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Returns need to be better if there is more risk and less liquidity, right?

One possible fee structure would be a reasonable fixed amount to cover expenses including supporting portfolio companies (maybe 2% isn't crazy), and an incentive fee on returns above some reasonable hurdle or benchmark.

If the investments yield an 8% gross annual return, the VC who is not at risk is getting paid a rich 3.6%, the investor a paltry 4.4%. Maybe it should be e.g. 20% on the excess over 7.5%, 30% on the excess over 15%.

Then if the investments yield 8% gross, VC gets 2% and investor 6%, and if the investments yield 20%, VC gets 5% and investor gets 15% (if I did that right, would have been 6%/14% under 2/20, at some higher point crosses over and VC does better)

When selling a company or taking a company public, the sale price factors in future growth and earnings, so it's not like you're "missing out" on that growth (assuming you get a fair price).

It's easy to conclude that 'All companies should hold out on selling' because if you look at the data for companies that held out, they outperform.

However, there's extreme selection bias. When your true value is in the tens of billions (FB/GOOG), you're never going to get acquired for a fair price because no company can afford you, so you are always going to be in the 'held out' cohort.

There are plenty of businesses whose true value (future discounted cash flow) is in the hundreds of millions or low single digit billions. At this price, many of these companies could find a suitable buyer at a fair price. Since liquidity is a good thing, there's no reason not to.

> If a company blows up, the vast majority of the returns are coming after 4-5 years. I mean, look at GOOG, and only returns since it went public (~6 years after founding)

Using GOOG as an example of expected returns is an absurd generalization. By definition, the expected return on a public stock following an IPO roughly aligns with the rest of the public market (4-8%).

Is there evidence of fund returns non-correlated to the public markets? Big IPOs in down markets? I see a lot of dot-bomb kinds of things, and the latest IPOs have been taking full advantage of the froth in the public markets. It's hard to imagine Snapchat making a go of it without the current stock pricing being so lenient.

These VCs have some interesting data about that: http://blog.ttcp.com/the-inverse-correlation-between-venture...

I'm not sure I agree with them or their particularly analysis, but I'm very convinced they are different because the way I see it, VC and the public markets are completely different things. It's like the farm system for baseball teams. VC is investing in the upcoming prospects, and the VC is investing in the existing major leaguers. Sometimes you'll have a farm system full of A+++ prospects that pay off huge (Google, Facebook), and sometimes you won't (pick a 5 year period where there were no massive VC payouts). And obviously the returns on those prospects will only go to whatever team they happened to be on (which VC picked them), whereas public market returns can go to anybody. But they are different companies at different ages doing different things. Thus to me it would be quite surprising if their returns were all that correlated.

And at some sense "froth" is irrelevant. A VC doesn't have to sell their Facebook or Google stock when it IPOs, they can hold onto it as long as they like. They are basically investing for the chance to get that amazing stock at a huge discount by getting it at the "prospect" stage, and once it goes public they can ride the public market waves as well.

Very good point about farm league and doing different things -- but it's not clearly the case that a VC can hold onto their Facebook or Google stock.

Generally, there are restrictions in the LP agreements that may limit the amount of the fund that is in publicly-traded securities. There may also be requirements for distribution to the limited partners of public-traded securities.

VCs are paid to make illiquid private investments and massage them through to the point that they are liquid (cash, or marketable securities). LP investors, as a whole, are less than sanguine on the VCs subsequently becoming public markets equities horse-bettors.

That is interesting. I did always wonder at what point the VCs transfer the returns of post-IPO shares to their LPs, because it seems like the timing on this can make a huge difference to the VCs return. Especially if the majority of your funds return is going to be concentrated in a few companies stock. Seems like it could make a big difference on what the carry is going to be which might make some weird incentives for the VCs.

I was basing my comment on something a Sequoia partner said that they'd never sold a share of their Google stock, but that might have been their own personal investment (or frankly I have no idea how it works -- do LPs always get cash as returns or do they get shares of the post-IPO stock?).

> do LPs always get cash as returns

Unless a special deal is arranged it is cash in, cash out.

> So the core part of the message that VC is broken because most of them don't beat the public markets doesn't really matter.

No, it matters. Investors want investments that are not closely correlated with the public markets, but they still want something that is going to have a decent Sharpe ratio (~return/risk).

Furthermore, is it even true that VC returns are not well correlated with the public equity markets? My guess is that they would be pretty closely correlated.

> Furthermore, is it even true that VC returns are not well correlated with the public equity markets? My guess is that they would be pretty closely correlated.

On the contrary, I would posit that they're not correlated, or perhaps only weakly so. One of my primary concerns with the venture capital industry and the private equity markets in general is that there is no mature mechanism for the market consensus to reflect short opinions.

In public markets, there can be significant dissenting voices expressed by short interest which will have a material impact on the price of an equity. In the private markets, pessimism from many parties cannot be used to directly influence the consensus price. In my view, this leads to a natural bias towards successful private companies rising in valuation over time, whereas public companies swing more easily in either direction and have a harsher regulatory climate.

