The wrong way to divide the pie

hands on a table with phone and page of data

Show me the incentive and I’ll show you the outcome. 

There’s a well-known adage in the investment world that also applies very well to the business world at large: If you want results, you must be willing to pay.

What they don’t tell you is that there is a right way to pay and a wrong way to pay. And the more you pay wrongly, the worse the outcome would be. 

When it comes to fund investing, limited partners do not dictate how each of the general partners will get paid. Some funds pay their partners by performance, others, such as Softbank, by seniority, while others choose to treat each partner equally. The mechanics behind these payments influence how each partner interacts with one another, ultimately leading to which deals get done and how—or whether they get done at all. 

Unfortunately, this is not always in the best interest of the limited partner more often than we might think.  

The economics of venture capital 

A typical venture fund gets paid in two ways: management fee and carry interest. 

A management fee is charged annually. It’s often around 2% during the investment, dropping down by 25-75 basis points during the harvesting period. Because venture fund has been traditionally small compared to private equity and hedge funds, these management fees are not massive (though this has changed in the last few years). 

Venture capital aims to generate a massively outsized return. Top decile venture funds may return 7-10 times the invested capital, and the manager takes a 20-30% cut on the profit called carry interest

Consider a $250 million venture fund. Each year, the fund makes about $5 million in management fee and, assuming a top quartile performance of 3-5x—call it 4x—the fund returns $750 million in profit and the partner takes 20% of that. That’s $150 million, spread over the 10 years fund life.

We will call the management fee and carry interest the “pie.” 

Where does the pie go? 

Unlike a startup, a fund is typically structured under a limited partnership with another entity. This other entity is referred to as the general partner of the fund (or the fund manager), and they have the legal right to control the fund. The carried interest is typically (though not always) assigned to the general partner of the fund, which they then split amongst various partners, investment professionals, and occasionally non-investment team members. 

The management fee is almost always assigned to the general partner of the fund to pay for headcount and other operating expenses. 

The term general partner thus refers to the legal entity in control of the fund, but it is also often used as the title of the investment partner themselves who work on and lead the deal.

Similar to a startup, venture funds maintain a vesting schedule for the carried interest in which the recipient receives the vested interest in the carry based on the agreed-upon rate and proportional to how long they work for the fund. 

But just like all incentives, this also varies depending on other factors.  

How is the pie divided? 

Knowing where the pie goes begs one question: how are the management fee and carried interest divided? 

Consider a team of ten salespeople. Few companies, if any, pay their sales team a fixed salary in equal amounts. Sales are incentivized based on their commission; the more they kill, the more they eat. 

But what if one sale generates 80% of the total sales, and the other nine only generate the remaining 20%? Naturally, the company will introduce a cap on how much such sales get paid to produce some semblance of equality to the rest of the team—which will inevitably create a feeling of unfairness to the person who generated 80% of the sales. The company has to please the top salesman or risk losing their top talent and revenue source while making sure the rest of the team does not feel like they’re missing out on preferential treatment. 

This is exactly what happens in venture capital. One win can produce as much as 80% of all return. In such a case, should the pie be paid mostly to the partner that brings in the deal? After all, they’re the one who works most often with and spends time nurturing the company until it exits? Or should the pie be shared equally amongst the partners because no one really knows which companies are really going to take off? 

Like the answer to most questions, it depends. In this case specifically, it depends on the size and workflow of the partnership. 

How is the pie created? 

Let’s start with the workflow:

At the start, each partner is typically responsible for sourcing, investing, and managing their own subset of the portfolio. They do collaborate, picking each other’s brains, and together act as the investment committee to keep each other accountable and act as a check and balance. 

So how does a deal get done? 

In most firms, deals go through a series of steps, starting with an initial meeting of about 30-60 minutes. If a deal is interesting, a partner will typically lead that deal through further diligence. A deal concludes when the startup founder meets with the partnership of the investment partners and is met with a decision. But not all deals see this entire process. In fact, most deals get dropped off along the way.

Unlike a law firm partner who can deliver counsel and get paid on their own, a VC investment partner is highly unlikely to get the deal done by themselves. They require buy-in from other investment partners. The way they generate these buy-ins, as it turns out, could be directly traced back to the way they are incentivized. 

To vote or not to vote, that is the question—and it depends on team size

Consider a partnership of two investment partners. It’s feasible to assume they both could talk through each deal, make a decision unanimously, and share the pie equally. 

But when the partnerships get too large, consensus decision-making becomes impractical. It also gets increasingly difficult to “split the pie equally” without performance consideration because it introduces free-rider problems. 

In 2016, Sequoia Capital had 11 investment partners. At the time of writing this article, Andressen Horowitz has more partners than I care to count or know. The running joke is that everyone at Andressen is a partner. 

Clearly, not all these partners can discuss and make decisions on each deal across all stages of the deal’s lifecycle. So while one partner cannot advance the deal on their own, it is also impractical to loop everyone into the deal. Naturally, politics dictate a faction will be formed; certain investment partners will “team-up” with another. 

When politics are introduced, so is the quid-pro-quo nature of dealmaking. Investment partners are afraid of shooting down the deal of a partner they team up with because the same might happen when they bring up a deal. Standards deteriorate and a committee of partnership turns into silo decision-making units.

This is exasperated further if the incentive is shared based on performance. Each partner is motivated further to get their deal across the finish line. The competition for the best return for the fund becomes a competition for the individual best return. The more capital they can point out the deal they source and lead, the more likely they are to win large performance bonuses. 

Keep it lean, keep it fair

Venture is as much a partnership between investors and founders as it is amongst the investment partners themselves. 

This partnership keeps each partner accountable for their work. Incentive systems that encourage each investment partner to rival each other in a zero-sum game will ultimately lead to quid-pro-quo, less scrutiny of investment rationale, and ultimately lower return. 

The right incentive system should encourage the partnership to work together and engage each other in as many deals as possible. Performance-based rewards are not a bad thing, but team-based rewards should be materially larger to incentivize collaboration. Venture capital is based on a network, and the first and most important network begins within the partnership. 

Thus, the best way to divide the venture pie is to simply create a larger pie where everyone ultimately has more than enough to eat. 

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