It's an insightful explanation - the structure of funds, expectations of LPs, common practices in the industry, and reputation concerns lead to some incentives that are logical for a VC to follow, but perhaps inoptimum.
Why is there no recycling? It seems like a no-brainer to for the LP to allow recycling, so maybe I'm failing to see some perverse incentive that would exist if recycling were allowed?
There is actually some recycling allowed, as described in the "disclaimer" section. But the reason is interesting:
Many organizations that invest in VCs are extremely efficient, analytical operations. They model each investment in their portfolio carefully.
Imagine you are considering playing blackjack at a $1-per-bet table. You start with $100. You play well, so you expect to end up with about $97, since with good play, the house edge is about 3%. Two hours later, all your money is gone!
Did you lose every time? No. But you re-invested the proceeds of each game, and that modified your return expectations.
Similarly, when VCs have unlimited re-investment, it plays havoc with their investors' return calculations. Also - separate issue - if you re-invest late in a fund's life, you increase the odds that the fund closes up shop while it still has a bunch of active companies in its portfolio.
So while it's not prohibited outright, it's often restricted, and knowing that can help you understand certain behaviors.
Most funds allow for recycling within defined parameters of total dollars or time frame. VCs and LPs are not ignorant, and the issues raised in the article are not new. In most of the funds whose legal structure I am familiar with, a 2x return in a year would be welcome, and the original invested capital would be recyclable into new investments to create further return.
> It’s 10x return on what they reserved to invest – a bigger number that takes in to account the total amount they predicted you’d need over the course of your company’s future
Does anyone know of any examples where a VC did not allow a sale to happen because they were going to do another round? The argument here makes logical sense but I have never actually seen an example of this.
It's not "because they want to do another round." They don't necessarily want to give you the extra money, but the final amount of their return does need to be a multiple of the number they could have invested, not the number they did invest.
Thus they need your company to grow more than you might think they do, and they could block a sale in the hopes that will happen. If you end up needing more investment after the sale has been blocked, that's fine, because they have money in reserve, but actually giving you the money is not the overwhelming motivation.
Articles like this, which paint VCs with perjorative stereotypes (e.g. "Golf games get abbreviated.") are not helpful. As long as you consider the VC an "other" - a different species from you, you won't be able to work constructively with one. Anytime we paint another group of people as an "other" whether because of race or culture or whatever, we do our selves a disservice and encourage conflict and misunderstanding. We're all people, and we're all pretty much the same.
A VC is just an entrepreneur whose line of business is money management instead of software development. If you want to understand the differences between money management and software development and what that means for how VCs try to build a successful business in that industry, go talk to VCs. But approach the conversation as a peer and fellow entrepreneur, not as someone trying to understand an alien.
I'm hearing echoes of my liberal arts education in that first paragraph. For what it's worth, if you otherize the VC but understand what 2 and 20 means, you will successfully predict the behavior of a VC much, much, much more often than someone who has a deep personal relationship on a human level with his VC but who does not understand the math in this post.
This is not a hypothetical. Many entrepreneurs have become friends with entrepreneurs-specializing-in-money-management before. Then their friend e.g. blocks a sale (want to hear a story about that? Find any five experienced people in the Valley -- I think you'll hear about three) and the entrepreneur is dumbfounded. This was not dumbfounding behavior -- it is predictable like the sun rising in the east.
Totally agree- I didnt mean not to understand the incentives, I just meant don't paint all VCs as a group as having a certain set of values or goals. Everyone, whether VC or entrepreneur, acts in response to a combination of the incentives in front of them and the rewards they value. If you understand a person's goals and the incentives in front of them, you can often predict what they are going to do reasonably accurately. Whether entrepreneur or VC, some people want a lifestyle business; some people want fame; some people want fortune; some people want to solve hard problems; some people want to create meaningful change in the world; etc. Different industries offer different ways to achieve any of those goals with varying levels of risk.
By all means, do everything you can with any business partner, whether a colleague, a VC, or a potential acquirer to understand what their goals are, and what behavior they are incentivized towards in their effort to reach that goal.
I'm disappointed you got downvoted for this, because I think it's a legitimate viewpoint.
I actually showed this article to a few VC friends in draft form for feedback. I got mostly positive comments, with one person who was upset at the "golf games" wisecrack (to be fair - that comment was born of a very specific, very frustrating experience with one person). I think an important point of context is that I've raised money from 6+ funds, work closely with many VCs, and count several of them as friends.
"Otherizing" is a legitimate point of criticism for general social discourse. But this article had a very specific goal: to take a number of widely-seen behaviors, and explain them in economic terms. I used light language to do that, but I think it's a crucial point of understanding that most entrepreneurs lack. In fact, I think much of the criticism of VCs is born from a misunderstanding of what they're about.
So while you're right that we're all human beings who can live in harmony together, I think there's more useful analysis past "they're entrepreneurs too".
And I think if most entrepreneurs sit down with VCs, they'll have better things to talk to them about than fund structures and carry terms. I'm just weird in that I find that stuff fascinating!
Since you're a VC, you might do well to write an article explaining what the VC hit rate is (so they understand the percentages), IRRs, and what the carry and take are.
It would help young entrepreneurs understand exactly how you are making money off of their work, which would promote greater understanding when it comes time to make tough decisions from both sides.
Yes - as I've noted in other posts, I'm a partner at a VC firm. Your suggestion is a good one - I've already started putting something together. There have been some pretty good tutorials on the web in the last few years, so I'm a little worried the work is redundant, but I'll see if I can put something together that is reasonably comprehensive but concise. We're also a large firm, so I can't get everyone here to agree to share any of our data publicly, which I would like to do, since it would make it easier to use real numbers.
Anytime we paint another group of people as an "other" whether because of race or culture or whatever, we do our selves a disservice and encourage conflict and misunderstanding.
It goes both ways, though. VCs still make entrepreneurs pay the VCs' own (!) legal fees, they still roll out criminal terms like participating preferred and multiple liquidation preferences ("because fuck you, that's why") which are essentially legitimized extortion, and they still take months to make decisions that could be made in under a week with appropriate masculinity. Terms and behaviors like that emphasize the separation: you're not among us, and this is what you'll deal with for the right to breathe the same air as we do.
Why do they get away with this? Because most of them look out for each other, not entrepreneurs. Because if you don't take that "deal" with the 4x liquidation preference and participating preferred, the VC offering it is going to call up 6 other VCs and damage your reputation and they will lose interest as well (the extortion factor).
The two-class world still exists, and unless you worked directly with Mark Zuckerberg, VCs are of a higher class than entrepreneurs and they don't even want to share an elevator with you. It shouldn't be that way, but it is. Yes, being an entrepreneur is more fun when things are going smashingly well, but VCs don't have to worry about their kids' school bills when things aren't going well. Plus, VCs can always become entrepreneurs and have a leg up (from the connections and inside track they established while in VC) when they do so. The 25th-percentile outcome for a VC is that he doesn't make partner but gets an executive position at a portfolio company. The 25th-percentile outcome for an entrepreneur is, for a hint, not the option to go into VC for a few years.
