The Unusual Economics of My New Small Fund

Charlie O’Donnell wrote a short blog post of the economics of his fund and no surprise, it was representative of how a typical VC fund operates. But since my fund is far from being typical, I would like to share with you the weird, un-sanitized and detailed economics of it so lets get started!

Management fees: *UPDATE* I’ve decided to go with no management fees PERIOD!

I am about to say something no other sane VC has said before: I dislike management fees. As a kid, I had no allowance so I earned every dollar I made. It’s a philosophy I carry with me to this very day.

Fees often provide improper incentives for VC’s so I decided to do something different: I came up with a one time management fee of 4% and it’s a lump sum paid out only in the first year. After that, no more fees.

My fund is about $25 million, so the fee works out to $1 million. Whoa, did I just hit the jackpot? Far from it. The life cycle of the fund is 5 years so I have to stretch out that million dollars. Startup costs aren’t cheap either:

Limited partner agreement. This is the fancy legal document that your investors sign. It’s typically 30-50 pages long and absurdly expensive – you can expect to pay anywhere between $25,000 all the way up to $100,000!

So how much will I be paying? $25,000. Yes, I know, that’s an insane amount of money to spend but an iron clad LPA is crucial because it helps you avoid legal headaches in the future.

Also keep in mind that the lawyer is not only drafting an LPA, but an subscription agreement and your standardized term sheet.

Back office: It works out to $100k every year and covers almost everything: accounting, audits, taxes, financial statements, capital calls, banking etc. In the end, that’s half of the $1 million fee already gone.

Staff: Just one analyst will be hired to help source & manage deal flow along with liaising with our existing portfolio companies. Salary will be 80k; 400k in total over 5 years so that leaves me with less than 100k in fees. P.S I’m still looking for an analyst so send me an email if you are interested.

Offices: I have a co-working space in Brooklyn that runs for about $6000 a year. It comes with a desk, computer, wi-fi and access to conference rooms for pitches.

Carried interest. Here is where I stray from the herd: 20% is standard but it’s based heavily on performance. Basically, if I make a 2x return, it is bumped up to 25%. A 3x return is and so fourth with a ceiling of 40%.

40% sounds excessive but it’s based on performance which in this scenario would have to be a 5x return – no easy task! Also keep in mind that I am taking a massive pay cut on management fees. If I had gone with the traditional 2.5% annual fee for 5 years, that works out to $3.125 million in fees so I am sacrificing $2.125 million – something very few VC’s would be willing to do.

But the good thing is that the $2.125 million will be used to invest in more startups which could mean a greater return down the line.

Salary: obviously with a one time management fee structure, I won’t be able to pay myself an annual salary.

Financial projections. This is the fun part – guessing how much money the fund will (hopefully) make. But first, PLEASE READ Dave Balter’s blog post on angel investing, because it will give you the reasoning behind why I adopted my business model.

Nouveau Capital is essentially an angel/seed fund that uses a “first one in and first one out” business model and it’s quite simple: we provide an average of $250k in funding and get a 10-20% equity stake which we then resell to Series A investors for a profit.

Let’s do the math. I expect to invest about $5 million every year into 20 startups at $250k each. The statistics show that only 40% of seed funded startups go on to raise a Series A round and according to CrunchBase’s dataset, the average Series A round is valued at just over $5 million. So assuming I own a 20% stake, I expect to resell my shares for around that same number ($5 million).

And assuming that only 40% of my portfolio companies go on to raise a Series A, that’s 8 startups which have the potential of producing a return, which in this case would be for a total of $40 million, an 8x return on *INVESTED capital.

*It’s important to distinguish between “invested” and “committed” capital. In my case, only $5 million out of the $25 million is invested and therefore carry calculations are based on that amount. But if the LPA is structured around committed capital, I would have to return all $25 million first before any carry is made*

Of course, that’s the best case scenario and there is a good chance that might not happen so lets assume that only 4 startups were able to raise a Series A round and produce a return of $5 million each. That’s still $20 million, a 4x return. Not too shabby.

Even you cut the number in half again to 2 successful startups, it still works out to a 2x return.

But lets go back to the best case scenario and crunch the carried interest numbers. Since my distribution waterfall is based on performance thresholds, an 8x return works out like this:

2x return=25% if I double the original invested capital of $5 million and produce a $5 million profit, that’s $1.25 million ($5,000,000×0.25) in carried interest.

Keep in mind that the calculations are based on a return total of $35 million ($40 million minus the original invested capital of 5 million because you obviously have to pay back your LP’s first)

3x return=30% with another 5 million in returns (10 million in total at this point), I would achieve the 3x return threshold and that works out to $1.5 million

4x=35% $1.75 million

5x=40% $2 million (enough to buy a Bugatti Veyron wahoo!)

5x and beyond: now that we have reached the ceiling of 40% and can’t go any further, the remainder of the returns ($15 million) and all future returns will be charged at 40% so in this case, $6 million (hello Pagani Zonda!) is the final carried interest.

Add it all up and the grand total in carried interest is $12,500,000 (enough to buy a swanky NYC penthouse!). As for the investors, their haul is worth $22.5 million which represents a 4.5x return – not bad at all! So even with 40% carry, the investors still manage to get a superior return and everyone is happy.

Of course, there is also the complicated issue of clawback and future losses but I won’t get into that.

Continuing with the best case scenario: if I invested the remaining 20 million (assuming I recycled my management fees with early returns) and got the exact same results every year for the remaining 4 years, the total return works out to $175,000,000 ($200 million minus the original investment of $25 million)

And the icing on the cake is that I won’t have to pay any state taxes thanks to Gov. Cuomo’s Start-up NY program (although I would still have to pay federal taxes).

In the end, running a small fund is no walk in the park even with a short term business model like mine. It requires an insane amount of attention and you will be running on fumes for quite awhile. But my hope with this new investment model is that it will make the process smoother and more profitable.

And yes, I could end up driving a Bugatti or Zonda if this all works out but even if it doesn’t, I can rest well at night knowing I did a job I loved and felt passionate about.