by Scott Kupor
But wait a second. Is there really a profit on which the GP is entitled to take her 20 percent? The answer is maybe. We need to take a little detour to introduce two other important concepts before we can conclusively answer that question.
As with fine wine, VC funds should get better with age. In fact, that’s why people in the industry refer to funds by their “vintage year” (or birth year), just as winemakers date mark their wines based on the year of the grape harvest.
As we discussed earlier, in the early years of a fund, VCs are calling capital from LPs and investing that capital in companies. This is a decidedly negative cash flow motion—money is going out with (likely) no near-term prospect of money coming in. That’s an expected effect, but eventually a VC must harvest some of those investments in the form of those companies going public or being sold.
The effect of calling capital from LPs in the early years coupled with the long gestation cycles for companies to grow and ultimately exit—in many cases it takes ten or more years for companies to be sold or go public—creates what is known as the “J curve.” As you see in the figure on the next page, the LP has negative cash flow (from the capital it’s giving to the venture firm for investment) in the early years of a fund and (hopefully) positive cash flow in the later years of the fund, a combination both of the capital having already been called and invested and the portfolio companies being sold or going public.
J CURVE
Venture capital is truly a long-term game. But, as explained in our discussion of the Yale endowment in chapter 4, cash does eventually need to come out the other end. Successful GPs will manage their portfolios to drive to this outcome, which can affect how they interact with entrepreneurs on this topic.
One phrase you often hear in the hallowed halls of VC firms is “lemons ripen early.” That is, the nonperforming companies tend to manifest themselves close in time to the initial investment. Interestingly, this exacerbates the J-curve problem in that not only are VCs investing cash in the early years of a fund, but the nonperforming assets are certainly not helping the GP return money to the LPs.
Understanding Valuation Marks
Venture firms (as is the case for other financial companies) are required under generally accepted accounting principles (GAAP) to “mark to market” the value of their underlying company holdings on a quarterly basis. But, unlike a hedge fund, for example, where the mark is based on the actual, marketable value of a public security, VC marks vary highly based on multiple valuation methods prescribed by different accounting firms, as well as a VC firm’s qualitative assessment of the likely future prospects for that business.
That means that for every company in a GP’s portfolio, there is likely another VC invested in the same company that marks it at a different valuation than she does.
These are the primary methods used by venture firms:
Last round valuation/waterfall—Some firms value their companies by taking the last round valuation in the private market and assigning that value to the firm’s ownership in that company. For example, if a firm owned 10 percent of a company and the last round valuation was $200 million, a firm that utilized the last round/waterfall method would report the value of its holdings as $20 million (0.10 × $200 million).
Comparable company analysis—Other firms, particularly for companies that have substantive revenue and/or profits, will use a public company comparables analysis. In this method, the firm will devise a set of public “comparables”—companies that have a similar business model or are in a similar industry—and pick a valuation metric (often a revenue multiple) to reflect how the broader public market values this set of companies. That metric is then assigned to the financials of the portfolio’s companies. For example, if a portfolio company is generating $100 million of revenue and its “comparable” set of companies are valued in the public markets at five times the revenue, a venture firm would then value the company at $500 million ($100 million × 5). The firm would then multiply this company value by its percentage ownership in the company to reflect its holdings based on whatever percentage of the company the firm owned. Often, a firm will then also apply what’s affectionately known as a “DLOM” (a discount for lack of marketability) to reduce the carrying value of the company—basically, this discount says that because the stock is private and can’t be freely traded, it’s worth less than that set of comparable public companies.
Option pricing model—The newest (at least to VC firms) tool in the valuation tool set is what’s called an “option pricing model” (OPM). This one is the most complicated mathematically and uses the Black-Scholes option model to value a portfolio company as a set of call options whose strike prices are the different valuation points at which employee options and preferred shares convert into common stock. Perfectly clear, right? Here’s a quick example: If our hypothetical company raises a Series C financing at five dollars per share, the OPM says that all we know for certain is that anyone who holds Series C shares should value them at five dollars—simple enough. But if you own a Series B or a Series A share, the OPM says those are worth some fraction of five dollars—why? Well, to really answer that question you’d need to have a Nobel Prize in economics (as does Myron Scholes, the co-inventor of Black-Scholes), but the not-too-mathematical answer the OPM generates is that those Series A or B shares could be worth many different values based on a series of probabilistic outcomes if/when the company ultimately gets sold or goes public. So the OPM will assign a value to the Series A and B that is a substantial discount to the price of five dollars per share that is assigned to the Series C.
Let’s look at an example to see how all this influences valuation marks.
Assume that our GP owns 10 percent of a company for which she paid $10 million. Lucky for our GP, the company just raised new money at a $3.8 billion valuation.
How would our GP “mark” the valuation of the company based on the differing methods we described above?
