Don’t Go Chasing Distribution Waterfalls: The Future of VC Compensation

Just recently I read Kanyi Maqubela’s post on distribution waterfalls and carried interest and felt compelled to write a rebuttal.

First of all, there is no such thing as a European style waterfall – not anymore at least. If anything, most American VC firms are the ones who use that supposedly “European” style waterfall where the principal must be paid back before any carry is made.

Since most LPA’s are bespoke agreements and highly individualized, a European or American style waterfall doesn’t really exist.

During the dot-com boom, VC’s were robber barons and had LP’s on their knees with deal by deal carried interest because times were pretty damn good.

But when the party ended, LP’s lost their collective shit and implemented the safer distribution waterfall that we now see commonly today.

Deal by deal carry is incredibly rare now and I doubt many US or European VC firms are able to convince their LP’s to agree to it.

Instead, we are now seeing more distribution waterfalls that directly rewards performance. For example, carried interest that incrementally rises based on return multiples (if the VC gets a 2.5x return on invested capital, the carry increases from 20% to 25% and so fourth).

But what I really want to expand on is the future of VC compensation.

Just recently a new fund called Maiden Lane emerged from the brain trust over at Angel List. Maiden Lane’s approach is simple enough: a 200k check for select angels to invest in a company of their choosing and 30 percent carry with no management fees.

It’s quite brilliant when you think about it: spread the money around to the best and brightest angels and let them invest in the next big startup.

And the implications of this new model are huge.

Instead of LP’s focusing on investing large chunks of capital in a small handful of funds, they can now leverage the talent and experience of multiple VC’s. And the best part is not having to pay those pesky management fees anymore.

I foresee a future where VC’s and angels make individual capital calls to LP’s. Found a new startup that you think will be hot? Pick up the phone or fire off an email to an LP requesting 250k. Rinse and repeat as needed.

Now VC’s and angels won’t have to go through the time consuming process of raising a multi-million dollar fund.

There is also the possibility of a new class of angels/VC’s that could be created.

If LP’s wrote smaller checks, they can try out new and emerging angels that have potential. A 250k bet on a new VC is certainly less risky than giving him $10 million for a fund.

And with the smaller amounts and no management fees, the VC is forced to source and invest only in the most promising startups.

The competition landscape will also be drastically changed.

Traditionally, VC firms competed against one another for LP funding. But if Maiden Lanes new model proves to be successful, it could create a new wave of smaller VC’s who will compete against the billion dollar funds. After all, why would an LP keep paying millions in fees for a under performing VC when they can get results from just a few quality angels?

If all of the above comes to pass, Sand Hill Road might be forced to rethink their compensation structures. Perhaps we will see one time management fees where fees are only paid out in the first year or maybe the VC has to earn the rest by achieving milestones for the remainder of the funds life cycle.

Another interesting scenario would be VC’s and angels earning equity stakes not through investing startup capital, but through real value add.

Since the JOBS act would allow Joe Investor to play VC, the new injection of capital could number in the billions. Startups won’t need to pitch VC’s for funding anymore because they can get it elsewhere. So instead of funding, VC’s could offer services in exchange for equity. Help scale my startup and I’ll give you 5% equity. Help me hire the best engineers and I will give you 2%.

VC’s of the future will no longer be merchants of startup capital but merchants of startup services instead.

Could this spell the end of traditional venture capital as we know it? Could Fred Wilson’s prophecy of VC ceasing to exist in 25 years actually come true?

If you ask me, the end has already begun. Although I agree with Fred that VC’s themselves won’t disappear, their roles will change dramatically. But I for one, welcome change. After all, we invest billions of dollars every year in change and innovation.