In the venture capital world, there are largely 3 constituents: The GPs (investors), the LPs (pension funds, endowments, universities, family offices,

Clouded Judgement 10.25.24 - Misaligned Incentives

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2024-10-31 19:30:01

In the venture capital world, there are largely 3 constituents: The GPs (investors), the LPs (pension funds, endowments, universities, family offices, sovereign wealth funds, etc who give money to GPs), and founders (portfolio companies). In the early days of venture capital, it felt like the incentives were all quite aligned between these 3 groups. Win together, lose together. There were even specific mechanisms introduced in the GP - LP part of the equation to ensure this - the GP commit. This is the amount of money the partners themselves commit to the fund, oftentimes expressed as a percentage of the overall fund size. As a GP, if your own money was at stake, you’d put more thought into every individual investment.

Today, I want to talk about the GP - Founder leg of the equation, and how the incentives are diverging. I think it’s an important dynamic for all founders to recognize. In order to have this conversation, we must first start with defining the incentives. For the GP, the monetary incentives are two fold - salary and carry. Or, “2 and 20.” Venture funds charge a management fee based that is a percentage of the fund size, collected annually. Generally this is ~2%. Then there is carry, or the GP’s share of profits. Generally, this is ~20%. To make it concrete - let’s use an example of a $100m fund that gets to a 3x. In this scenario the GP will collect ~$2m annually (used to pay fund operating expenses and salaries of the team), and $40m of carry ($100m fund turns into $300m, which translates to $200m of profits, and 20% of that is $40m). There’s nuance here, but broadly the 2% lasts for ~10 years, and steps down over time (probably averages closer to ~1.5% annually blended over 10 years).

For founders - the monetary incentives are clear. Build a large business where the equity stake translates into significant value!

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