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How VCs Make Money

vcstarterkit.substack.com

412 pointszigzaggy84 comments

One thing that you have to keep in mind is that the 20% part is effectively a European call option on the fund's portfolio, with strike equal to the fund's initial value (so ATM - At The Money - when the fund starts) and notional amount of 20% of the fund's value. The manager gets that option for free, in fact he's paid 2% a year to hold that long option (and do his/hers job). Call options are more valuable if the underlying security is more volatile (because there's higher chance of ending in the money), which of course encourages high risk taking.

This is all not necessarily bad, but the incentives are not to be ignored. VCs have absolutely zero interest in stable businesses (remember - they want the volatility). If you're a stable business you would want a value investor who keeps close to 100% of his net worth in his fund, like Warren Buffet or Seth Klarman to give two famous names.

It’s strange how often people need to be reminded on here that VCs invest in businesses that grow fast or fail. There’s a vocal contingent on here that feel it’s some kind of moral failing and are mad that nobody is getting excited about their bingo card creating website.

> There’s a vocal contingent on here that feel it’s some kind of moral failing and are mad that nobody is getting excited about their bingo card creating website.

LOL. I hope this is HN /s. If so, it has several layers of humor.

The guy who actually created a bingo card creation site has been fairly vocal with his stance that VC money should only be taken for rocket-ship trajectory businesses — with bingo card creation and other businesses he ran not being of that ilk.

IIRC, people have tried to get him on the VC track with a different business to no avail (yet).

Additionally, he (informally?) advises people who are applying to YC, and I think one point he consistently brings up with founders is whether they are sure that their business even wants to go on the VC path/trajectory. I think that’s a great question that many people don’t stop to ask due to the pejorative “lifestyle business” label (cough that might have a high chance of increasing ones net worth by millions rather than billions cough).

Regardless, to confirm and reiterate your point, VCs aren’t looking for singles... their looking for home runs, and they don’t mind striking out while pursuing that goal. If you take VC money, fully expect to be pushed to those extremes.

Funding a company is hard. I'm bootstrapping and funding will become a key issue in the next couple of months. My preferred solution is a classical bank loan, maybe backed up by some of the available government-sponsored programs. Why? Because while I maybe could frame my business in some VC-friendly way and go out pitching it I don't want to give up more control than absolutely necessary. Also, I am perfectly fine to have a well running mid-sized business one day (if luck will have it). VCs are not, and being forced to go for 20x+ exit can only mean one huge acquisition or an IPO. Not my cup of tea.

Also, every minute I pitch a VC is minute I cannot pitch actually paying customers. I get that some businesses need a lot of money to come up with a product and thus need VCs. I'm lucky to not need that amount of money and to finance the whole product development myself for the next couple of months.

But I can't stop wondering if it would be possible for VCs to buolzd a portfolio of profitable, cash positive mid-sized businesses to find the more adventurous investments.

Assuming that this is a business that has some sort of online component (esp. payments), consider Stripe — they offer loans based on cash flow history with their service.

I’m not sure what level of cash you need, but this might do the trick without giving up equity or control.

Not affiliated with stripe — just a fan.

Thanks for the tip, certainly will take a look, could be very helpful in case I sell stuff myself. Which also needs a lot more capital.

Does stripe also have a B2B / invoicing functionality?

Yes. Stripe Billing (https://stripe.com/billing) supports recurring invoicing (e.g. subscriptions) and non-recurring invoices.

Cool! Will definitely have a look at it!

The person you mentioned above, nickname patio11, happens to work for Stripe now. I am a huge fan of both him and the company.

You bring up a really good point about backing.

Banks generally don't give out loans to any kind of small business that doesn't have > $100,000 in assets and/or some indication of past profitability. Note that this represents pretty much all internet businesses. So it's not surprising that little funding is available for startups.

What if angels simply got into the co-signing business? Like, why give a VC $1 million when you could co-sign $100,000 loans for 10 startups? Then write it up as 10% ownership in the company or something like on Shark Tank. Sorry I'm probably conflating terms, but we have kickstarter.com so I don't understand why we don't have something like a readily available angle fund website yet.