Last round valuation/waterfall—Under this method, the value of the company would be $380 million (0.10 × $3.8 billion). So, on the initial investment of $10 million, that is a hypothetical return of thirty-eight times.
Comparable company analysis—Assume our company is forecast to generate $130 million of revenue in the coming year. Looking at high-growth multiples for comparable companies in the public markets, investors might assign a multiple of ten on that revenue, resulting in a $1.3 billion value for the company. So the GP might value the company at $130 million (0.10 × $1.3 billion) and then assign a 30 percent DLOM to that, resulting in a $91 million valuation ([1 – 0.30] × $130 million). That’s a hypothetical return of nine times—not bad, but quite different from the thirty-eight times above.
OPM—You’ll have to trust me on this one, since the math does not easily lend itself to a paragraph summary! But an OPM with reasonable assumptions on time to exit and volatility would yield about a $160 million valuation for the GP’s holding, or a sixteen-times hypothetical return.
So which accounting methodology is right? Well, the answer is that they are all theoretically “right” in that different accounting firms would likely sign off on these as consistent with GAAP. But, at the same time, they are all “wrong” in that none of them actually tells an LP anything about what the company might ultimately be worth to the fund when and if it ultimately goes public or gets sold and the proceeds of those events are distributed back to LPs.
Now that all that is as clear as mud, let’s return to where we started.
As a reminder, our GP is in year three of her fund. She’s invested $100 million and has just received a check for $60 million from selling one of her companies (in which she invested $10 million). She was planning to keep 20 percent of the profit for herself and give 80 percent back to her LPs. What do you think?
Well, if all the other investments in the fund have gone to z
ero (in other words, bankrupt), then she invested $100 million and has only returned (and will only ever return) $60 million. In that case, the answer is pretty simple: no. There are no profits, and all $60 million goes to the LPs—and our GP not only earns no carry on this fund, but she will also have a hard time raising her next fund!
But what if, instead of every other company in the fund going kaput, the other companies are valued based on interim valuation marks at $140 million? Forget about which combination of the valuation methods we talked about is being used; it doesn’t matter as long as the GP’s accounting firm is willing to sign off that the other $90 million she invested in other portfolio companies is worth $140 million. Again, these are marks because we are not talking hard cash here, but rather just an accounting of how much we think we could generate if we were to sell all these companies today.
In this case, the fund has $60 million of actual cash and $140 million of hypothetical value in the form of marks, for a total of $200 million in current value. The fund only raised $100 million from its LPs, so there is $100 million ($200 million in current value—$100 million invested) of theoretical total profit. So, since the theoretical profit exists, our GP can now keep 20 percent of the $50 million in cash profit as her carried interest. So 80 percent ($40 million) goes to the LPs and 20 percent ($10 million) goes to the GP.
Let’s now assume that the fund has reached its time limit and is over. Most venture funds have a ten-year life with two or three one-year extension periods.
What happens if that $140 million in interim marks we booked in year three were ephemeral and all the companies comprising those marks proved to be worth no more than the paper this book was written on?
So, in reality, the fund generated only $60 million in total returns on a fund of $100 million; all those other profits disappeared. But the GP distributed $10 million to herself back when the prospects for the fund were looking up. What do we do now?
Unfortunately for our GP, she overdistributed profits to herself and is now subject to what’s called a clawback—the money needs to be returned by the GP to the LPs. That sucks, but it is fair in that the GP never would have been entitled to that money had she waited to distribute the $60 million until the fund was over. She didn’t, after all, really generate any profits on the $100 million of capital the LPs gave her to invest. (To avoid this problem, some LPAs restrict the GP’s ability from being able to take any carry until she has returned the full $100 million in LP commitments back to the LP in cash. Admittedly, this is pretty rare.)
While it may not seem this way, we simplified things quite a bit in our example. There are a few other nuances to the economic terms of the LPA that are worth reviewing (and unfortunately complicate our example a bit).
First, what about those pesky management fees we talked about earlier? In our $100 million fund, the GP is of course supposed to use that money to make venture investments, but she’d also like to be able to use her annual management fee to pay the basic expenses of the business.
If the fund lasts for ten years and she is entitled to an annual fee of 2 percent on the $100 million committed amount of capital, then the total fees over the life of the fund will be $20 million (10 years × 0.02 × $100 million). If the GP collects all these fees, however, she will not be able to invest the full $100 million fund into companies; there’s only $80 million left to invest.
Some GPs may decide to do this. But, as you might imagine, the LPs don’t really love this approach because for their $100 million in committed capital, they’d like to have as many portfolio company investments as possible. And so would most GPs. After all, the more at-bats you have (hopefully), the more likely you are to improve your at-bats-per-home-run average.
The way to satisfy the desires of both the GP and LP is to “recycle”: most LPAs have a provision that allows the GP to reinvest, or recycle, some portion of her interim winnings into other companies.
