I wrote a post last week about the challenges in valuing portfolio companies in venture capital that I thought was wonky and inside baseball. But when I got lots of follow-up questions from people, I realized that the basic mechanics of how the VC industry works remains opaque — including even to entrepreneurs who interact with the industry on a daily basis. So this post is an attempt to clear some of that opacity, by defining some basic terms (bolded below), beginning with a bit of history…
Where does the money come from?
Some have argued that Queen Isabella of Spain became the first true venture capitalist when she backed an entrepreneur (Christopher Columbus) with capital (money, ships, supplies, people) for his venture (voyages seeking westward routes to Asia). Because Queen Isabella was taking a big risk for something so probabilistically unlikely, she had an asymmetrically high payoff compared to her at-risk capital; most people at the time thought the idea was insane and certain to fail.
Something similar played out in the United States, in the whaling industry circa the 1840s. Financing a whaling venture back then was expensive and fraught with risk, but, when successful, also highly profitable. So in New Bedford, Massachusetts, “agents” (the equivalent of today’s venture capitalists) would encourage these whaling expeditions (the “startups”) by raising capital from corporations and wealthy individuals (the equivalent of today’s limited partners) to fund the ship captains (the entrepreneurs). As the ventures were plagued with failure — 30% of voyages lost money — returns were asymmetrically high and skewed to the top agents.
Less than 50 years later, J.P. Morgan — the financier and banker whose legacy led to the Wall Street investment bank Morgan Stanley — would act as “venture capitalist” to entrepreneur Thomas Edison by financing the Edison General Electric Company in 1878. He also became its first evangelist and beta tester by having Edison wire his Manhattan home. Rumor has it that not only did Morgan’s house almost burn down from some of the early wiring mishaps, but his neighbors also threatened him over the huge noise emanating from the generators required to sustain the illumination. In any case, banks would continue to play a significant role in the direct financing of many startup businesses until the 1933 passage of the Glass-Steagall Act restricted these activities.
Today, VC firms exist by the grace of limited partners (LPs) who invest some of their own funds into specific VC funds. They do this because as part of their desire to maintain a diversified portfolio, VC is intended to produce what investment managers refer to as alpha — excess returns relative to a specific market index. Though each LP may have its own benchmark, common benchmarks are the S&P 500, Nasdaq, or the Russell 3000; many LPs will look to generate excess returns of 500-800 basis points relative to the index. So if the S&P 500 were to return 7% annualized over a 10-year period, LPs would expect to see at least 12-15% returns from their VC portfolio. As an example, the Yale endowment’s venture capital portfolio has generated returns north of 18% per year for the past ten years vs. an S&P 500 return of about 8% in the same time period.
There are all types of LPs, but most tend to fall into the following buckets:
Universities (e.g., Harvard, Yale) — Nearly every university solicits donations from its alumni for their endowments. The returns on investment from these endowment funds are used for operating expenses and scholarships and, in some cases, to help fund capital expenditures such as new buildings. The Yale endowment, for example, contributes to about 1/3 of the annual university operating budget.
Foundations (e.g., Ford Foundation, Hewlett Foundation) — These non-profit organizations are bequeathed money by their benefactors and are often expected to exist in perpetuity on those funds. The returns on investment of these funds enable the foundation to make charitable grants, and, in the U.S., foundations are actually required to pay out 5% of their funds each year in support of their respective missions to maintain their tax-free status in the U.S. Thus, over the long term, real returns need to exceed this 5% payout level to ensure a foundation’s existence.
Corporate and state pension funds (e.g., California State Teachers Retirement System, IBM pension). A few corporations, most states, and many countries provide pensions for their retirees, funded mostly by contributions from the current employee base in a pay-as-you-go system. The ability to generate real investment returns helps offset the inflation (particularly in healthcare costs) and the shifting demographics (which results in more retirees than current employees) that continually eat away at the value of the pension fund.
Family offices (e.g., myCFO, US Trust). These investment managers invest on behalf of very high net-worth families. Their goals are set by the individual families, but often include multi-generational wealth preservation and/or funding large charitable efforts.
Sovereign wealth funds (e.g., Korea Investment Corporation, Temasek). These organizations manage the economic reserves of an entire country (the reserves are often the result of something U.S. citizens know nothing about — government surpluses!). The returns are then used for the current or future generations of citizens.
Insurance companies (e.g., Metlife, Nippon Life). Insurance companies invest the premiums they earn from policyholders (known as “float”) for when they are required to pay out future benefits.
Fund-of-funds (e.g., Harbourvest, Horsley Bridge). These private firms raise funds from their own LPs and then invest that money in venture capital and other financial managers. They aggregate small LP assets and then deploy that capital into VCs (as opposed to other venture LPs who invest directly into VC funds) because as smaller instances, they would otherwise find it difficult or economically inefficient to do so.