I'm also curious about government-sponsored programs (does anyone know any?). I imaging they work somewhat like the FHA down payment grants for first-time homebuyers:

https://www.bankrate.com/mortgages/first-time-homebuyer-loan...

https://www.fha.com/program_genesis

If someone really wanted to stimulate the economy, I think internet startup down payment grants would go a long way towards that goal.

Not sure what the benefit is for the VC of co-signing a loan vs just loaning the cash themselves, but let's ignore that for now.

The terms here are that the company accepts a very low valuation ($1mm) on some equity, and then they still need to pay the money back???

Ya you're probably right. I got the idea watching an episode of Shark Tank where Kevin O'Leary offered to give someone some money with similar terms but at 15% interest because he felt that the contestant needed the money to survive (so it was riskier than usual like a credit card). Luckily they turned down the offer, and the others congratulated them that they made the right choice.

But to me it seems like there are A) a lot of startups that want loans and can't get them (almost all of them) and B) a lot of wealthy people that can't find easy investments that return over 10% interest.

So I wish there was a standard way that angels could co-sign loans (possibly even with some leverage, so maybe they could put down as little as 20% like a down payment) and then those startups could actually build something rather than spending all of their time bootstrapping and consulting to make rent.

I guess I just thought that there might be a hack here that would let banks get into the startup business through existing channels and also let angels get some leverage by potentially putting down less than the total amount they would have given before. Angels would still have the liability of potentially having to pay the whole loan back, but could take on some interest to free up the money for other things in the meantime.

So ya, it's a potentially bad deal for the company, but it's better than the current situation of not being able to get a loan anywhere.

VCs sell rocket fuel.

If you're building a rocket, buy some rocket fuel. Otherwise, go to the gas station/bank.

Yea, I mean I get why a lot of people would be angry that their very real, but not VC fundable, business is hard to finance. There's a lot of things that should exist that have small markets, long time horizons, lots of upfront risk, are in markets that VC's don't understand, etc.

The shame is that for many of these there are likely possible funding sources that could exist, but new asset classes are hard to get started, especially when LPs are pretty risk averse and experience strong herd mentality effects.

I think it's a failing of our economic system that wealth is concentrated enough for VC's to exist in the first place. It would be better if such investment power was distributed.

The problem as I see it is that Bingo just isn't a dynamic game, you have a static card with single numbers called out. My bingo card app is unique in that fact that your card changes in direct relation to the number of possible win paths you have at any given moment.

Yes! VC is an asset class targeting high-growth, high-risk opportunities. As an LP (e.g., pension fund, college endowment, individual baller), you put some % of your money in VC funds as part of a broad portfolio of investment types.

If you want to grow a stable business and share portions of your revenue, there are other sources of investment such as Private Equity and plain-old debt (loans).

  Call options are more valuable if the underlying security is more volatile 
  (because there's higher chance of ending in the money)

Whatever the volatility is you still (in Black-Scholes) have a 50/50 of the option ending ITM (stock returns are normally distributed, higher volatility just means higher std. deviation). One reason why ATM options are more valuable with higher volatility is because there's a greater chance of the option ending far away from the strike price (either in the positive OR negative direction), so there's a lot of time value on those.

This doesn't discount the rest of your post though, clear that VCs go for high risk options.

Oh yes, you're completely right. I oversimplified :)

And, to nitpick back: the logarithm of stock return is normally distributed under B-S.

Sorry to be that guy again but B-S assumes stock prices are log-normally distributed but stock returns are normally distributed :) [0]

[0] https://www.investopedia.com/terms/b/blackscholes.asp

It's all fine :).

I thought that "stock return" is the [exit price]/[entry price], for an asset that does not pay dividends, no? exit/entry still requires a log() to be normally distributed, for example exit/entry is non-negative, wile gaussian is of course sometimes negative, no matter what the mean is.

I think your formula is slightly off.

Stock return = (exit_price - entry_price + dividends) / entry_price.

It’s clear that then the mean return is the dividends paid and can be negative if the exit price is sufficiently low. I think by a bit of squinting (using the central limit theorem) you can say that this should be normally distributed as long as entry_price and exit_price have the same distribution

I still think it should be log()ed explicitly.