While both markets are influenced by things like interest rates, I would default to assuming that they significantly diverge in aggregate returns over time. They also have significant differences in liquidity, which means unhealthy economic trends in one may take a relatively long time to manifest in the other, even if they were otherwise correlated.

Here's an easy one: 20% of profitable returns, without the 2%. If you don't make the money, you don't get the money.

It's a lot easier to get the money out of your investors than to beat it out of your competitors, haha.

Hedge funds are all the same at the end of the day.

How are the VCs going to keep the doors open?

If you take away the 2% return, you've basically said that only super rich people that can afford not getting paid for 5-10 years should be VCs. Do you think that all the best investors in the world are super rich people?

Also, when to take that 20% is an issue. Perhaps a VC that is strapped for cash would push a company to exit sooner, or sell the stock right after the IPO, so they could take some of their profits off the table and thus get some working capital. However maybe they'd get a better return for both themselves and their investors by waiting another 5 years. Sequoia has very famously said that they've gotten more returns from their companies post-IPO --> now than they have from initial investment --> IPO. If you believe in the long term prospects of a company you essentially want to never sell the stock.

I'm not suggesting there isn't an alternative, but I'd like to see it. The LPs who continually agree to this fee structure aren't idiots.

>If you take away the 2% return, you've basically said that only super rich people that can afford not getting paid for 5-10 years should be VCs. Do you think that all the best investors in the world are super rich people?

You can take away the 2% and leave some value value that still pays the investors. The problem with 2% is that the fund managers often taken home %1 type wages without actually performing. A %1 fee with a clause that caps all fund managers salaries at $60k (or some livable wage) ensures that the investors can live, but puts all of the income incentive on their bonuses which is tied to fund performance.

> The problem with 2% is that the fund managers often taken home %1 type wages without actually performing.

Right, and fund managers will work for free instead. I know quite a few of them and I would not want to trade with them. Spend half your life in transit lounges of airports and the other half in hotel rooms, maybe if you're lucky you get to see your kids on the weekends. I know divorced couples that get more family time than some of the VCs I work with, they're the hardest working people that I know, much harder than most founders.

I suspect that your viewpoint is not illuminated with actual experience of the VC world.

Note that people that made enough money to start a VC fund usually value their time well and if you want to get them to pull your cart for you (as an LP you have to do absolutely nothing) they expect to be compensated for their time.

It's easy to dump on the management fee, especially seeing the world through the underfunded entrepreneur's eyes.

But the VC fee structure is probably among the most honest and legit setups in all of finance.

Look at Private Equity (PE) fees. In addition to whatever the LPs are directly paying, portfolio companies themselves are posting up huge fees back to the PE firm. Plus dividends, director fees, you name it. "Promotes" for putting a deal together with a syndicate. Etc. etc.

Look at lending. You've got stated rates but all kinds of extra fees, origination expenses, etc. baked in. When your lender gives you an APR, he is looking at a projected IRR that is way higher, I guarantee.

Early stage VCs -- with few exceptions, and those mainly during weird downturn / recap scenarios -- are generally getting plain vanilla convertible preferred stock. No management fees. No origination / finder's fees. No director fees. No promotes.

There are, by the way, some mechanisms for dealing with absurd fees (in VC and other asset classes). They're well known, and already practiced by savvy LPs with leverage.

That's not realistic. It can take many years before there is a return even for a successful fund and during that time you somehow have to rent some space, keep the lights on, pay the secretary, pay the associates and pay for the DD costs for deals that went very far but eventually did not go through.

This really adds up.

> The ancient “2 percent and 20 percent” should be killed off and replaced with something that endorses higher alignment. Let the VCs fight for their supper.

I agree, this is a stupid fight. Higher alignment is called "Private Equity" and it already exists as a model. VCs will go where the market (i.e. the money) tells them, which right now is 2/20. All of the VCs that don't return their funds will simply stop getting LP money and cease to exist.

> I recently had a meeting...talking about the macro view of venture capital and how it doesn’t actually make sense....It took me a while to understand what this really means.

Ok so the author just had a meeting with an angel investor, decided to do all of the research (that's already freely available mind you) and came to the same conclusion as everyone else. Ugh.

>>>Higher alignment is called "Private Equity" and it already exists as a model.

That is NOT what PE is at all! PE is about buying WHOLE companies that have established businesses but are struggling. PE does NOT invest in growth companies that are new to the market / not yet proven, nor do they take small percentage ownership.

"Private equity" is any investment position, including VC, in a private company. What you are describing is specifically distressed investments. There are plenty of firms who make growth or mezzanine investments in established companies that need a quick infusion of capital.

> that have established businesses but are struggling.

> PE does NOT invest in growth companies

I've advised over 50 transaction on behalf of Private Equity firms. These are not true statements.

Just for context, the old "two and twenty" is the fee structure for most (still? many?) hedge funds. Who I assume VCs are competing with for investor money.