Charlie O’Donnell wrote a short blog post of the economics of his fund and no surprise, it was representative of how a typical VC fund operates. But since my fund is far from being typical, I would like to share with you the weird, un-sanitized and detailed economics of it so lets get started.
Management fees: I am about to say something no other sane VC has said before: I dislike management fees. As a kid, I had no allowance so I earned every dollar I made. It’s a philosophy I carry with me to this very day.
Fees often provide improper incentives for VC’s so I decided to do something different: I came up with a one time management fee of four percent and it’s a lump sum paid out only in the first year. After that, no more fees.
My fund is about 25 million dollars, so the fee works out to 1 million dollars. Whoa, did I just hit the jackpot? Far from it. The life cycle of the fund is five years so I have to stretch out that million dollars. Startup costs aren’t cheap either:
Limited partner agreement. This is the fancy legal document that your investors sign. It’s typically 30-50 pages long and absurdly expensive – you can expect to pay anywhere between $25,000 all the way up to $100,000.
So how much will I be paying? $25,000. Yes, I know, that’s an insane amount of money to spend but an iron clad LPA is crucial because it helps you avoid legal headaches in the future.
Also keep in mind that the lawyer is not only drafting an LPA, but a subscription agreement and your standardized term sheet.
Back office: It works out to $100,000 every year and covers almost everything: accounting, audits, taxes, financial statements, capital calls, banking etc. In the end, that’s half of the 1 million dollar fee already gone.
Staff: Just one analyst will be hired to help source & manage deal flow along with liaising with our existing portfolio companies. Salary will be $80,000; $400,000 in total over 5 years so that leaves me with less than $100,000 in fees. P.S I’m still looking for an analyst so send me an email if you are interested.
Offices: I have a co-working space in Brooklyn that runs for about $6,000 a year. It comes with a desk, computer, wi-fi, and access to conference rooms for pitches.
Carried interest. Here is where I stray from the herd: 20 percent is standard but it’s based heavily on performance. Basically, if I make a two times return, it is bumped up to 25 percent. A three times return is 30 percent and so forth with a ceiling of 40 percent.
40 percent sounds excessive but it’s based on performance which in this scenario would have to be a five times return – no easy task. Also keep in mind that I am taking a massive pay cut on management fees. If I had gone with the traditional 2.5 percent annual fee for five years, that works out to 3.125 million dollars in fees so I am sacrificing 2.125 million dollars – something very few VC’s would be willing to do.
But the good thing is that the 2.125 million dollars will be used to invest in more startups which could mean a greater return down the line.
Salary: obviously with a one time management fee structure, I won’t be able to pay myself an annual salary.
Financial projections. This is the fun part – guessing how much money the fund will (hopefully) make. But first, please read Dave Balter’s blog post on angel investing, because it will give you the reasoning behind why I adopted my business model.
Nouveau Capital is essentially an angel/seed fund that uses a “first one in and first one out” business model and it’s quite simple: we provide an average of $250,000 in funding and get a 10-20 percent equity stake which we then resell to Series A investors for a profit.
Let’s do the math. I expect to invest about 5 million dollars every year into 20 startups at $250,000 each. The statistics show that only 40 percent of seed funded startups go on to raise a Series A round and according to CrunchBase’s dataset, the average Series A round is valued at just over 5 million dollars. So assuming I own a 20 percent stake, I expect to resell my shares for around that same number (5 million dollars).
And assuming that only 40 percent of my portfolio companies go on to raise a Series A, that’s eight startups which have the potential of producing a return, which in this case would be for a total of 40 million dollars, an eight times return on invested* capital.
*It’s important to distinguish between “invested” and “committed” capital. In my case, only 5 million dollars out of the 25 million dollars is invested and therefore carry calculations are based on that amount. But if the LPA is structured around committed capital, I would have to return all 25 million dollars first before any carry is made*
Of course, that’s the best case scenario and there is a good chance that might not happen so lets assume that only four startups were able to raise a Series A round and produce a return of 5 million dollars each. That’s still 20 million dollars, a four times return. Not too shabby.
Even you cut the number in half again to two successful startups, it still works out to a two times return.
But lets go back to the best case scenario and crunch the carried interest numbers. Since my distribution waterfall is based on performance thresholds, an eight times return works out like this:
Two times return=25 percent if I double the original invested capital of 5 million dollars and produce a 5 million dollar profit, that’s 1.25 million dollars in carried interest.
Keep in mind that the calculations are based on a return total of 35 million dollars (40 million dollars minus the original invested capital of 5 million dollars because you obviously have to pay back your LP’s first)
3 times return=30 percent with another 5 million dollars in returns (10 million in total at this point), I would achieve the 3 times return threshold and that works out to 1.5 million dollars.
4 times=35 percent 1.75 million dollars.
5 times=40 percent 2 million dollars.
5 times and beyond: now that we have reached the ceiling of 40 percent and can’t go any further, the remainder of the returns (15 million dollars) and all future returns will be charged at 40 percent so in this case, 6 million dollars is the final carried interest.
Add it all up and the grand total in carried interest is $12,500,000. As for the investors, their haul is worth 22.5 million dollars which represents a 4.5 times return – not bad at all. So even with 40 percent carry, the investors still manage to get a superior return and everyone is happy.
Of course, there is also the complicated issue of clawback and future losses but I won’t get into that.
Continuing with the best case scenario: if I invested the remaining 20 million dollars (assuming I recycled my management fees with early returns) and got the exact same results every year for the remaining four years, the total return works out to $175,000,000 (200 million dollars minus the original investment of 25 million dollars.)
And the icing on the cake is that I won’t have to pay any state taxes thanks to Gov. Cuomo’s Start-up NY program (although I would still have to pay federal taxes).
In the end, running a small fund is no walk in the park even with a short term business model like mine. It requires an insane amount of attention and you will be running on fumes for quite awhile. But my hope with this new investment model is that it will make the process smoother and more profitable.
And yes, I could end up driving a Bugatti or Zonda if this all works out but even if it doesn’t, I can rest well at night knowing I did a job I loved and felt passionate about.
Image credit: CC by Mark Wallace