Coming back to options world, entry_price is a constant when opening the contract, let's ignore dividends, the formula is (exit_price - entry_price) / entry_price = exit_price/entry_price - 1 = exit_price/constant - 1.

This is normally distributed if, and only if exit_price is normally distributed. You'd want to to add back the 1, log() it, add back the log(constant) to cancel it out and just work on the log(exit_price) normally distributed random variable.

Stock return really is not normally distributed. Log(stock return) is normally distributed (under B-S, it's an assumption after all). Stock return is log-normally distributed. Multiply by 1/entry_price and subtract 1 to get your version of stock returns.

Good insight, but the incentives don’t exactly match up to how you describe. Their investments actually looks like an American option instead of a Euro option because they can flip their investments when in the black. Since it’s not possible to cash out Euro options in this way, their incentives and compensation look much more like American options than Euro ones.

Yeah, realistically it's something like a call option, not exactly European or American. The details depend on how precisely is the fund structured. Most importantly - when exactly the fund managers are allowed to cash-out their 20% of wins (at the end of life of the fund? perhaps the fund is in principle perpetual? perhaps whenever there's a successful "exit" of one of the investments? perhaps every year if it's in the green?).

Wow, what a great post.

The most interesting question for me is, if you are a company with VC money and they are on your board, does the age of the vintage of the fund the money came from impact the strategy of the company down to a product level?

It looks like you could literally calculate/estimate the time left in the fund and see how much pressure it will put on the CEO to get positioned for an exit, then predict that impact on product, and the entire culture of the company.

e.g. "we're an engineering driven company," vs. "the fund that gave us the money has 2-3 years left in it, which means all our product decisions are based on getting positioned for a forced exit, so create tech debt and STFU."

If I understood the post correctly, fresh investments typically happen at the beginning of the fund. Only half of investable money is invested so that follow-on investments could be made when those portfolio companies go to raise again. It seems like the pressure might be on you, as a startup founder, if your vintage is underperforming and the fund is nearing the end of its expected return. Others in the vintage may have even had an easier time exiting, even if modestly, because they weren't encumbered with the pressure of carrying the vintage -- if that makes sense -- since they wouldn't be around near the expected return date.

That's the "Investment Period" quoted in the tweet. In the example it's 4-5 years, which means the fund needs to do its initial investments in 4-5 years from the fund start date. If you're in the later portion of this window, you're effectively going to get less time to build your business before the firm is pushing you to exit or looking to abdicate/write you off.

Most funds these days, at large firms, are fully deployed within three years. So a ten year fund still has 7 years left on the clock, and then there are ways to extend the clock beyond that.

The huge winners take even longer to reach a liquidity point, and this class of investors are very patient.

VCs worry about that sort of stuff when they decide which fund to spend out of but companies generally don't.

LPs are patient with the returns, and in extreme cases VCs could even "buy out" the equity from themselves with another fund.

The only thing really visible to portfolio companies is "we have X dollars for these stages".

Brilliant post — very informative + clearly written.

> What goes unsaid, is that only the actual partners in the fund get any carry, associates just get a comfortable salary and the prospects of becoming a partner (at another firm obviously)

"(at another firm obviously)" — I've heard this in other discussions about VC careers too. Why is it the case?

Because it takes 10 or more years for one fund to run its course. If the associate stays with the VC firm, it's a long uphill road rising to the top. The fastest shortcut is to jump over to another firm that needs that associate's skillsets, and might even be open to issuing a profit's interest (split off of carry).

How come they need to wait til the whole fund to run its course before bringing on new partners? Don't they raise new funds every few years, before old ones have entirely exited?

Yes but the average partner per fund for microVC (under $100M) is less than 2 people (1.94 is the average). So unless you're working for a large VC platform with several funds and plenty of room on the team's cap table, you're waiting patiently on the sidelines of a very long game.

And they can also probably file 83(b) elections claiming the profits interest have zero value to start the LTCG clock and avoid wage tax...

