Would a VC finance a company without examining its budget? Would a VC make a follow-on investment in a portfolio company without seeing its income statement? This is highly unlikely, yet this is precisely what many LPs fail to do when they back venture managers. An LP recently shared with us a conversation he had with a prospective GP:
LP: Thanks, that was a great pitch. We like the story and think you have a very experienced and cohesive team. We’d like to move forward with our due diligence. Can you send us your management company’s operating budget and cash forecast?
LP: We are interested in how you are planning to run the management company, how you will allocate your “top line.” We also heard you talking a lot about cash-efficiency and want to understand how you practice it in your own company.
GP: Frankly, we do not disclose this information and do not think it should be part of your decision process.
LP: From our standpoint, it’s helpful to understand how our managers optimize their expenses. Do you fund a company without looking at its budget?
GP: That’s different. We know what we are doing and in our business we don’t share that information with our investors. It’s very confidential.
LP: OK. Can you at least give us a sense of the expense category breakdown, how much you will spend on office space, personnel, marketing, travel, etc.?
GP: Sorry, but we’ve never been asked this before. In light of our aggressive closing schedule, it probably makes sense for you to consider our next fund.
This dialogue is becoming more common as LPs continue to focus on the tens of millions of dollars that many funds are generating in fees alone. Not that the fees themselves are new; the 2.5% fixed fee has been a standard for most Silicon Valley venture firms for more than a decade. However, at the time of its creation, most funds were less than $50 million. Two and one-half percent of $50 million ($1.25 million) is a far different figure than 2.5% of $1.5 billion ($37.5 million). Further, most of the firms that have raised funds greater than $1 billion have multiple funds under management, meaning they are drawing multiple layers of management fees.
In recent years GPs were paid far more in fees than they were in carried interest and without the nasty clawback (and performance) requirements that carry brought. This issue has developed into a fundamental lack of alignment between LPs and GPs. The return of “smaller” funds in the $300 million to $400 million range does not rectify the alignment. Many of the “smaller” vintage 2003 and 04 funds and their management fees are additive to several prior funds under management.
In the not too distant past, most funds were in the $15 million to $30 million range. Two and one-half percent of a $30 million fund provided $750,000 in fees annually, enough for two to three modestly paid GPs, office rent, administrative staff and legal fees. Industry folklore is rich with stories of the early days of today’s fabled GPs, when many would stay with their friends or lawyers while traveling to save $35 in hotel expenses. Clearly, GPs were not getting rich on fees.
But the great returns of the VC industry drove more dollars into the business. Fund sizes grew and investment cycles shrank. The 2.5% management fee precedent stayed more or less constant as LPs made so much money that no one seemed to mind. Several “safety valves” were eventually introduced into partnership agreements, but for the most part fixed management fees both created and maintained the precedent. Even as some large funds reduced their fees to 2%, the structure remained fixed.
Many of today’s top firms have evolved over time to raise multiple overlapping funds with multiple overlapping management fees. An example of a firm with multiple funds under management might look like Figure 1.
Assuming management fees remain at 2.5% for the first five years, then drop to 1.5% for the last five years, the annual management fees may look like Figure 2. This begs the question on whether management company expenses have also increased by 15,600% during this period. The answer lies in examining the management company’s budget.
Clearly, fund size does play a role in determining expense budgets for a management company. With multiple offices, large back-office infrastructures and expensive real estate, many firms need a sizeable budget to help defer the cost of a 50 to 75-person organization. Regardless of size, an understanding of the expense structure should help both GPs and LPs determine the appropriate budget required to run a healthy and cash-efficient management company.
What’s in a budget?
Venture capital is a people-intensive business. As a result, salaries and compensation should be the highest single category of expense. The subject of “appropriate” GP compensation has been well studied.1 In general, GPs should be well paid for being in a tough and complex business. Their compensation (cash as well as carried interest) should fluctuate with their results. At most firms though, cash compensation is fixed without a clear link to performance. A well-known venture capital firm refused to invest in a Blueprint portfolio company by saying: “We’d rather make two times a $10 million investment than 10 times a $1 million investment.” An expense budget survey would probably suggest that managers in this firm do not have the incentive to make the best investments they can, but only those investments that allow the largest amount of money to be put to work.
Rent is an expense firms can take advantage of in a changing economic climate. In Silicon Valley, real estate vacancies are at a historical high. Class A office space in desirable areas is available for less than one-third of what it was in the “bubble” days, and firms can and should renegotiate for more favorable rates with their landlords. As a guideline, extremely attractive and well-furnished Class A office space is available in the San Francisco Bay Area for $1.60 to $2 per square foot per month. With a generous space budget of 400 square feet per person, a 20-person organization can conduct business for about $12,800 to $16,000 per month.
Venture firms need the freedom to invest in their business in the form of marketing, market development, brand building and portfolio support. As a guideline, many firms hold annual meetings and quarterly events for their investors or portfolio companies. Annual meetings are often covered by the fund itself, not the management fee.
In some cases, GPs engage public relations firms to build up their brand image in the community. This is an expense of wide-ranging latitude, as different firms have different philosophies on how to increase deal flow, brand and image in the community. Still, marketing expenses can run as high as $1 million per year for a market-minded firm.
Travel is the most wide-ranging expense category because it depends on the corporate cultures of the GPs as well as their geographical dispersion. At one end of the spectrum, private jets are used by venture firms that frequently need to visit LPs or other GPs. Typically, firms that use private jets do not back companies outside of a short driving distance, so the jets are mostly for non-deal travel. In the middle range, GPs will fly first-class to LP and portfolio company meetings and stay at four-star hotels. For example, a VC firm recently hosted a recruiting day for a principal position and flew 30 candidates first-class to California for interviews. The travel expense alone for the weekend was $100,000. But, more entrepreneurial GPs will “eat their own dog food” by traveling coach and booking flights early. Some will remember Bill Gates was several times a billionaire before he bought a first-class ticket. Even today, Intel executives fly only coach.
As LPs begin to explore these budget items, many will come to believe that budget-based management fees, rather than the fixed-percentage model, will yield the best visibility and force GPs to manage their own business as they manage others. Many firms have moved to this model, including Mayfield, Menlo Ventures, New Enterprise Associates and U.S. Venture Partners.
Careful examination of GP budgets, should it ever become practice, is likely to further expose the often-egregious cash compensation structure of many firms. If this is true, LPs need to understand how to change the structure to create incentives for managers to perform – rather than just raise funds. Unfortunately for the industry, the precedent of fixed-fees is strong and pervasive. As newer emerging managers come to market, transparency and a true-partnering approach with LPs may offer a window that did not previously exist. LPs have to learn to say “NO” to firms that will not, at the very least, share their management company budget philosophy. Until that happens, the move to reasonable fee structures will be slow in coming.
George Hoyem and Bart Schachter are managing partners with Blueprint Ventures. Based in San Francisco, Blueprint is an early-stage venture firm with two funds under management. Hoyem’s investment focus is software, wireless, security, and other IT and communications infrastructure companies. Schachter focuses on communications and IT infrastructure, wireless technologies, nanoelectronics, software, and communications semiconductors.
1 Hoyem, G. & Schachter, B. (2003, June). Can emerging managers compete effectively for venture talent? Venture Capital Journal, 53-54.