How would a person start a venture capital fund?

Having recently raised one, I’ve learned a lot: Jason Lemkin just raised a $70 million fund; here’s how he did it

In order to start a VC Firm you need a track record. If you haven’t already made some good investments — it’s going to be tough to start your own fund. Go work at a fund first and make some good investments there.

Assuming you have at least a partial track record, then, there are two-and-a-half basic paths on how to start a venture capital firm.

1. Start Small before your start a Venture Capital Firm

Start as an angel investor, make some good investments, and then, after proving yourself as an angel, raise a small fund. Perhaps $5m, $10m, $20m to start — mainly from Very Rich Individuals.

2. Grow within a Venture Capital Firm

Go join an established fund, and build a track record. At least a partial one. At least invest in 2+ companies that can be Unicorns. You won’t have truly proven yourself. But it may be enough to raise a small fund.

3. Partner with someone starting a Venture Capital Firm

Often, a “financial” VC will seek out an operational partner. Or a successful, but perhaps less “branded” VC, will seek out someone with a brand, but perhaps a less established, or less traditional, track record as complementary.

What doesn’t work that well is to go straight from Successful Founder to First Time VC with a Relatively Big Fund. At least not for most LPs. 

Most LPs are looking to see that you’ve put institutional capital to work — not just founded an amazing company.

Related: The 4 Questions Every Founder Should Ask Every VC. That Almost No One Asks

How Does a Venture Capital Firm Work?

The 2 and 20 Venture Capital Model

The basic model in venture capital is “2-and-20”, or 2% in committed capital paid in fees annually, and 20% of the profits going to the partners. 

So take Storm V, a $180m fund.  

The LPs (the Limited Partners, the folks that give VCs the money to invest) pay 2% of the committed capital each year for “fees”. 

So in a $180m fund, the LPs “pay” the firm $3.6m a year to run it. 

That’s not chump change, but it’s not as much as you think including rent, travel, expenses.  It’s not all salaries.

And the partners also have to invest a roughly similar amount back into the firm as LPs themselves — several percent of the “committed capital.”

Then, the General Partners keep 20% of the profits — after repaying all the money invested, plus all these expenses.

Then, once the firm has returned $180,000,000 in cash back from its investments — the size of the fund — if the firm returns more than $180m, then and only then the partners get to keep 20% of whatever the profits are beyond that.  

That’s returns from IPOs and acquisitions.  So this can take 10-12+ years … if you even get past 1x, the so-called “hurdle” before any profits.

So if you do amazing investments it can be pretty lucrative.

If you do mediocre investments it isn’t.

If you do poor investments, in 5-10 years, you’re out of a job.

I’m making a lot of simplifications here, but it explains roughly how it all works.

Starting a Venture Capital Firm Budget and Fees

The fees in starting a venture capital firm varies a lot, but in general, you can assume about 2% of each fund goes to “management fees”, for its operational budget.

Usually, the partners will pay themselves salaries very roughly equal to about 2-3% of the size of the fund.  

The rest will go to office, admin, travel and associates and non-partners.  

And whatever’s left?  The partners that own the management company keeps the surplus.

So let’s take a hypothetical:

  • $200m fund
  • 2.5% management fee, or $5m a year paid by LPs (the investors in the fund) for operational expenses.
  • 3 general partners, take $1.5m in salary collectively.
  • Fancy South Park office is $50k a month, or $600k a year
  • 3 EAs at $200k a year, burdened
  • 2 associates at $400k a year, burdened
  • $500k a year in travel and expenses, marketing (if any), “IT”, etc.
  • $500k in CFO and audit fees, accounting, legal, admin.

What’s left? $1.3m.  The partners that own the management company split this and dividend it out to themselves.

The bigger the fund, the more of the “excess” they can keep, especially if they are partners in multiple, overlapping, active funds.

As you can see, in starting a VC, there’s a pretty large “fee drag.”  

I.e., you have to actually earn a lot more on investments than you might think, because you don’t earn “carry”, or profits, until the investors reach 1x which, generally, but not always, includes repayment of fees.

Related: Small Checks From Large Venture Funds: Maybe One is Enough

The Two Skills You Need to be a good Venture Capitalist

One, being picked by at least some of the best founders

The best founders always have options.  

It’s not just about “winning” the deal. 