> (at another firm obviously)

I have no insider knowledge but I guess it might be due to glass ceilings: https://en.wikipedia.org/wiki/Glass_ceiling

> I have no insider knowledge

Probably best to stop there then, as this has nothing to do with it.

To cherrypick quotes from topmost the comment:

"It’s hard to escape from the shadow of your mentor and find your own footing."

"It’s a harder sell when you are promoting from within..."

"A16Z used to have a rule where no one internally would be promoted to be a GP..."

From where I come from, the term glass ceiling is not just limited to women but all forms of discrimination at workplace denying someone/anyone a rise up the ranks. In the US, the term seems to be exclusively used in the domain of gender dynamics.

That may be how you use the term, but that's not what the term means.

> The metaphor was first coined by feminists in reference to barriers in the careers of high-achieving women.[0]

> "A glass ceiling" represents a barrier that prohibits women from advancing toward the top of a hierarchical corporation.[0]

[0] https://en.wikipedia.org/wiki/Glass_ceiling

Thanks.

> That may be how you use the term

That's the thing: It's not just me, but the entire country where I work, doesn't limit its usage to gender or minority.

> but that's not what the term means.

"a situation in which progress, esp promotion, appears to be possible but restrictions or discrimination create a barrier that prevents it."

https://www.thefreedictionary.com/glass+ceiling

"Invisible but real barrier through which the next stage or level of advancement can be seen, but cannot be reached by a section of qualified and deserving employees. Such barriers exist due to implicit prejudice on the basis of age, ethnicity, political or religious affiliation, and/or sex."

http://www.businessdictionary.com/definition/glass-ceiling.h...

"Since becoming commonplace in contemporary language it [glass ceiling] has become generally applied to obstacles encountered in any field and by any group"

https://www.phrases.org.uk/meanings/glass-ceiling.html

"a point after which you cannot go any further, usually in improving your position at work"

https://dictionary.cambridge.org/dictionary/english/glass-ce...

Your username is accurate in this case.

May be. I try to be a little less ignorant everyday, though. That's why we are here, on news.yc, I guess; to exchange ideas, to engage in discussions, to learn from whoever would teach.

Fair enough.

To your point in the other related thread about the usage of the term glass ceiling, there's nothing discriminatory about this specific practice in the VC community. No matter the gender, race, sexual orientation, or whatever other metric you'd use to describe an associate that could in theory be used to discriminate, a VC firm does not have an incentive to promote from within, and actually has incentives not to do so as described by another poster.

Thanks. I concur. I must point out that glass ceiling is also used to mean, a point after which you cannot go any further, usually in improving your position at work...

I've seen more than one associate at a VC firm become partner. And I don't know that many VCs funds intimately (about 40).

Partners have two jobs at firms: raise money from LPs and convince great founders to take the firm’s money. If you were hiring a partner you would choose to go in this order: poaching a star partner from another firm, hiring a star founder/operator, an all-star associate at a more successful firm, promoting your own associate.

Any of the first three options will help sell LPs and founders on your new fund by bringing along some brand name credibility. It’s a harder sell when you are promoting from within, especially as associates do not have experience raising money from LPs.

Another reason: Venture firm partnerships are inherently political environments and perception matters. It is akin to why grad students are discouraged from becoming professors at the same school they got their PhD from. It’s hard to escape from the shadow of your mentor and find your own footing.

There a few other reasons that promotions are rare, but they do happen. A16Z used to have a rule where no one internally would be promoted to be a GP because they only wanted to have former operators be partners (they have now since changed that policy https://a16z.com/2018/07/17/connie-chan/)

I remember going to A16Z a few years ago, and everybody was called Partner. Looking at Connie's LinkedIn profile it looks like she too was "Partner" and then promoted to "General Partner". Does that mean the "Partner" title is kinda BS and they only really mean Partner when you are a GP?

Yes, a16z famously lets everyone call themselves “partner” as a form of title arbitrage

https://vcstarterkit.substack.com/p/how-vcs-choose-twitter-b...

Funny article. Surprisingly useful (as someone who is not part of VC Twitter)

However, I've heard partners at a16z get carried interest in the funds to which they are connected. So the title isn't actually far off.

