The Rules of the (VC) Game

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TLDR

• Before investing in VC funds, you need to understand the money (so you can make more).
• Before joining a VC firm, you need to understand the money (so you can get a share).
• GPs make the investments, and LPs provide the money.
• Management fees go to the VC firm, and GPs and LPs share the returns.

More VC, please!

I get the following questions a lot:

You have diversified your investment portfolio and added venture capital (VC) to your holdings, right?

How did you join a VC firm?

Why did you leave VC?

These questions open up a can of worms I’ll address in future posts¹. To understand the discussion, let’s begin with how money flows in VC.

Rich, Busy, Looking for Adventure

Imagine you are rich².

You have money to burn. You could put your money into a bank account, but that doesn’t grow over time - it’s not returning more money. That means you won’t keep up with inflation. Becoming less rich? Ugh.

You want to find a place that can make you money without asking you to do work. Trading time for money? Ugh.

Most people look for returns by putting money into stocks and bonds. Both are riskier than leaving it in your bank account - stocks and bonds go up and down in value. They usually increase, and this is especially true over long time horizons.

But you are rich.

You want to grow your money even faster and account for the possibility that stocks and bonds may go down by putting some of your money into an “alternative” option. Something that isn’t going to follow what stocks or bonds do.

These alternative investments are riskier. And so they claim to generate higher returns than your plain old stocks and bonds to compensate you for the risk.³

What’s riskier than putting your money into a small team trying to make the next Facebook, Google, cold fusion, or NZT? You need to go out, find some of these teams, and give them your money for a share of their companies.

But you are rich.

You’re willing to pay someone else to find these teams and filter out the good ones, negotiate with them, track them, and do all the financial stuff to ensure you get your money back and more.

And the teams might fail. You may not get your money back.

And even if you do get your money back, it’ll take a while. You can’t build Google in a day.

That sounds like an adventure for your money, your capital, eh?

Time to find “someone else.”

Seeking Hungry, Outgoing Know-it-all

Meanwhile, there are people out there who claim to know things.

They know the right teams who are building amazing products.
They know the right industries that are about to go mainstream.
They know the right investors who are investing in great companies.

If only they had enough money to bet on this foresight.

They may have enough money of their own, so they’ll say they are angel investing. You could do the same, but that sounds like work.

The folks who don’t have enough money are the ones who want you. They want to partner with you. To make it legitimate, they start a firm - a venture capital firm.

The fancy title they give themselves (besides founder) is General Partner (GP).⁴ They may join up with a few other folks - they’ll all be GPs.

Now they need to go out and find you and other rich people to give them money so they can place those bets on what they know. They’ll give rich people the fancy title Limited Partner (LP) in return for the money.

You are rich, so you get to be an LP.

But you want more than the title, remember? You want a return on your money. And you want it to be bigger than you could have gotten through boring investments like stocks and bonds.

What’s 20% among friends?

Wait!

The GPs need to run a firm, which means they need a nice office, swag, money to woo those teams, and staff to help them. They will charge you a management fee every year to cover these expenses. It’s only 2%.

But they promise to make you so much money that you won’t care about this fee.

The money you make is on the returns from the investments. But…

You want everyone on the same team, right? If you want the GPs to care about the outcome, they should share the upside.

The GPs and LPs agree: let’s split the returns⁵ - 20% to the GPs, and 80% to the LPs. The GPs’ share is called carry⁶.

These returns happen when a company has a “liquidity event,” which means that people who own shares can legally exchange them for cash. Usually, this occurs when a company is legitimate enough to make an initial public offering (IPO) on a stock market, or if another company decides to buy (acquire) them.

You are rich, so there’s one more thing you want.

Why would you give all of the money to the GPs at one time? They’re not going to invest it all right away, so that money will be sitting in a bank account, and that’s what you are trying to avoid. Instead, you tell the GPs to call and ask for the money as they need it. You want them to call capital.

That’s fair, no problem. Let’s make some money!

Find teams… and rich people again

The GPs get down to business.

They find companies, interview founders, evaluate their progress, and begin writing checks for promising investments. As they do so, they call you for some money. The capital calls start.

Some of this money goes towards the management fee.

The fee pays for the office and GP salaries. It also pays for the auxiliary people on their team - analysts who research, financial experts to track all the money, and HR folks. The fee could cover some operational people who advise the teams to execute better and faster.

The carry is where the big win is, though. So let’s go out there and find some great teams!

But in the back of their heads, the GPs are worried. What happens when they’ve invested all the money in the fund and are waiting for returns? They want to make more investments and will need more money. They’ll need to think about raising another fund…

Questions to dig into next time

Now you have an overview of how money flows and in which directions. That movement leads to more questions if you want to enter the venture capital world as an investor or as a person supplying the investors with money.

If you have money and want to invest in venture capital, you’re asking:

• How much money does a fund need to return to be worth the fees and added risk?
• What happens when a fund does poorly?
• What happens when a fund runs out of money to invest?
• When do I get my money and those sweet returns back?
• What are you doing with your money, Aamir?

If you want to join a VC firm, you’re asking:

• How do I get into a firm as an investor? How did you do it, Aamir?
• If I have options, how do I decide between firms?
• What does the day-to-day look like? How can I become good at startup investing?
• Can I get some of that carry?
• Why in the world did you decide to leave?

The next few posts will cover these points of view and provide my perspective on them.

1. I’ll link to those when they’re done. ↩

2. You may also be an institution, like a non-profit foundation, college, or university. ↩

3. Remember, prior performance is not an indicator of future returns. But folks love to tell you about the past to lead you to the dreamy future you want. ↩

4. These titles are not made up - they are legally defined and matter because of the structure of the firm and investing funds. ↩

5. A “hurdle” is often in place to ensure the LPs get their money back first, and then the split begins. ↩

6. “Carried interest,” which you may hear about every few years when politicians bring up potential sources of tax revenue. ↩