Last week, I wrote about the one ingredient required to “get into” venture capital – context. For folks investing today, there are countless more opportunities to invest and some of them actually do not require that much context. It’s the subject for another post, but we seem to be living in a world of abundant capital, and more and more entities and families and the like seem to be interested in becoming limited partners. This has enabled an entirely new class of individual to 1/ become an investor and 2/ “get into the carry.”
If last week’s post stressed the importance of context as a prerequisite of being competitive in venture, this week’s post will stress the importance — and difficulty in accessing — the carried interest on a venture investment. (There are scores of posts and data on how venture math works, so I won’t reproduce those here. Below, I will offer a very simple math example to illustrate the point.)
For folks who find themselves in venture, the next hurdle is to figure out how to get into the carry. This works very differently across firms. Some firms simply don’t share carry past the general partners — no junior investment staff member receives contractually-based carry, which vests with service. Some of these firms may issue bonuses. I’d guess the majority of firms offer some contractual carry to junior staff, along with sweeteners for sourcing a winning deal and/or exceptional performance.
In either scenario, a junior investment member who sources, helps win, or helps a breakout portfolio company may not receive that much of the coveted carried interest associated with the deal. There are nuanced arguments here. The management company of a fund may artfully argue that the firm’s brand helped source the deal, too; that the firm’s reputation helped win the deal, too; that a senior investment member took on the legal responsibility of sitting on the company’s board of directors for many years; that the firm has to pay back its fees to LPs before dipping into the carry; and so forth. For the junior investment team member who worked on some aspect of the deal, they’re often left to the whims of their elders as to how much carry they’ll receive. For a young investor, this is compounded by the reality that they may need to switch firms to advance in title, so oftentimes folks will jump to a new platform and forego their carried interest from the previous fund.
No matter how you slice it, there are more options for would-be investors to run their deals and get into the carry. There has been explosion of new seed funds, many now saying we’re over 500+ micro-funds, defined as being sub $100M. Special purpose vehicles (SPVs) are now prevalent and have been weaponized by platforms like AngelList, who empower a new breed of investors to run their own funds (where risk is pooled) or as a set of individual SPVs, where an investor can get into the carry rather quickly since SPVs are done on a deal-by-deal basis — think of an investment fund with just one company in it.
What’s clear is that the next generation of investors want to “get into the carry” as fast as possible, and many of them are electing to strike out their own by creating their own funds, collecting LP capital, and running their own deals.
[This is a good point to stop and illustrate the quick math on carry — For the sake of this post, assume there is a $100M fund with 4 GPs and 2 junior members who don’t get carry. Assume the 4 GPs split carry equally. Assume total carry is standard 20%. Assume fees are 2% and it’s a 10-year fund, so $20M of the $100M are contractually at the GPs discretion to allocate to salaries, services, infrastructure, etc. which all need to be paid back — but that the GPs cannot get into the carry until all $100M has been returned to LPs. Once that happens, 20% of the “profits” get shaved off for the house. Now, let’s take this further – assume the fund has a massive winner and turns into a “4x gross” fund, which means they turned $100M into $400M. That means the fund’s profits are $300M, where 20% (or $60M) flow to the GPs — each GP pockets $15M. Assume they are good humans, and they together pool some of that to help payout staff from those vintages. Sounds good, right? There are a few issues here, however: 1/ Assuming a small fund like this would own 10% (which is still high) of their company at exit, to generate $400M gross returns their portfolio would, in aggregate, have to generate $4B of enterprise value. Good luck with that! And 2/ this could take 5-7 years, even longer, to transform into reality.]
I see a lot of folks dying to get into venture, but lots of them haven’t obtained the “context” I wrote about last week. More troubling (for them) in my opinion is that with more entry points now that don’t seem to reward context, I see more folks flooding into a business model they don’t quite fully understand. In the $100M fund example above, assume with 4 GPs, they have $2M a year in fees to allocate. They’ll have an office, some staff, business expenses, travel, legal, accounting, tax, compliance, reporting, and much more. What could seem like a lavish gig could quickly feel less appealing than some other well-paying jobs in the Bay Area today. Even then, assume folks are comfortable taking that risk — they are playing for 5% carry in a world where there are so many funds, the rewards folks are fiercely fighting for may in fact be quite small, relatively speaking.
There are other folks who are creating single GP funds, which if constructed properly, could generate returns that are meaningful to an individual assuming they stay small (where it’s hard to earn a salary). However, it still costs real money to rund a traditional fund, no matter how small, so AngelList’s ability to turn this into software is very powerful. Then there are folks who don’t need the salary of a fund in management fees and are running AngelList Syndicates (essentially SPVs) to invest in specific deals. Say a Syndicate leader invests in 30 SPVs over 3 years, where 29 are losers, but just 1 is a winner — the GP in this case will only lose their principal investment in the 29 losers and take carried interest in the 1 winner, regardless of when that liquidity occurs. (Many folks believe this adversely harms the LPs in an SPV by not pooling risk.)
It’s worth it for me to stop here and underline that investing in startups isn’t entirely about the money nor should it be. Economically speaking, it is not an rational career to undertake. It’s great fun, do not get me wrong, but there’s more money to be made elsewhere, and faster. You have to really love the people and be very patient. Yet, I see so many folks drawn to the apparent glamour or allure of riches, and it is simply not like that *unless* an investment really hits. Then, yeah, it is a great business model, but it takes time, luck, and patience to see that through, ingredients which are difficult to assess in the early days of one’s investment career.
Last week’s post on “context” generated a rich discussion and one of the elements I found the crowd to be most curious about was the carry and how to access it. So, that’s why I wrote this post. If you’re lucky to be able to invest in good startups, you can get into the carry by asking the fund you work for, or running your own fund on AngelList (but you have to find LPs, which is even harder!), or can run SPVs on a deal-by-deal basis, which requires you to have cash up front and a steady stream of backers who will show up for each SPV.
There you have it. For an investor, “getting into the carry” is a must yet it is very hard to achieve. Folks today are taking many different paths to get there, but there are no promises unless you run your own fund or own deals — and to do that, you have to have LPs who will back you repeatedly over time. That LP and repeat-game dynamic itself will likely be the subject of the next post.