Lessons in Alignment

Why the F*ck didn’t anyone tell me I could take less?

I saw someone post this clip on Twitter last week and it made me laugh. Again. Quietly, there are a lot of founders asking themselves this question right now. The short answer comes from the late Charlie Munger:

“Show me the incentive, I'll show you the outcome.”

Some background for those living under a rock: venture went from a cottage industry of misfits to an overindulgent asset class filled with elaborate parties and a general arrogance of untouchability. In a runup that led to many overfunded companies and inflated valuations, impressionable founders forgot that their companies were actually theirs. Wowed by private jet flights, expensive dinners, and visions of mansions, many were told they should raise more money at high valuations because it wasn’t that much dilution and their company was only going to get bigger.

It turns out that advice was like getting pain management advice from a Purdue Pharma rep - sure, some companies needed that capital, but many (most?) should have just forged ahead without it. VCs even likely thought they were doing the right thing. I wrote previously about the alignment between VCs and Founders. The reality is as the asset class and fund sizes ballooned, VC playbooks had to change. Kyle Harrison wrote about it here in much more detail.

Back to incentives: VCs are paid in management fees and carried interest. Management fees are a function of fund size; carry is a function of investment returns. The former is predictable and steady. The latter is often out of an investor’s control, particularly in venture where the investor doesn’t control the company (and so many other variables). If a VC wants to ensure they are paid more, they increase fund size since they have less control over returns.

I’ll write a separate post about fund models, but in short, there are three levers to a fund: number of investments, check size, and reserve ratio. Every fund operates differently but every fund is some ratio of those three levers: (X# of investments * $Y check size * (1+Z%) reserve ratio) = fund size. To scale fund sizes (and get larger management fees), many funds started writing larger checks, into more companies, and would try and put more money into companies they deemed winners in their portfolios. Even if this meant performance suffered.

Management fees are the recurring revenue of the asset management business. As fund sizes grew, so did the non-return-based fees (management fees) VCs collected. Here’s some crude math to put some numbers around this (some assumptions like recycling, timing, etc):

As you can see, the smaller funds needs to 10x (amazing) while the medium fund only needs to 2x (nothing special and arguably bad given the illiquidity) for both GPs to net the same amount over the life of the fund. The difference is where those dollars come from: management fees (locked in) versus carried interest (this changes if the fund doesn’t perform this well). And the large fund is a totally other story.

The incentives were clear. And the outcome was predictable.

This fund size and asset class growth led to misalignment in the ecosystem. Founders got advice from VCs who had incentives to deploy faster and in bigger chunks (easier to put more money in fewer companies than the same size checks into more companies each fund). VCs suggested that founders raise more, sooner, and at higher valuations (also boosting their returns, justifying bigger funds).

Here’s a real story about a fallen unicorn with names redacted: a company had an acquisition offer on the table. But an Investor on their cap table wanted to put more money into the company. That investor convinced the founders (with visions of private jets, elaborate parties, houses, and fame) to raise more money at the same valuation as the acquisition offer. A few years later, the founders’ equity is currently worth $0 as the company is worth far less than the preference stack (total amount raised).

Management fees: that’s why the f*ck nobody told you that you could take less.

Founders: in a world where advice flows freely like AWS startup credits, I encourage founders to scrutinize the motivations behind the guidance they receive. Understand why someone is encouraging certain behaviors or actions. What are their motivations? No matter how altruistic someone seems, figure out their angle, how they benefit, and what motivates them. Understand people’s goals, targets, and strategies. Understand their incentive and you’ll understand the outcome.