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Know How Your VC Gets Paid

The bear market brings several implications for startups looking for funding.
March 17, 2009
URL: http://www.entrepreneur.com/article/200814

Startups planning to raise venture capital in these turbulent times should pay attention to the way investors get paid during bear markets. Compensation incentives drive the behavior of venture capitalists more than they do for angels and other noninstitutional investors.

Most funds pay staff salaries from a management fee that's calculated as a percentage of assets under management. Warren Buffet likes to call these investment professionals the "2-and-20 crowd," because the formula used to calculate their fees is typically 2 percent of funds under management and 20 percent of the upside return. Some VC funds with specialized skills or storied histories can justify fees of 3 percent and 25 percent to 30 percent of the upside.

The current recessionary environment has exacerbated an already difficult situation for VC funds. The past decade hasn't been kind to the industry. While management fees have enabled most VC professionals to earn a decent living, the investment returns haven't enabled the industry at large to get rich or satisfy the expectations of pension funds and other investors. Only the best venture capitalists--the top quartile--have earned annualized returns exceeding 10 percent. According to the National Venture Capital Association (citing Thomson Reuters data), in 2007, the median return of VC firms in the industry was below 5 percent for nine of the previous 10 years. The top firms and partners have done well in certain years, like 2005, but the industry cannot thrive if the median returns don't justify the higher risk profile of VC deals.

For startups trying to raise money now, there are several implications:

Asheesh Advani is president of Virgin Money USA, author of Investors in Your Backyard and founder of CircleLending, which pioneered the business of managing person-to-person loans and mortgages and was acquired by the Virgin Group.