Remember, none of the above institutions invests only in venture capital; rather, they all construct diversified portfolios comprised of different types of assets — public equities, bonds, hedge funds, real estate, commodities, and so on. Venture capital investments tend to be a very small portion of most institutional asset managers’ portfolios: Yale has among the highest VC allocations at 16% of its net asset value; for most other LPs, 5% or less is a common target. Some LPs struggle to get to just 1% VC!
While VC dollars are a significant source of capital facilitating new business creation, the total capital deployed is remarkably small. Here are some 2015 numbers to illustrate:
- The U.S. VC industry raised about $28 billion in new capital.
- Google and Apple combined spent about $20 billion in R&D alone.
- Private equity buyout funds raised about 10x that amount.
- Hedge fund assets under management were about $3 trillion.
- The 500 largest U.S. public companies distributed more than $1 trillion in cash back to their shareholders.
- U.S. GDP was about $17 trillion. VC dollars are a fraction of a fraction of a percent of this.
In fact, U.S. VC funding over the last fifty years tops out at $600 billion — total.
Yet the entrepreneurial ecosystem that VCs have the privilege to help fund punches well above its weight in terms of impact on the U.S. economy: According to a study conducted at the Stanford Graduate School of Business, 43% of U.S. public companies founded since 1979 were funded by venture capital. These companies now comprise 38% of all employees, 57% of the total U.S. market capitalization, and account for 82% of all R&D spend — a proxy for further innovation growth — in the United States.
[The Stanford report measures its data from 1979 because before then many institutional investors — specifically those who manage pension money — were prohibited from investing in VC. But a regulatory change known as the “Prudent Man Rule” implemented in 1979 cleared the way for these institutions to include VC among their investable assets. So even though some VC funds existed prior to 1979, many people date the birth of the modern VC industry to that year.]
So: VCs simply raise money from LPs via a fund (in our case, we most recently raised our fifth and dedicated “bio” funds). In reality, the legalities of raising and closing a fund are actually not so clear. I won’t dive into the mechanics here, but there are a few things to note for the purpose of our discussion:
- Limited Partners (LPs) are so named because in the VC fund, they are legally “limited” partners — they do not have any decision-making authority in investments the fund makes and thus have no liability if things go awry.
- General Partners (GPs) are the legal decision-makers in the fund and also bear the full brunt of liability. GPs are fiduciaries to the LPs, meaning that they have a legal responsibility to act in the best interests of the LPs. (One clue that things are getting serious in a startup board meeting is when a VC declares “I’m a fiduciary!”)
When a VC closes a $100 million fund, it doesn’t collect that $100 million up front from LPs. Rather, the LPs make a financial commitment over the life of the fund to provide the capital when “called” (capital calls) by the VC. The reason for this practice of calling capital is simple — keeping cash idle in the VC bank account depresses the ultimate rate of return a VC can earn for its LPs. Just-in-time calling of capital eliminates this drag on returns. And when a VC does in fact call capital from LPs, it also calls capital from its GPs. The exact proportion is a function of the terms of the fund, but in most cases the GPs contribute between 1-3% of the capital and the LPs contribute the rest.
Show me the money
The common thread throughout the history to the evolution of VC is that venture capitalists invest funds — some combination of institutions’ and their own — in promising entrepreneurs who hopefully, over time, build great companies with great returns. VCs and everyone investing in venture capital are optimizing for slugging, not batting average (“the Babe Ruth effect”), where a few “home runs” or big hits account for most of the returns.
So what does that mean for how the economics of VC works?
The “J” curve
As with fine wine, VC funds should get better with age. That’s why people in the industry refer to funds by their “vintage year” (or birth year), just as winemakers date-mark their wines based on the year of grape production.
In the early years of a fund, VCs are calling capital from LPs and investing that capital in companies. This is a negative cash flow motion — money is going out with no likely near-term prospect of money coming in. That’s expected, but eventually a VC must harvest some of those investments through those companies going public or being sold. As the time to exit for many private companies continues to elongate (in many cases to 10+ years), the inflection point on the J curve has and may continue to push even further out.
One phrase you often hear in the halls of VC firms is “lemons ripen early” — that is, the non-performing companies tend to manifest themselves close in time to the initial investment. Interestingly, this exacerbates the J-curve problem in that not only are VCs investing cash in the early years of a fund, but the non-performing assets are also likely to get “marked” down in these early years as well.
By contract (defined in the limited partnership agreement), VC funds are required to report their interim performance to LPs, typically on a quarterly basis. There are two components to what VCs report — realized cash distributions and unrealized carrying values of the remaining assets. Realized cash distributions are just as the name suggests — cash (or stock) realized by a VC upon a portfolio company exit event that is distributed to the LPs. Unrealized carrying values, which we’ve already covered elsewhere, reflect the estimated fair market value of a portfolio company if it were to be liquidated today by the VC.