So in our example above, when our GP got that $60 million in year three from the sale of her company, she could have elected to recycle some of that money. If she wanted to cover her full $20 million in expected lifetime fees, our GP could have held back $20 million from the proceeds and then distributed the remaining $40 million based on her $10 million return of capital and then a split of 20 percent (GP) and 80 percent (LP) on the remaining $30 million of profit.
Our second simplification is how the capital gets contributed to the fund. Recall that we talked about how the GP calls capital from the LP as she makes investments. But we had simplified things by assuming that all $100 million came from the LP. In reality, the GP also has to have some skin in the game; the more the better (from the LP’s perspective). After all, nothing sharpens the mind like managing your own money alongside your LPs’ money. As a result, most GPs contribute 1 percent of the fund’s capital, and many times they will contribute 2–5 percent of the capital. Thus, over the life of a $100 million fund, between $95 million and $99 million will be contributed by the LPs, and between $1 million and $5 million will come from the GP.
If we return to our carried interest problem from before, we need to add this to the equation.
Let’s look again at the good scenario—the fund has returned $200 million in actual cash at end of life. How do we distribute that money? Keep in mind that $100 million is the return of capital invested, and the extra $100 million is the profit generated by the investments.
If the GP contributed 2 percent of the capital, this means that $2 million came from her and $98 million came from the LPs. So, logically (and this is how most LPAs read), we should return the capital to the parties in the same way that it came in: $2 million to the GP and $98 million to the LPs. Then we distribute the profits 20 percent ($20 million) to the GP and 80 percent ($80 million) to the LPs. Not much different from what we talked about before, but it’s important to note that capital generally first gets paid back in the same way that it came in.
The final complexity that we ignored—and rightly so, because it is not that common among VC funds (though much more so in buyout funds)—involves the opportunity cost of money. Because LPs have a choice of asset classes in which to invest, they naturally want to know that investing in VC funds will pay them a premium compared to other asset classes. After all, venture capital is risky and has long time horizons during which the LP’s capital is tied up. Instead of investing in a VC fund, an LP could choose to invest in the S&P 500 or some other asset class.
To account for this, some LPAs introduce the concept of a “hurdle rate” into the profits calculations. A hurdle rate says that unless the fund generates a return in excess of the hurdle rate (this is a negotiated number, but often around 8 percent), the GP is not entitled to take her carried interest on the profits. If the fund exceeds the hurdle rate, then the GP can start collecting her carried interest as if the hurdle rate didn’t exist. So, as long as you clear the bar, you are good; fall short and you get nothing.
A “preferred return” is another mechanism to accomplish this, but it is more LP favorable. Unlike the “clear the bar and take the money” aspect of a hurdle rate, a preferred return doesn’t just fall away when you clear it. Rather, if the preferred return were 8 percent, the LPs would get 100 percent of the money back until the preferred return is met, and then the GP participates in any profits above the preferred return. In our ten-year, $100 million fund, an 8 percent preferred return would amount to about $216 million [$100 million/(1.08)10] at the end of ten years; thus, a $200 million total fund return would garner our GP a big fat zero in profits!
Caring About How the Money Flows
As an entrepreneur, nobody expects you to ask your prospective VC funder to see all their documents and review them in detail. And I highly doubt any VC would hand them over to you even if you were to ask politely. But because economic incentives do matter, you should have an appreciation for how the money flows inside of a venture fund. After all, depending o
n how well the GP is doing converting her other portfolio companies into profit, she might think differently about liquidity with respect to your company.
How the fund is doing may also influence your GP’s willingness to invest additional money in your startup or her desire to seek an exit. If the fund is doing well—meaning the GP is on her way to her desired rate of return and thus likely to be able to raise a next fund from her LPs—she might be more interested in taking a gamble on your fund-raising and see whether you can help her generate even more profits for the fund.
But if your company is the lone shining star in an otherwise poor portfolio and you receive an acquisition offer that would meaningfully help the GP to get cash back to her LPs (and therefore increase the likelihood of her being able to raise a next fund), she might be more inclined to push you to take that deal, even if you think there is still more upside to come from running the business. Or if your GP is close to being in a clawback situation and you receive an acquisition offer that, while not that exciting for you, might give the GP just enough money to get herself out of that pickle, she might think differently about the offer.
And as we’ll learn later in the book, the GP is going to be an integral part of this decision-making process. In many cases, she will be a member of the board of directors and thus have a formal say in the vote on whether to accept an acquisition offer. There are of course legal issues that the GP needs to think about in her capacity as a board member that could limit her actions here. None of this is to suggest that GPs necessarily want what you might rightly consider a bad outcome for your company, but we are influenced by the incentive structures under which we operate. Even if she is not on the board, the GP will be a shareholder in the company, likely with special voting rights that attach to acquisition decisions. Better, therefore, to be informed.