I’ve had several people ask me what it’s like to run a venture-backed start-up with the current mess on Wall Street. My short answer, from a financing point of view, is that “not much has changed.” You can see why if you look at how the VC business works:
- Venture firms run venture funds
- Venture funds are typically 10-year, illiquid partnerships
- A fund typically has one general partner (GP) and multiple limited partners (LPs)
- The LPs are the investors who commit capital at the start of the fund
- LPs give that capital to the fund over the first few years through a series of “capital calls”
- LPs who miss capital calls are typically diluted out of the fund through draconian provisions in the partnership agreement
- The GP runs the fund, and earns nice fees for so doing. (Typically 2-3%/year of the committed capital and plus 20-30% of the upside. The fixed fees pay for healthy base salaries and the tasteful but not extravagant offices on Sand Hill Road. The upside cut is what buys Gulfstreams and ranches in Montana.)
- The GP follows some process to decide which early-stage companies it wants to invest in
- The fund buys preferred stock of those companies (founders and employees typically hold common)
- The fund holds those shares, seeking an eventual “liquidity event,” such as an IPO or acquisition.
Next to credit default swaps, complex derivatives and 30:1 leverage ratios, the venture capital business looks almost quaint by comparison: using no leverage, buy and hold the stock of a portfolio of early-stage companies.
Speaking of leverage, I thought I’d share this quote du jour that I found on Infectious Greed:
What is truly disgraceful is that investment banks could only manage returns on equity of 15-25% with a balance sheet that was often leveraged to the sky.
— Niels Jensen and Jan Wilhelmsen, of Absolute Return Partners
With a 30:1 leverage ratio, it means the underlying investments are returning <1% a year. While that makes sense in true arbitrage situations, the use of high leverage went well beyond classical arbitrage as far as I can tell.
Excellent post, Dave. Pithy, and insightful!