Venture fund economics refers to the financial structure and incentives of venture capital funds. Central to fund economics is the 2/20 model, a compensation framework that has become emblematic of the venture capital industry. This article delves into the intricacies of venture fund economics, shedding light on the origins, mechanics, and enduring relevance of the 2/20 model, while also exploring its variations and the strategic implications of different profit distribution structures.
2/20 Model History
The 2/20 model is a standard compensation structure for venture capital funds. It consists of two main components: a 2% management fee and a 20% carried interest.
The roots of the 2/20 model can be traced back to the post-World War II era, a time when the venture capital industry was in its infancy. One of the earliest and most influential figures in this space was Georges Doriot, often hailed as the “father of venture capitalism.” Doriot, a French immigrant and a professor at Harvard Business School, founded the American Research and Development Corporation (ARDC) in 1946. ARDC’s investment in a small company called Digital Equipment Corporation (DEC) in the late 1950s is legendary. With an initial investment of $70,000, ARDC eventually realized a return of over $355 MM when DEC went public. This success story not only solidified Doriot’s reputation but also showcased the potential of venture capital as a lucrative investment avenue.
As the industry grew in the 1960s and 1970s, the need for a standardized compensation structure became evident. Tom Perkins, co-founder of the renowned venture capital firm Kleiner Perkins, played a pivotal role in shaping this structure. Perkins, an engineer-turned-venture capitalist, believed in aligning the interests of fund managers with their investors. Drawing inspiration from his time at Hewlett-Packard and his experiences in the nascent Silicon Valley, Perkins championed the idea that fund managers should earn a significant portion of their compensation from the profits they generated for their investors. This philosophy laid the groundwork for the carried interest component of the 2/20 model.
Anecdotal stories from these early days often highlight the risk and reward nature of venture capital. One such tale involves Don Valentine, founder of Sequoia Capital. Valentine, known for his sharp wit and keen business acumen, once remarked that he looked for “horse races” rather than “horses” when making investments. This philosophy meant that he focused on burgeoning industries with massive growth potential rather than individual companies. His approach paid off handsomely with early investments in companies like Atari and Apple, setting the stage for Sequoia’s reputation as a leading venture capital firm and further cementing the 2/20 model as the industry standard.
The 2/20 model is a compensation structure that has become synonymous with the venture capital and private equity industries. It is broken down as follows:
2% Management Fee
This fee is typically calculated on an annual basis, taking into account the total commitments from Limited Partners (LPs) in the fund. It’s designed to cover the fund’s operational expenses, such as:
- Salaries of the fund’s team
- Office rent and utilities
- Health insurance
- Research and due diligence costs
- Travel and networking expenses
For instance, a venture fund with LP commitments of $50mm would charge $1mm annually as a management fee.
20% Carried Interest
Carried interest, often referred to as “carry,” is the portion of the fund’s profit that is paid to the fund’s managers. This 20% is taken from the profits generated from investments, ensuring that fund managers are rewarded when they generate returns for their investors.
For a fund that has generated profits of $20mm, the managers would receive $4mm as carried interest, with the remaining $16mm distributed among the investors.
Pros and Cons of the Model
- Alignment of Interests: The model ensures that fund managers earn more when investors earn more. This alignment encourages optimal performance and decision-making.
- Operational Stability: The management fee provides a steady income stream. This ensures that the fund can cover its operational costs, irrespective of its investment performance.
- Performance Incentive: The carried interest component incentivizes fund managers to seek high returns. This can lead to more diligent research and strategic investments.
- Industry Standard: Its widespread adoption makes it a recognized and trusted model. This can simplify negotiations and establish clear expectations between fund managers and investors.
- Potential Misalignment: The desire for high returns might push managers to take excessive risks. This can jeopardize the principal investment of the fund’s investors.
- Fee Burden: In cases of mediocre fund performance, the management fees can erode returns. Investors might feel they’re paying too much for subpar management.
- Long-Term Implications: The model might incentivize short-term gains over long-term value creation. Managers might prioritize investments that promise quicker returns.
- Lack of Flexibility: The rigid structure might not suit all types of funds or investments. Some funds might benefit from a more tailored compensation model.
The 2/20 model, while widely recognized, is not set in stone. As the venture capital and private equity landscapes evolve, fund managers and investors often negotiate variations to better align with specific strategies, risks, and market conditions. Here are some common alterations to the traditional model:
- Reduced Management Fees: Especially larger funds might charge less than 2% as a management fee. This can make the fund more attractive to potential investors.
- Co-Investment Opportunities: Investors might get chances to invest directly in portfolio companies. This can be outside the fund’s standard terms and might not be subject to usual fees.
