How Do Investors Make Money?
When you're raising money for your startup, it helps to understand how the investors you're pitching will make money for themselves. The formula for paying investors is often not as simple as taking their return on investment and allocating it equally among the key players. For angel funds, venture capital funds and other investment partnerships, there are often complex formulas for how the individuals involved in managing investments make money. You should keep the following formulas in mind when developing your fundraising approach.
Angel investors typically make investment decisions regarding startups without paying others to manage their money. Therefore, the return on their investment usually won't involve paying any intermediaries. This can make a startup investment more attractive than alternative high-risk investments that usually involve paying a broker, money manager or another financial intermediary. One of the shareholders in my company once commented that he was particularly happy with his investment because it was one of the few direct, "commission free" investments he had made. Saving 1 to 2 percent per year in investment commissions and fees can make a significant difference in comparing startup investments to alternatives.
As I've mentioned in past columns, there's a growing trend for angel investors to come together and invest as a fund. Typically, these funds make investments ranging from $100,000 to $500,000 at one time and occasionally are supplemented with private investments from individual angels. These funds tend to be small in size, which makes it difficult to afford full-time investment professionals to manage the fund. Nevertheless, a significant amount of time is spent on meeting organization, decision coordination and due diligence required to manage these bands of angels and fulfill the promise of the angel fund model.
Therefore, more often than not, angel funds have one or more investment professionals--often working part-time--paid as managers for the fund. Their compensation involves cash and a bonus tied to the fund's performance. The exact nature of this compensation is related to the fund's origins. If the fund was initiated by its managers, the compensation is usually more substantial and tied closely to the performance of the investments the fund makes. If the fund was initiated by angels who subsequently hired a manager to handle the meeting coordination, the compensation formula is skewed toward cash rather than performance bonus.
This matters for you because it determines if the investment manager for the angel fund is really just a gatekeeper or is both a gatekeeper and a genuine contributor to the investment decision making. When pitching angel funds in which the managers are paid based on fund performance, you should keep in mind that the terms of the deal will often involve negotiating with the fund manager. Put another way: Avoid the temptation to disregard the gatekeeper once you're past the gate. In these types of angel funds, the angel investors will vote on whether your pitch was a success and then appoint a small committee to conduct due diligence and negotiate the deal; more likely than not, the fund manager will be on this committee.
Venture Capital Firms
Warren Buffet famously describes some investors as the "2 and 20 crowd." This refers to the formula that has become popular among many investment funds--particularly hedge funds that invest in the stock market, but also venture capital funds that invest in private companies--when compensating fund managers.
The investment management fees are calculated as 2 percent per year of the total size of the fund plus 20 percent of the upside return. Some venture capital firms with specialized skills or outstanding reputations can justify fees of 3 percent and 25 percent to 30 percent of the upside, but most tend to charge fees in the "2 and 20" range. The fees are paid by their investors, often called limited partners. This means that a $500 million fund generates $10 million in fees per year, even before it's earned any of the upside returns. That's enough to pay generous salaries to several partners, associates and support staff.
There's an interesting discussion in the blogosphere about whether the "2 and 20" formula makes investment managers lazy. The argument is that since they earn such generous salaries, they don't work as hard as they should to coach their companies to generate returns. I haven't met enough lazy VCs to form an opinion on this, but it's worth reading the blogs on this topic. After Warren Buffet's disparaging remarks on the "2 and 20 crowd" in his letter to Berkshire Hathaway shareholders , this debate has led to a very revealing discussion about how investors justify the money they make. For a glimpse of the discussion, read these blogs from TheFeinLine.com and SeekingAlpha.com .
Since the real legwork for most venture capital firms is done by associates and other non-partner investment professionals, such as vice presidents and principals, it's actually more helpful to study their compensation. These are the individuals who'll be screening your business plan, meeting you and deciding if you should present to the partners.
The typical associate earns an annual salary of $100,000 to $200,000. That amount is usually higher for associates based in competitive markets, such as New York City, or those working for larger funds. In addition, some funds allow associates, VPs and principals to earn some of the upside of the investments the fund makes, often called a carried interest or "carry."
Most VC funds encourage associates to find attractive deals that get funded to increase their salary or their carry. It's not unusual for associates and non-partner professionals to toil for many months or years before successfully finding a deal that gets funded, let alone one that gets funded and achieves liquidity for the investors. Evaluating performance of non-partner professionals is very difficult if the returns are only realized many years later, often after the associate has moved on to another job. This leads to a culture that many entrepreneurs complain about: The associates have the power to say "no," but not "yes."
You can spend a lot of time explaining your business to an associate who wants to learn about your market and appear knowledgeable to the firm's partnership, but at the end of the day, it's the partnership that will decide to fund you or not. Some associates, however, have considerably greater decision rights and a keen ability to help the entrepreneur get funded. For example, they may have earned the trust of the partners or spent many years understanding the motivations of each decision maker.
You should listen carefully to feedback from associates wanting to help you navigate the partnership; they can be the closest thing you have to a friend in the fundraising process. But if you haven't been introduced to a partner after two or three meetings with an associate, you're probably wasting your time.