VCs Challenged by the Downturn

While current startup difficulties deserve the most attention (broken cap tables, valuations lower than capital raised, slowing growth rates, etc.), venture firms, especially ones that deployed significant amounts of capital in 2020 and 2021, are challenged as well. Writing checks into startups whereby their real valuations are likely 30 – 70% lower, even after a couple years of growing, makes for an exaggerated J curve (rates of return are negative in the first few years due to the drag from management fees). Only, the story is worse, and more complicated.

While venture fund fees are usually 2 and 20, meaning a 2% management fee and 20% of the carry (profits). The 2% management fee is paid on committed capital. With a $500M fund, that’s $10M/year in fees. Most funds are 10 years with two optional one year extensions, so best to think of the management fee side as really 20% of the fund (2% per year for 10 years). Instead of 2 and 20, 20 and 20 is the real way to think of it (20% of the fund as management fees and 20% of the profits as carried interest). Yes, the fees can be substantial, but it’s best to think of venture as get rich slowly, as most don’t beat the S&P benchmark and take 7+ years to see any distributions.

With venture funds, the general partners (GPs) are required to put 1-3% of the capital in themselves. So, if it’s a $500M fund, and the partners collectively are putting in 2%, they’re committing $10M. Many of the younger partners, while they’re making a good salary, often have to borrow money for their portion of the GP commit. Well, that debt they’ve taken on looks even more distressing considering it could be years before their portfolio company valuations are back to the original investment value, let alone at a scale where they’ll make good money on an exit. 

Net net, the chance of this cohort of VCs making substantial profit is low yet personal debt is high. VC is a tough job to get, and right now, quite a few VCs are thinking about their current careers. Vintage 2020 and 2021 venture funds are likely to perform poorly save for the occasional power law winners. Venture is still an important part of our economy that has an outsized impact, and should be supported and encouraged, even if a couple years prove difficult.

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