- Follow-On Opportunities: Limited partners might be given the chance to invest additional capital in portfolio companies during subsequent funding rounds. This allows investors to maintain or increase their stake in promising ventures.
- Sliding Scale Carry: As returns surpass certain benchmarks, the carried interest percentage might increase. This rewards managers for exceptional performance.
- Budget-Based Management Fees: Some funds adjust their management fees based on a predetermined budget. This ensures that the fees directly correlate with the actual operational costs, providing transparency.
- Preferred Return: Some funds set a minimum return threshold. Carried interest applies only to returns above this rate, ensuring basic returns to investors before managers earn their share.
- Clawback Provisions: If early investments perform well but later ones do not, these provisions require managers to return some of the previously earned carried interest.
- Catch-Up Provisions: Once the preferred return is met, managers might receive a larger portion of profits until they “catch up” to a predetermined percentage of total profits.
- Deal-by-Deal Carry: Instead of waiting for the end of the fund’s life, carried interest is distributed as each individual investment is exited.
The alterations to the traditional 2/20 model are typically formalized in the Limited Partnership Agreement (LPA), a foundational document that outlines the terms between the general partner (the fund manager) and the limited partners (the investors). The LPA provides a comprehensive framework for the fund’s operations, including details on fees, distributions, and other economic terms. While the LPA sets the standard terms for all investors, there are instances where specific provisions or exceptions are granted to certain limited partners. These exceptions are often captured in a side letter, a separate agreement that amends or supplements the LPA for a particular investor. Side letters can provide certain investors with preferential terms, such as reduced fees or unique rights, based on their size, influence, or strategic importance to the fund.
American vs European Waterfalls
In the realm of private equity and venture capital, the distribution of profits between fund managers and investors is often structured through what is termed a “waterfall.” The waterfall defines the sequence in which profits are distributed. Two of the most common waterfall structures are the American (or deal-by-deal) waterfall and the European (or whole fund) waterfall. Each has its own nuances and implications for both fund managers and investors.
American Waterfall (Deal-by-Deal)
The American waterfall, often referred to as the deal-by-deal waterfall, allows fund managers to receive their carried interest on a deal-by-deal basis. Once the initial investment in a particular deal is returned to the investors, and any preferred return is achieved, the profits from that deal are split between the investors and the fund managers.
Imagine a fund that has invested in three startups: A, B, and C. If Startup A is sold and generates a profit, the fund managers can immediately take their carried interest from the profit of Startup A, even if Startups B and C have not yet realized any returns.
European Waterfall (Whole Fund)
The European waterfall, or whole fund waterfall, requires that all capital contributions from investors be returned, and sometimes a preferred return achieved, before the fund managers start receiving their carried interest. This is applied across the entire fund, not on a deal-by-deal basis.
Using the same scenario with Startups A, B, and C: Even if Startup A is sold at a profit, the fund managers would not take their carried interest until capital contributions and preferred return are returned. Once achieved, the fund managers can start taking their carried interest.
The choice between American and European waterfalls can significantly impact the distribution of profits. The American model might incentivize fund managers to seek quicker exits, while the European model encourages a more holistic approach to the fund’s overall performance. The decision on which structure to use often depends on negotiations between fund managers and investors, taking into account the fund’s strategy and the risk appetite of its investors.
The 2/20 model’s enduring presence in the venture capital and private equity sectors is a testament to its foundational principles and adaptability. At its core, the model seeks to balance the interests of fund managers and investors. The management fee ensures that fund managers can maintain operations and conduct thorough research, irrespective of the immediate performance of their investments. Meanwhile, the carried interest component aligns the fund managers’ financial incentives with the success of their investments, ensuring that they are motivated to achieve high returns for their investors.
Over the years, while the investment landscape has evolved and become more complex, the 2/20 model has remained relevant. Its simplicity offers a clear and straightforward compensation structure that both parties can understand. Moreover, its adaptability, as evidenced by the numerous alterations and variations, allows it to cater to different fund strategies and investor preferences. This combination of clarity, alignment of interests, and flexibility has solidified the 2/20 model’s position as an industry standard, even as the dynamics of the investment world continue to change.
The landscape of venture capital is as dynamic as the startups it nurtures, with financial models like the 2/20 serving as its backbone. This model, with its historical roots and adaptability, has proven its mettle by aligning the interests of those who manage funds and those who invest in them. As the world of investments continues to evolve, understanding the nuances of such models becomes paramount for both seasoned investors and newcomers to the industry. The 2/20 model stands as a testament to the industry’s ability to innovate not just in technology but in financial structures, ensuring that the spirit of entrepreneurship is supported by sound economics.