Funds have a long lifetimes, especially if you count follow-on investments from the same LPs.

Timing is very important, and it's likely that another VC firm has more opportune timing than the one you are currently at.

Just like becoming principal engineer. You will never do it at a company you joined as merely senior, unless you are approx employee #5 or earlier.

it should be obvious why. there's no more room (nor need) at the top. if you wait for it, you are not waiting for your skills to be recognized, you are waiting for someone to die.

This article needs to define its terms. What is a GP? Sure I can google it but this is supposed to be an article that explains that kind of thing, I may as well just google how VCs make money and read a different article.

GP = General partner;

LP = Limited partner

GPs are the VCs, the ones wearing Patagonia puffer jackets. LPs are the actual investors, including pensions, endowments, sovereign wealth funds, high net worth individuals, and on occasion, larger institutionals like hedge funds and publicly traded corporations.

I think the reason GP and LP weren't defined is that they're abbreviations for common[ish] terms that apply to partnerships generally, not specifically to venture capital or finance.

My bet would be General Partner, LP = Limited Partner?

Im not an expert, but LP since it refers to investors is likely a limited partners.

VCs are probably also structured as limited partnerships.

Limited partnerships will typically have "General Partners" who have voting control and no liability protection. And Limited Partners who have no voting control, but have liability protection. All the partners are "owners".

A partnership agreement can probably structure control any way, but in my limited experience the above are generally true.

Limited partnerships are tax advantaged structures that dont require any W2 wages to be paid to execs (unlike S corps and LLCs). This means all the money can be given out as distributions which avoid all self employment taxes. The main advantage of an LP (like an LLC or S corp) is that they are tax pass through entities so income taxes are only paid once (unlike a C corp)

Unlike an S corp, limited partnerships can distribute tax liability to GPs and LPs using any algorithm they wish. LLCs must distribute tax liability to shareholders according to their ownership percent.

For those who don't know, their website https://vcstarterkit.com/ is pretty amusing as well.

Missing only a complementary headset with a little yellow foam ball on the mike so that, as a legendary, venerated VC, with zippered vest and arms outstretched, you can stand on a dazzling, shiny stage and impart your profound wisdom to the enraptured audience before you.

I've sometimes wondered if transitioning from CTO to VC makes sense/is possible, has anyone tried that?

I have not tried it but I have seen it done. Some VCs like to have in-house technical expertise to better assess candidate companies. I'm not sure if it would be a clean transition but there definitely seems to be a pathway for it.

Paul Graham essentially went this route, no?

I don't think Paul was ever much of a fan of VCs, particularly early on. See http://www.paulgraham.com/venturecapital.html

YC, effectively, owns the whole stack (i.e. vertical). Their main selling point is the YC network and being founder friendly to derisk creating startups. YC also created the continuity fund that is where the typical VC comparison would be. I am not sure what the terms on it are but I imagine it is geared only to their companies. This means YC is willing to assume more risk and gives a vote of confidence for their products. It's amazing really to see this grow as big as it has in 15 years give or take.

I enjoy reading Adrian Colyer‘s blog https://blog.acolyer.org/

He is a Venture Partner with Accel in London. Prior to this position he spent 20+ years of the career in technical roles.

I think VCs can only benefit from professional diversity. AFAIK, some of the funds even for associate positions they are looking for CS people

The TL;DR here is that it's possible to transition into a VC role as a former CTO but it's not a common pathway.

Many VCs have followed a standard pathway from Harvard/Stanford/Whartonn MBA into a fund (because it checks the boxes of LP due diligence) , but if you are looking to shortcut that process, then you have to consider how other VCs got their start.

The great debate in VC is whether Operator VCs (those who have founded or operated a business) are better suited to VC than Investor VCs (those who haven't founded or operated a business, like most Wall Street types)?

The data indicates there is no clearcut answer. You can read the CB Insights analysis here: https://www.cbinsights.com/research/founders-best-venture-ca...

Also, Fred Wilson (@AVC) wrote an article that indicated investor VCs make the best kind of VC more often (which of course can be analyzed otherwise): https://avc.com/2017/05/investor-vcs-and-operator-vcs/

The important things to note are that 1) VC is not monolithic and 2) VC is multi disciplinary.

