The 2-and-20 compensation structure for venture capital funds is a one-size-fits-all approach that misaligns incentives and can help VCs to get paid handsomely while their funds perform abysmally.
That was one conclusion from a much–discussed report on the venture capital industry from the Kauffman Foundation last month.
“It’s interesting that VCs have positioned themselves as supporters, financers, and even instigators of innovation, yet there has been so little innovation within the VC industry itself,” the report states.
But moving away from 2-and-20 won’t be easy. Somewhat surprisingly, the greatest resistance to ditching the model isn’t likely to come from venture capitalists themselves. Change will need to be spurred by the investors, or limited partners (LPs), who pour money into venture funds, said Diane Mulcahy, director of private equity with the Kauffman Foundation and one of the report’s authors.
“The problem is not that the venture capital industry needs to ditch 2-and-20, it’s that institutional investors need to stop paying 2-and-20,” Mulcahy said.
The 2-and-20 compensation package is so ingrained in venture capital that it’s tough to say exactly when or why it started, according to Kauffman. The basic idea is that venture capitalists get paid in two ways: a 2 percent annual management fee on capital committed to the fund and 20 percent of the profits each time a portfolio company is sold.
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“Two-and-20 has indeed stood the test of time and seems to be the right mix for the majority of firms and LPs,” said Emily Mendell, spokeswoman for the National Venture Capital Association (NVCA).
The problem lies in the intersection of the 2 percent part of that equation and large venture funds. For example, a fund with $1 billion in capital can generate $20 million in annual management fees to a venture firm, completely independent of the quality of investments in the fund.
“VCs with large funds can end up getting an enormous fee stream that allows them to lock in a very high and stable source of personal income that is not at all related to their investment performance,” Mulcahy said.
Many VCs that Mulcahy spoke with for the report said they’d be amenable to changing how they’re compensated, and there’s even some realization within the industry that 2-and-20 has created bad incentives.
“Because of the management fee, people got rich when their funds didn’t return capital,” said Steven St. Peter, a VC who until recently was a managing director with MPM Capital in Boston.
“That is fundamentally a problem because firms’ behaviors switch to collecting management fees and getting rich on those, and away from getting rich on the investment returns,” St. Peter said. “Ideally, you do both.”
Despite what essentially amounts to easy money for big funds, St. Peter said most VCs would be “very open” to discussing new compensation structures.
For high-demand funds, a new compensation structure could actually help them generate even more profits. For example, a top fund could hold an auction that initiates a bidding war between would-be investors, perhaps generating a 30 percent cut of profits on exits instead of 20. That would then potentially enable the fund to decrease the 2 part of the equation and better align its own priorities with those of its investors.
So what’s stopping investors from negotiating better terms with venture funds?
“The fear among LPs is they won’t get invited to the party even though they’re paying for it and even though it’s not a very good party,” Mulcahy said.
In other words, investors in venture funds are afraid that if they become vocal about changing VCs’ compensation structure, they’ll get frozen out of the best funds. Plus, negotiating a departure from 2-and-20 with one venture investment then invites questions as to why LPs didn’t negotiate similar deals with all the venture funds they plow cash into.
So the commitment to 2-and-20 remains, and minus an outcry from LPs, there’s little reason to think it’ll change.
“If those percentages were not making sense for LPs, they would be asking for different terms and it’s not something we’re seeing in any big way,” said Mendell of the NVCA.
Mulcahy would prefer to see the industry move toward a “budget-based” replacement for the 2 percent management fee. Under this scenario, VCs would agree to manage a fund for a fixed cost that covers salaries, rent and other overhead items, which would remove much of the incentive to raise larger and larger funds.
As for the 20 percent payout, a better structure would pay VCs a percentage of profits only after the fund’s returns exceed an agreed-upon public markets benchmark. In this model, a fund that generates returns 3 percent greater than a public benchmark could take a 20 percent cut of profits for itself. If returns exceed public markets by 6 percent, the fund could take a 25 percent cut of profit, for example.
In any case, if change is to come from inside the venture industry in the absence of an outcry from LPs, it’s highly likely that the smaller funds will have to lead the way.
“The big firms with billions under management aren’t the ones interested in changing the equation,” St. Peter said. “It’s working quite well for them.”
