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How VCs Make Money
- H8crilA 7y agoOne 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.
- woah 7y agoIt’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.
- csa 7y ago> 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.
- hef19898 7y agoFunding 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.
- csa 7y agoAssuming 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.
- hef19898 7y agoThanks 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?
- clintonb 7y agoYes. Stripe Billing (https://stripe.com/billing https://stripe.com/billing) supports recurring invoicing (e.g. subscriptions) and non-recurring invoices.
- paulddraper 7y agoVCs sell rocket fuel. If you're building a rocket, buy some rocket fuel. Otherwise, go to the gas station/bank.
- nickpinkston 7y agoYea, 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.
- nicoburns 7y agoI 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.
- soapboxrocket 7y agoThe 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.
- robbiemitchell 7y agoYes! 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).
- camjw 7y agoCall 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.
- H8crilA 7y agoOh yes, you're completely right. I oversimplified :) And, to nitpick back: the logarithm of stock return is normally distributed under B-S.
- camjw 7y agoSorry 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 https://www.investopedia.com/terms/b/blackscholes.asp
- H8crilA 7y agoIt'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.
- camjw 7y agoI 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
- smabie 7y agoGood 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.
- H8crilA 7y agoYeah, 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?).
- motohagiography 7y agoWow, 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."
- alpha_squared 7y agoIf 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.
- mdorazio 7y agoThat'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.
- davidu 7y agoMost 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.
- refrigerator 7y agoBrilliant 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?
- harveyesq 7y agoBecause 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).
- refrigerator 7y agoHow 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?
- harveyesq 7y agoYes 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.
- DrAwdeOccarim 7y agoAnd they can also probably file 83(b) elections claiming the profits interest have zero value to start the LTCG clock and avoid wage tax...
- ignoramous 7y ago> (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 https://en.wikipedia.org/wiki/Glass_ceiling
- Roritharr 7y agoI've sometimes wondered if transitioning from CTO to VC makes sense/is possible, has anyone tried that?
- tiborsaas 7y agoYou 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.
- xky 7y agoI 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.
- superhuzza 7y agoPaul Graham essentially went this route, no?
- harveyesq 7y agoI don't think Paul was ever much of a fan of VCs, particularly early on. See http://www.paulgraham.com/venturecapital.html http://www.paulgraham.com/venturecapital.html
- sjg007 7y agoYC, 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.
- zkid18 7y agoI enjoy reading Adrian Colyer‘s blog https://blog.acolyer.org/ 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
- xorfish 7y agoSo 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?
- harveyesq 7y agoBingo
- fnord123 7y agoIf 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/ https://finance.yahoo.com/quote/SPY/performance/
- xorfish 7y agoSo 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.
- notfromhere 7y agoThere 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.
- WooShoa 7y agoI 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.
- ninkendo 7y agoThis 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.
- harveyesq 7y agoGP = 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.
- bennylope 7y agoI 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.
- agustif 7y agoMy bet would be General Partner, LP = Limited Partner?
- achenatx 7y agoIm 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.
- imgyuri 7y agoFor those who don't know, their website https://vcstarterkit.com/ https://vcstarterkit.com/ is pretty amusing as well.
- jordanpg 7y agoMissing 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.
- pipogld 7y agoI 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.
- EGreg 7y agoVC means Venture Capitalist
- Bootwizard 7y agoYou are reading a news site run by a Venture Capital company. I feel like you should know what VC means.
- posedge 7y agoHe is probably referring to GP and LP, which are not explained in the text. I found that annoying as well.
- flashjpr 7y ago> 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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- teslaberry 7y agozero interest rates = vc multiples going up over time = ponzi finance. it's the nature of time.
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- chewz 7y ago> 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-returns-v-stocks-and-bonds/ https://finnscave.com/2016/12/13/venture-capital-cash-return...