The best VC fund managers need to be great at raising capital, have excellent deal flow/selection, know how to communicate, negotiate and close deals, be valuable board members, manage a fund portfolio and exit portfolio companies to return capital to the fund's LPs.

Finally, here are the top three reasons why Fred Wilson thinks many of the best VCs, at least of his generation, were not entrepreneurs and operators before becoming VCs: 1. Manage People. Avoiding the temptation to operate and instead managing well from a distance. 2. Strategic Mindset. Understanding where value is going to be in an emerging market, how to get to the best strategically positioned companies first, and how to guide those companies toward a strategy that wins the market. 3. Being a portfolio team player by wearing many hats and ultimately doing whatever it takes to help solve the startup founder's biggest problems.

Also see,

“Investor vs. Operator VC” by Rory Stirling https://link.medium.com/nIPkvG31z1

Thank you very much, very helpful!

You can transition to VC any time if you have cash to burn or have connections that help you convince others to burn their money :) In the first case you are rather an angel investor.

There are plenty of examples.

The other day I talked to one of the PagerDuty founders, who is a VC now.

IMO it's a hard transition to make. VCs need networking and salesmanship more than they need technology insights.

It's possible in the same way that engineer -> product manager happens. You'll benefit from your understanding, but the biggest job requirements are ones you didn't have before.

So if 2/3 of the funds income is from the management fee, wouldn't that mean that the average VC fund clearly underperforms the market?

Bingo

If management fees are 2/3 of the fund's income then the management is twice the performance fee. Given value of fund at start (f_0) and value of fund after a time period (f_1) then the value is:

    0.02f_1 = 2( 0.2 ( f_1 - f_0))
    f_1 = 20 (f_1 - f_0)
    20 f_0 = 19 f_1
    f_0 = 0.95 f_1
    f_1 = 1.053 f_0

So management fee is 2/3 of the income if the performance is 5.3%. SPY performance is all over the place[0] but you can see years with 10% or 20% growth.

But check my math because I'm a moron.

[0] https://finance.yahoo.com/quote/SPY/performance/

So depending on how carry is calculated that would be 4.24% or 2.24% performance per year. That is far below the average return of the market.

There was a Kaiser(? maybe someone else) that over a 20-30 year period, most VCs don't return capital.

Your average VC fund absolutely underperforms, and even the "good" funds sometimes just get lucky and run with that until the good will runs out. Andreessen's 2010-11 funds have underperformed the market.

I find it interesting when people make a fundamental miscalculation like you did. They perform EXCEPTIONALLY well … when you start understanding who they are performing for.

Gold rush … something, something … shovels.

But I know. I know. I speak heresy on this site. I repent and beg for forgiveness for saying the kind has no clothes on.

So who are the shovel manufacturers in this case?

They're great for the VCs who want to harvest management fees, but not-great for the institutions who put their cash in.

The real question is: as a society should we give 2/20 to people who spend most of their time wasting time on twitter and quoting Sapiens to each other?

Just like most start-ups underperform the market.

But then you get some rocket ships.

And everyone (LP, VC) thinks they can pick the future rocket ships (VC, startup).

Maybe some of them can.

> How VCs Make Money

A: They don't. VCs are an asset class that generally is loosing money (liquidity adjusted). So do not put your money into VC.

[] https://finnscave.com/2016/12/13/venture-capital-cash-return...

I hate acronyms. I hate them even more when I found them in articles with no reference about what they stand for. Just one reference at the beginning of the text would suffice. That should be a rule in writing articles. Without it, it makes it more difficult to learn something new and it makes the whole text losing intellectual integrity.

VC means Venture Capitalist

You are reading a news site run by a Venture Capital company. I feel like you should know what VC means.

He is probably referring to GP and LP, which are not explained in the text. I found that annoying as well.

> Do you need $200M to operate a twenty person firm for four years and to keep the lights on to make follow on investments for the next six years? Not really.

What a joke. Ofc you do. Like all satire aside, that's a middle-class statement.

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