote-buying, the people who aggregate cheap votes gain a ridiculous amount of power. This was a major problem in the Gilded Age. Venture capitalists are cheap vote aggregators when it comes to passive capital and high-talent business formation.
The most underreported self-dealing by the VC class isn't the 2-and-20, but the revolving door between VC firms and overpaid executive positions at VC-funded companies. Being a partner at a VC means you get a lot of executive positions to hand out to your B-school friends who turned out to be underachievers. This means that a bunch of people will owe you favors, 10 years down the line. This type of personal draw-out (funding suboptimal businesses to win future favors from founders and other VCs, rather than the best) is also impossible to prove or even measure.
VCs draw a decent salary for themselves, but the personal career benefits of being a king-maker (which are impossible to track) are even bigger. The savvy ones essentially assure that they'll become two- or three-digit millionaires (billions is unpredictable and hard to assure; you typically have to go all-in on your own company) in the next bubble cycle. You can't not get rich if you're a VC, and for 95-99% of these guys, I could do their jobs better and I'm a 31-year-old relative nobody.
For better or worse, they're the main (and perhaps the only reliable one) valve between top talent and the ocean of passive capital seeking better returns than what index funds offer, and they're not going to give that up.
It's a Cheap Votes Problem. Why is it illegal to sell one's vote? Because, even if the statistical power of one vote is low, the statistical power of a bloc of votes can be quite high (voting blocs grow quadratically in contribution to variance). If you allow vote-buying, the people who aggregate cheap votes gain a ridiculous amount of power. This was a major problem in the Gilded Age. Venture capitalists are cheap vote aggregators when it comes to passive capital and high-talent business formation.
"Being a partner at a VC means you get a lot of executive positions to hand out to your B-school friends who turned out to be underachievers"
You clearly have a bone to pick with the industry and that's fine. But no VC hands out executive roles to anyone they don't believe to be top talent; they'd destroy their own career, reputation, and compromise the returns of their fund.
Now, they could very well be wrong about somebody and give a job to a C- player but that'd be an honest mistake.
You clearly have a bone to pick with the industry and that's fine. But no VC hands out executive roles to anyone they don't believe to be top talent; they'd destroy their own career, reputation, and compromise the returns of their fund.
Now, they could very well be wrong about somebody and give a job to a C- player but that'd be an honest mistake.
But no VC hands out executive roles to anyone they don't believe to be top talent; they'd destroy their own career, reputation, and compromise the returns of their fund.
Well, then they're just really awful at judging talent, because founder quality is at an inexcusable low.
I doubt they'd destroy their careers by placing incompetent people in these startups. Why? Most of them fail anyway, and that's part of the design. Also, most non-founder executive roles are sinecures.
Well, then they're just really awful at judging talent, because founder quality is at an inexcusable low.
I doubt they'd destroy their careers by placing incompetent people in these startups. Why? Most of them fail anyway, and that's part of the design. Also, most non-founder executive roles are sinecures.
How do you measure founder quality? Most startups have some amount of traction when they raise VC funding. Either hundreds of thousands of users or $1M or more in revenue, especially with the bar for Series A getting consistently higher. That would speak to the quality of founders increasesing over time, not decreasing.
And that could well be the end of the article folks. VC as an industry has too much money so it doesn't generate good returns. This shouldn't be shocking to anyone.
If say GE generates $8.8b in dividends ($0.22 per share per quarter and 10b shares) and it's priced at $10 a share that's an 8.8% yearly return! But if the stock price is $50 a share it's only 1.76% return which isn't as impressive.
The only difference in those two scenarios is how much money is chasing GE's dividends.
The returns to VC are too small because the pool of talented, motivated individuals to start companies isn't getting bigger anywhere near as fast as the cost to do so has fallen. That means that VCs are over-paying for the companies that they can buy into (because they have to do SOMETHING with the money) and because they buy into more companies that won't necessarily be successful.
VCs (the human beings) don't scale the same way the companies they're investing in do. The whole idea of VC was that money was scarce and a person could only make a few bets so they could afford to spend a lot of time with each of their portfolio companies. As the amount of money needed has crept down I suspect that the number of investments has crept up and that means less time to go around and probably less good outcomes.
When it "only" takes $500k to take a swing with a company a VC can afford to look at it as a calculated bet that might pay off rather than an investment which needs care & feeding to be successful.
tl;dr the landscape shifted under VCs with the dropping price of starting a company and not all of them know how to successfully operate in this new world.
Just in case this comes across overly negative I don't hate VCs at all. I think that VC as a whole is great. I'm sure some of the individuals aren't all that great but as an industry I think its fantastic. But as an industry it might end up shrinking, too.