I’ve just re-read the a 2012 report by the Kauffman Foundation about the contractual relationship between venture capital funds (often called GPs, short for General Partner) and their investors (often called LPs, short for Limited Partners). Kauffman is a major investor in venture capital and they were (and still are) unhappy with the standard arrangements between GPs and LPs, and also with LPs for not pushing harder for change. In fact they were unhappy enough that they titled the report “We have met the enemy …. and he is us”.
The standard contract between GPs and LPs is the so-called “2 and 20” arrangement, where the GP gets an annual management fee equal to 2% of the fund size and a 20% ‘carry’ or share of the profit. The main problem with this arrangement is that the partners in venture capital funds, i.e. the GPs, can make a lot of money from the management fee even when they generate poor returns. This is particularly the case with larger funds and when a GP has multiple funds under management.
The Kauffman Foundation makes two recommendations to address this problem that we are implementing here at Forward Partners. The first of these is to “Eliminate the black box of VC firm economics” – i.e. for LPs to insist on seeing details of carry, compensation, general expenses, and investment by GPs in their own funds, before making investment commitments. The second is to shift from a 2% management fee to paying fees based on a firms budget.
Both of these seem very reasonable to me. If a company we were thinking of investing in didn’t want to share details of its finances we would worry that management might be wholly aligned with our objective of maximising the share price and I’m sure we would feel the same way if we were investing in funds. Similarly, all our portfolio companies work out what they need to spend to achieve their objectives and have that as their budget and it makes sense to me that VC funds should be run in the same way.
Transparency and alignment. Both very important.