VCs report interim performance for two primary reasons:
First, most LP compensation plans are designed around investment returns relative to various benchmarks. Thus, while eventual cash is king to the livelihood of the institution, annual cash in the form of bonuses each year is queen to the individual employees of LPs. Calculating those bonuses requires a measure of interim performance.
Second, remember how we talked about how, to maintain their tax-free status, U.S. foundations are required to pay out 5% of their assets each year in the form of grants? To satisfy this requirement, foundations have to know what 5% equals in terms of real dollars, which requires that they have a fair value assigned to every asset in which they invest. This is easy if they hold public Google stock, as they can just look up the price on a Bloomberg terminal. But to do so for private assets requires the VC to make a fair value assignment for them.
Interestingly, this is why the longer gestation period for VC funds could impact foundations more so than other LPs — they have to pay out 5% annually, whether that is based on cash received or whether just interim unrealized carrying value. Since foundations can’t spend marks, the timing of cash returns from VC and other private asset classes truly matters there.
University endowments don’t have a legal obligation to pay out each year, but they are an important contributor to operating expenses at their universities and therefore de facto pay out each year. Because they have more flexibility on the absolute amount, most universities use what’s called a “smoothing formula” for payouts that helps them avoid major ups or downs in the value of their portfolios. So Yale for example pays out an annual amount equal to 80% of last year’s payout + 20% of its targeted payout (an amount set by the investment committee) multiplied by the value of the portfolio from two years prior. This helps the university plan its budget without too much variation from changes in the endowment value — but to do so does require that all managers (including VCs) provide Yale interim estimates of the value of their investments, even if the actual cash outcomes end up being very different.
Speaking of those actual cash outcomes (the gestation period of J curve), let’s assume the VC has done its job — investing the $100 million fund it raised in great entrepreneurs, some of whom ultimately built great companies. Let’s also assume one of the companies in which the VC invested gets sold and, based on its stake of ownership, the VC receives a check for $60 million.
How does the money then get divvied up between the LPs and the GPs?
Most VC funds entitle the GP to earn a carried interest — a portion of the profits of the fund — of 20%. So, in our example, if the fund gets a $60 million check, it gives 80% (or $48 million) to its LPs and keeps 20% (or $12 million) for the GPs.
But is there really a “profit” on which the GP is entitled to take its 20%? The answer is… maybe. If all the other investments in the fund haven’t worked out, then the fund invested $100 million and has only returned (and will only ever return) $60 million, so in that case the answer is no. There are no profits and all $60 million goes to the LPs. The GPs not only earn no carry on this fund, but will also have a hard time raising their next fund.
What happens if, instead of every other company in the fund going extinct, the other companies are valued based on interim unrealized carry value at $140 million? Now, the fund has $60 million of actual cash and $140 million of hypothetical value in the form of marks, for a total of $200 million in current value. The fund only raised $100 million from its LPs, so there is $100 million ($200 in current value minus $100 million in LP money) of theoretical total profit on which the GP can now take 20% of the $60 million in cash. So, 80% ($48 million) goes to the LP and 20% ($12 million) goes to the GP.
Why didn’t we calculate the 20% based on the full $100 million in theoretical total profit? Because we can’t distribute marks, just like foundations (and other LPs) can’t spend marks. Another nuance to introduce here is the concept of recycling. Most VCs have a provision in their agreements with LPs that allows them to re-invest (“recycle”) some portion of their interim winnings into other companies. So, in our example above, the VC might have elected not to distribute the full $60 million (to the GP or the LP), but rather to utilize some/all of the money to re-invest into other companies in the current fund.
Since we glossed over the finer legal details of fund formation for the sake of simplicity, there are some other concepts to at least be aware of. For example, some funds prohibit the GP from taking any carried interest until all $100 million in cash had been returned to the LPs. How and when monies can get distributed is outlined in what is called the waterfall language of the limited partnership agreement that governs the fund.
We also ignored the question of whether the management fee — the annual fee based upon the size of the fund that the GP uses to pay salaries and other expenses associated with running the fund — counts when calculating the fund’s profits. This too is specified in the limited partnership agreement.
Now, fast forward to when the fund is over; most funds have a 10-year life with two or three 1-year extension periods. Assume that all of the $140 million in interim marks proved ephemeral and all of the companies that comprised those marks proved to be worth no more than the paper this post was originally written on. In our last example, the fund generated only $60 million in total returns on a fund of $100 million, but the GP distributed $12 million to itself back when the prospects for the fund were looking up. In this case, the GP has over-distributed to itself and is subject to what’s called a “clawback” — the money needs to be returned by the GP and distributed to the LPs. That sucks, but is fair in that the GP never would have been entitled to that money had it waited to distribute the $60 million until the fund was over. Yet again (and again and again and again), cash remains king.
VC is an interesting business that has long lurked in the shadows of finance. Hopefully, this post helps shed light on it.