Venture Capitalists Innovate Business Model
Eric Benhamou Founder and General Partner of BGV shares his perspective. In her recent HBR post “Venture Capitalists Get Paid Well to Lose Money”, Diane Mulcahy offers a stinging indictment of the VC industry. In not so many words, she charges venture capitalists with the cardinal sins of gluttony by gulping fat fixed fees for a decade, and of sloth for delivering performance that fails to even match that of most public equity indices. While she does allow for the fact that a few firms demonstrate superior sustained performance, commensurate with the risks associated with the asset class, and while she does concede that the industry tends to churn out the weak players over time, her prognosis is ominous and tantamount to saying: “as it stands today, the VC industry does not deserve to exist!”. While I largely agree with Diane’s criticisms, my outlook is far more upbeat. I will start by a general observation from the very same report that Diane quotes from (2013 annual industry performance data from Cambridge Associates). It is true that the VC industry performance has been lackluster over the past 5 years as compared with public equities. But if we take any 10-‐year period (approximately two full business cycles) starting from the inception of the venture capital industry, VC performance has outstripped public equity indices – in some cases by a factor of 2X to 3X. The crisis that started with the explosion of the dot com bubble in 2001 has taken a long time to recover from. This is somewhat understandable when one deals with entities that have a time constant of 10 years (the median life term of a VC fund). But the venture industry of today has little to do with the venture industry of 2001. While the numbers clearly support this fact as Diane correctly points out, the transformations do not stop with the raw numbers of VC funds, firms or professionals. To begin with, let us remember that many well-‐known funds, which have always charged a 2% annual management fee, have also delivered spectacular results to their LPs, and these LPs did not mind one bit paying them. Others have used a transparent budget based approach to clearly explain the nature and magnitude of their operating expenses. But in an effort to be more specific and direct, let me offer my own venture fund BGV as an example, and take her four key arguments one at a time and explain how we deal with each. VCs aren’t paid to generate great returns. At BGV, our financial model is called NFSOP (a.k.a. No Fees, Share Of Proceeds). Correct, we do not charge any management fees to our investors. There is no way for us to make money unless our LP s make money. There is no way for us to coast, or get fat. We pay for our office, our computers, our administrative salaries, our travels, our conferences, our industry reports, etc.. ourselves. Because these expenses are out of our own pockets, we manage them tightly, much in the same way as the entrepreneurs of our portfolio companies manage their own expense budget. It would be hard for us to tell our entrepreneurs to pay themselves $100K per year until they are profitable (as apparently some VCs have done) unless we paid ourselves … $0K per year. Of course, we want to make money too. But we are comfortable waiting until our LP’s make money, and taking a quarter of their proceeds when they get realized.
VCs are paid very well when they underperform. At BGV, if we underperform, we have no fee income to rest upon. If our exits are long in coming, our cash flow suffers. We feel what our LP s feel. There is no buffer. VCs barely invest in their own funds. It is true that the common practice is for VCs to personally invest 1% into their funds. At BGV, we invest 20%. This is more than what our largest LP invests. With a commitment of this magnitude, we can stand up and tell our investors: it is not just that we don’t make money on fees. We have more at stakes than you do in this fund. If you lose money, we lose more. There is no way to escape. The alignment of interest is complete. The VC industry has failed to innovate. If the various points above aren’t enough proof that our financial model is a radical innovation and departure from the financial model that prevailed in the “lost decade” (2000-‐2010), let me describe another BGV innovation: over the past couple of years, we realized that most corporate development organizations of large corporations have become far more sophisticated about venture capital. Often, they have their own corporate venture capital arm. Almost always, they engage in direct investments and commonly partner with institutional venture capitalists or angel investors. At BGV, we allow our corporate partners to make direct investments along side us in portfolio companies of their choice. This enables them to target their capital on those that have strategic value to them without having to invest in the full portfolio. This “a la carte” approach overcomes the drawbacks of the blind pool and offers our corporate partners ultimate flexibility of choice in their investments, all the while without having to incur a dime in management fees. In conclusion, I fully support Diane’s diagnosis and indictment of many venture capitalists. But unlike her, I have full confidence that our industry will not remain inert and oblivious to these glaring shortcomings, but instead will rise to the occasion and transform itself, just like our portfolio companies succeed by transforming the strategies and business models of their predecessors.