I thought it would be useful to demystify how VCs make money.  Here is a short explanation.

First, VCs get capital commitments from limited partners (i.e., investors).  Let’s say VC1 has a $100mm fund.  That means that it has capital commitments from investors of $100mm.   Capital is called when needed for investment, fund expenses or management fee.  Importantly, VC1 does not collect all the money in advance and then invest in short term securities.  And, VC1 does not reinvest capital returned (with very few limited exceptions) – VCs are not hedge funds!  All capital returned from investment gets paid out.

Second, the General Partner of VC1 is the entity that runs the fund (let’s call it GP1).  Importantly, GP1 will have also committed investment capital to VC1.  So, in this respect, you can think of GP1 as a limited partner.  It literally has an investment share in the fund just like any other limited partner.  And it literally has to pay in $$ when VC1 makes a capital call.  Now, there are interesting ways for the GP to fulfill its portion of a capital call using “fee waiver”, but I am not going to address that here.  Perhaps I will in another post.

Third, VC1 pays GP1 a management fee (via a separate fund management entity – again, to make this post simple I am not going to elaborate on the fund management entity here).  Typically, that might be 2% of committed capital per year paid quarterly.  So, for VC1, that would be $2mm a year.  That is a hefty sum (and over the life of a fund, can amount to a large amount of management fee; most funds have a life of 10 years and the management fee often ratchets down after 5 years).  VC1 use that money to pay salaries of the investment professionals, other staff, office expenses, office leases, due diligence expenses, etc.  For a large fund (and I consider $100mm to be large although it really is not – Cayuga Venture Fund is much smaller than $100mm), the management fee can result in sizable salaries.

Fourth, GP1 is entitled to a carried interest in fund profits.  The amount is typically 20% of profits.  In its simplest form, think of profits as amounts returned to the fund in excess of capital commitments.  Therefore, the returns from the sale/IPO of the fund’s portfolio companies must clear capital commitments before GP1 gets any carried interest.  So, if VC1 invests $3mm in Portfolio Company 1 (PC1) and PC1 is sold later and VC1 gets a return of $15mm on the investment, all that return goes back to the investors assuming that the fund is not yet cleared (note that some GPs actually take their carried interest on a deal by deal basis and this can result in the dreaded claw back – again, a topic for another post).   If VC1 has a bunch of exits of its portfolio companies and total capital commitments are 100% returned, then GP1 gets its 20% of ongoing profits and the owners of GP1 (real warm bodies like me) split up those points.

So, in summary, how do VCs make money:

1.   salary paid from management fees.  Just like paying the portfolio company management team for doing its job.

2.  return on investment from the GP investment share.  This is one area that is often overlooked by people not familiar with venture capital.  The GP is a real investor and gets a return of capital when there is an exit event and at the same time as other investors.

3.  carried interest kicks in after the fund is cleared (again, there are some different payment schemes that apply, but GP1 is only entitled to keep 20% of profits; so, the safest bet is not to take any profit share until the fund is fully cleared).

Hope this demystifies VC compensation a bit.  I have taken a few liberties to keep this as simple as possible.  There is actually a great deal of complexity when operating a live fund.

“Horse trading” is a bad phrase in the startup/VC community.  It typically is used in the context of someone (often a VC) attempting to change deal terms between a signed term sheet and the closing of the investment.  The typical time between term sheet signing and closing is 45 – 60 days so there is ample room (unfortunately) to revisit issues.  I do not like horse trading and do not like it when others do it.  Yet I see it all the time.  I guess it is part of the VC investment game.  But it can be incredibly frustrating and not a good way to build trust.

So, what to do about it?  Short answer:  basically nothing – expect it a bit and take advantage to negotiate something in your favor.  Unless the term sheet deal is being turned upside down, horse trading typically falls into the nuisance category as opposed to the torture category.

VCs horse trade with each other too.  If a new investor is making, for example, a Series C round investment, that means there are likely Series A and Series B round VCs with whom to negotiate.  Many terms of the Series C round are going to have more of an impact on the Series A and Series B holders than on the management team.  So, prior to closing, the VCs themselves are negotiating just as much as management.   And there are all sorts of tensions that can build dependent on how aligned the Series A and Series B investors are with the existing management team, etc.

Here is an example.  Let’s say that the Series A liquidation preference (LP) is 1X and that the Series B LP is 1.5X.  The Series C investor negotiates a term sheet that provides for the Series C to be senior to the A and B and also for the Series C to have a 1X LP.  Term sheet gets signed and the parties are working towards the closing (lots of transaction docs keeping the lawyers busy, due diligence clean up, etc.).  As the document drafts are going back and forth, the Series C new investor says “I did not realize the Series B has a 1.5X LP; we need that too.”    A response might be “what do you mean you did not realize that?  You saw the Series B deal docs already……how did you miss that?”  Or, it might be “you are nuts to be bringing this up now.”  Or possibly, “I can understand where you are coming from, but why bring it up at this point.”  Or possibly, “Ok, I would ask for the same thing if I were you, but let’s lose that full ratchet anti-dilution protection…..”

Anyway, I am sure you get the point.  It is horse trading, and will inject a bit of agitation into any deal.  Get ready to deal with it…..unfortunately.  If you ever catch me doing it whack me over the head with a horseshoe.