How Do Investors Get Paid?

Startups planning to raise venture capital in these turbulent times should pay attention to the way investors get paid during bear markets. Compensation incentives drive the behavior of venture capitalists more than they do for angels and other noninstitutional investors.

Most funds pay staff salaries from a management fee that's calculated as a percentage of assets under management. Warren Buffet likes to call these investment professionals the "2-and-20 crowd," because the formula used to calculate their fees is typically 2 percent of funds under management and 20 percent of the upside return. Some VC funds with specialized skills or storied histories can justify fees of 3 percent and 25 percent to 30 percent of the upside.

The current recessionary environment has exacerbated an already difficult situation for VC funds. The past decade hasn't been kind to the industry. While management fees have enabled most VC professionals to earn a decent living, the investment returns haven't enabled the industry at large to get rich or satisfy the expectations of pension funds and other investors. Only the best venture capitalists--the top quartile--have earned annualized returns exceeding 10 percent. According to the National Venture Capital Association (citing Thomson Reuters data), in 2007, the median return of VC firms in the industry was below 5 percent for nine of the previous 10 years. The top firms and partners have done well in certain years, like 2005, but the industry cannot thrive if the median returns don't justify the higher risk profile of VC deals.

For startups trying to raise money now, there are several implications:

• Many VC firms won't survive. VC firms don't die quickly. The investments from their limited partners are usually locked up, so firms die quietly by foregoing the launch of a subsequent fund.
• You'll need to focus on top-quartile venture capitalists. If there were ever a time to focus your efforts on the best venture capitalists, this is it. Beyond the advantage of survival, these venture capitalists are the most likely to have funds still "in the money" during tough times. If venture capitalists believe they have no chance at getting carry on the fund, they lose interest in the remaining deals and in seeking new deals. This could explain why some venture capitalists aren't returning calls.
• You'll need to make friends with associates and vice presidents. These and other nonpartner professionals need to get deals funded to prove their value. In this difficult market, they can help you navigate the funding process and become internal advocates for you.
• Having multiple venture capitalists on your board could be more toxic than usual. In bull markets, having multiple investors on your board benefits you. In bear markets, this could be a double-edged sword. The idea of multiple investors may seem reassuring because it provides for multiple sources of funding, but the prolonged nature of this recession could cause toxic investor relations. The timelines of venture capitalists on your board could be misaligned if the recession persists, leading to challenging board meetings and investor dynamics.

—By Asheesh Advani, president of Virgin Money USA, author of Investors in Your Backyard and founder of CircleLending, which pioneered the business of managing person-to-person loans and mortgages and was acquired by the Virgin Group.

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