Nothing is more motivating than having a personal stake in a business, without this, the incentive to deliver top performance just isn’t there. Analysts and Limited Partners (LPs) are beginning to realize that traditional venture capital models might be broken, specifically, because General Partners (GPs) don’t have enough skin in the game. Venture capital, as an industry, has consistently underperformed liquid indices like the Nasdaq 100 and the Russell 2000 over the past decade. Recent Ernst and Young surveys indicate that 89 percent of LP respondents do not expect to see any noticeable improvement in the industry’s performance. With potential legislative changes and innovations in crowd finance on the horizon, mid to low quartile funds that are unable to differentiate themselves will be left behind.
It is not the practice of venture investing that is broken, but rather an inability for GPs to adapt the structure of the traditional venture fund model. Specifically the “2 & 20” compensation structure, 10 year lock up periods and incentives that reward fund size and quantity over performance. In brief, LPs do not expect to compensate GPs like assets managers, but rather like investors.
Beginning with size and compensation, if a fund is large enough ($250M or larger), a 2 percent yearly management fee ensures that GPs will be thoroughly compensated regardless of whether or not they make a profit from their 20 percent carry. This lack of performance motivator was verified by Silicon Valley Bank’s study of capital returns from 850 randomly selected venture funds spanning from 1981 to 2007, which revealed that 93 percent of surveyed venture funds holding over $500M in commitments consistently failed to return twice the invested capital after fees. And venture funds that held commitments lower than $250M were six times more likely to return twice the invested capital, after fees, than larger venture funds. Demonstrating that in the existing venture capital market, smaller is better because GPs generally have some skin in the game with smaller funds and reap rewards of the profits they deliver.
Today, legislative changes and advances in crowd-finance are bringing enhanced transparency to the industry. AngelList, for example, allows individuals and institutions to invest alongside industry notables and celebrities, via syndicates, under a similar 20 percent to 25 percent carried interest model, without the 2 percent yearly management fee. These changes to the industry will likely result in:
- Significant enhancements in the competitive landscape of the industry;
- A direct assault on the 2 percent management fee model;
- Increased individual access to deal flow; and
- Obsolescence of lower to medium quartile venture funds embracing conventional VC models.
In response to the changing marketplace my company, AKT IP Ventures, has developed an alternative to the traditional venture capital model. We are a 360 Incubator and early stage venture fund that invests both money and experienced teams to transform patent-based ideas into successful businesses. Our model functionally covers the full life cycle of a business – from prototype to strategic product development, to market placement, to sales and ultimately to seeing the business out to exit.
We derive only a 1.5 percent management fee and our fund’s lock-up period is only 5 years. We also offer LPs in universities and NPE funds the added bonus of unique domain expertise that can be used to transform select IP portfolios into thriving businesses. We are able to do this because by fusing our GP with the operator and time early stage opportunities more accurately.
The existing model of VC is unsustainable and industry is ripe for change. Over the last decade 60 percent of venture capital professionals have left the industry. Venture need to consider positioning themselves around niche, or themed investments that can directly deliver value to LPs beyond a mere return. But most importantly LPs should insist that fund GPs have some real skin in the game if they hope to remain competitive in the future.