It’s about being picked by the great ones.  

At least, enough of them per year to hit your investing quota. 

There are many reasons to be picked. 

Track record, celebrity, value-add, reputation, brand, platform and more.  

But if you aren’t picked, you have to invest in spaces, geographies, and niches where truly the very, very best founders have far fewer options.  

Otherwise, even achieving 1x is difficult.  

Look at the disruption of Y Combinator  and Andreesen … they did what it took to be picked by many of the best.

Two, pick well from who picks you.  

Now being a good “investor” comes into play. 

Because the difference between a Very Good and a Great founder and start-up is subtle in the early days … but huge as time goes by.

Venture Capital Compensation

Venture capital compensation is so all over the place.

Most importantly — you have to think about earnings on a net basis.

Let’s take a $150m fund, with 3 partners … with a 2% fee structure … and 3% of the fund contributed by the partners themselves — the “capital commit” (some amount is required by LPs, the funds that invest in the VC funds).

OK, so 2% of $150m is $3m in fees per year. 

That sounds like a lot, and it is. But let’s assume there’s rent, 3 associates, 2 analysts, an admin or two, and a lot of Travel & Entertainment (say, $100k per partner per year in expenses here and $25k per other professional in expenses).

Rent, non-partners, expenses, and T&E then will likely consume say $1.5m-$2m of that $3m.

That might leave $500k-$1m left for the 3 partners to split as annual salary.

Let’s call it $300k each in salary.

In this example, the partners are putting in 3% of the $150m themselves, or $4.5m over the life of the fund.

Let’s simplify and call that $450k per year (that’s too oversimplified, but makes math simple). In California, that’s probably equivalent to $700k or more in pre-tax dollars.

So the 3 partners here are “investing” $700k a year in pre-tax equivalent dollars out of their own pockets, and taking $750k out in taxable income collectively in salary.

In this case, the partners aren’t making anything net.

The earnings are only in the future profits, the carry.

Now, this is a particular example. In more established funds, the % contributed by partners is not only lower … but often the retired partners make up most of it (many times, as part of getting an ongoing % of the carry / investment profits).

In that case, especially as the fund sizes get large, the salaries can be quite large and the capital contributions quite low for the newer GPs. 

At older, established, large funds, the GPs can make $1m-$1.5m and not put all that much of their own cash into the funds.

And if you can raise multiple funds quickly, you can “stack” fees on top of each other. This can create a lot of cash flow in some scenarios.

But most smaller and newer funds on a net basis don’t pay much at all if anything net of partner capital contributions. Here, you’re betting on the investments to make you money 8, 10, 12 years down the road.

And if you do that right, it is a good deal. Because you get substantial leverage on your capital commitment.

If you think of it that way, it makes a ton of sense. If you think of it in short-term economic terms, net of capital commitments … it may depress you.

Reasons you should not start a venture capital firm or join one

  • There are very, very few partnership slots.
  • Venture capital is a tiny industry.
  • There is no point in adding a partner that isn’t accretive. So the odds of you making partner are very low. Possibly zero.
  • It is brutally competitive to get into hot deals.
  • At most firms, there is no clear promotion path and a non-GP slot usually lasts 2 years or so.
  • Firms are super-hierarchical, and patronizing. She or he with the hot hands rules it all.
  • Often, the partners can’t stand each other.
  • The skills you learn aren’t very portable to other jobs.
  • Yes, you do have to risk your own money, as a general partner at least. It varies, but often 2% of the fund comes from partners. That can be a lot.
  • In a big firm, often one person makes all the decisions. Forever.
  • You are just a number.
  • You will likely do nothing enduring, nor will you change the world in any way.
  • If you like to work on a team, it’s not a team sport.
  • Many non-GPs are pretty jaded.
  • At seed and very small firms, the salaries actually can be pretty terrible. A $20m fund might have $400,000 in fees per year to pay everyone — all the staff, rent, salaries, expenses, travel, etc.
  • Even if you do happen to be any good at it — and you probably won’t be — your boss most likely will take credit for whatever great deals you do source.
  • The world does not need another venture capitalist.

So do it if you have a true passion for it, and are willing to break through the odds — and can truly, somehow, hustle into the very best deals.

Related: The Top 10 Pieces of Advice I’d Give to My Younger CEO Self

Published on December 20, 2016

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