The one question I get asked repeatedly when I talk to our investors is: “How can you afford to pay all these people?”
Let me explain. At Speedinvest, we employ, directly and indirectly, more than 70 people. Given a fund size of little more than €400m, this is quite unique in the VC industry.
My simple answer has always been: “Well, as partners, we pay ourselves less.” Here’s why:
Commoditisation drives innovation
The European funding landscape is more competitive than ever. A record-breaking 2019 saw more than $36bn of VC money invested into startups across the continent — more than double the amount raised in 2015. Entering 2020, many thought this year would see the trend continue, and the money continue to roll in.
Instead, the Covid-19 pandemic has presented us with some of the most challenging business conditions in recent history and, as a result, many investors have become very cautious with their money. Still, VC funds across the world sit on unprecedented levels of cash and, therefore, unprecedented levels of management fees (usually 2% of the fund).
In other words, you could describe the situation in our industry as follows:
- Uneven playing field for founders: the Covid crisis has accentuated a trend that was already quite visible for insiders. While founding teams with high pedigree continue to enjoy massive oversupply of capital, everyone else suffers from lack of true risk taking by VCs — these ‘unproven teams’ typically require much more operational support than the experienced, serial founder.
- Commoditisation of capital: historically high levels of ‘dry powder’ (unspent capital) in the VC industry, as well as private equity and corporate venture capital continuing to come into tech, has lead to a structural oversupply of capital, creating a significant challenge for most VCs as they find it increasingly difficult to differentiate themselves from each other.
The core element of differentiation in our industry has always been brand.
Long-standing firms are able to impress their investors (limited partners or LPs) and founders with impressive partner track records and a list of breakout companies they have backed. One famous example is US firm Benchmark — investor in Uber, Airtable and Tinder — whose brand power translates into a simple landing page without any further context. People have to find their way to Benchmark, not the other way around.
So, if you are Benchmark, life is pretty easy. Your brand power allows you to participate in those oversubscribed ‘momentum’ deals with top founders. Beyond that, you focus on being a helpful board member.
Innovation in a service industry comes at a cost
Now, brand value is elusive and only comes with time — not something European VCs have on their side compared with their US peers. So the industry has to build other forms of leverage to offer. This differentiation comes in all shapes and sizes, most commonly centred around some sort of value add, which can be sectoral expertise, access to experienced operators and mentors or internal platform teams. A16z (Andreessen Horowitz), for example, quickly moved to a top spot in Silicon Valley through its focus on building an operational platform model. In Europe, we’ve seen unique approaches from firms such as Entrepreneur First and Project A.
“Brand value is elusive and only comes with time — not something European VCs have on their side.”
All these efforts, which are accelerating in times of excess capital, are ultimately designed to help founders beyond money, and to drive long-needed innovation in an industry that has not changed at its core over the last 50 years.
There is no magic trick in a service industry such as VC. Any meaningful effort to build sustainable differentiation will require resources, which in turn will cost money.
So, unless you have a top brand or you rely on your persuasive marketing powers, you will have to invest in your own firm’s capabilities to deliver such added value.
Given that options for VCs to generate incremental revenues beyond their yearly fees are very limited, mostly driven by governance requirements from institutional LPs, you will have to look at compensation — specifically, partner compensation, which in most funds makes up the biggest part of the budget.
Eating your own dog food: think like founders in building your firm
Trash talk on VC is plenty and easy; elderly white men dispensing large cheques are not the most controversial of targets. But founding partners take on a great deal of financial risk in setting up a VC firm, and it requires a great deal of their own investment in the early stages, with little in the way of returns.
For a first-time manager, it can easily take more than a year before the first close happens, sometimes much longer — a period of heavy workload, but no pay. Unless you raise big funds quickly, in the first years of your firm there’s also not much to pass around. Back of the napkin: 2% fee on €25m fund size is €500,000. Adding up the cost of travel, legal, admin and so on, nobody is getting rich through fees. Compare this to the pay in larger funds — one estimate puts the average combined partner salary and bonus for an investment fund larger than €10bn at over €1.3m in 2019. There is no hope for an emerging VC fund to pay anything close to that.
“A prospective VC founder is looking at realistically 15 to 20 years before potentially reaping the true financial benefits of their work, if at all.”
Now pair this with the very, very long-term return cycles of the venture industry. If you include the prospect of follow-up funds, a prospective VC founder is looking at realistically 15 to 20 years before potentially reaping the true financial benefits of their work, if at all.
Think of venture capitalists like serial founders — experienced business brains with the knowledge and history to be successful. Like a founder starting a new business, when you start a new venture fund you take the pay cut and invest instead in building the business.
So it is quite understandable that, as assets under management accumulate, partners are ready for some meaningful pay cheques. With fees of a couple of million per year, you have a choice. You can reinvest in the capabilities of your firm or go with a small but well-compensated team.
This is the point where a long-term founder view makes the difference. As long as you’re not cash-constrained and you believe that additional resources help your long-term chance for success, you will keep as much money in the firm as possible, as your carry value increases significantly faster than what you lose in terms of fixed cash income.
In contrast, most VCs in the past have clearly opted for the senior partner-heavy boutique investment model. Apart from personal incentives, the reasoning behind this is quite transparent and rational, if you believe that:
- You already have access to sufficient top quality deal flow (limited competition), and
- Picking the winner drives the majority of returns, with all else being “nice-to-have”.
In contrast, it is rational for you to invest more heavily in your founder support offering, if you believe in a world where:
- Your support as an investor can actually make a significant difference in the outcome, and
- Founders will increasingly choose investors that offer more than money (and brand only).
With many more VC funds fighting for deals and an increasingly international, if not global, marketplace for capital, we strongly believe in this second world.
Put your money behind supporting your founders
Whether it’s attracting talent, optimising growth channels or expanding into a new market, early-stage startups often lack the manpower to run these departments effectively. Here, a VC with dozens of investments can provide economies of scale by sharing senior resources across the portfolio, creating shared knowledge and avoiding information asymmetries.
“If you can consistently change the trajectory of your portfolio companies… it leads to more consistent and outsized returns.”
As ever, all these things come at a cost, and eventually, the founding partners will have to cover this by paying themselves less. None of these tasks are trivial and building out such capabilities as a VC is often uncharted territory, which will also go wrong more than once.
But, if you can consistently change the trajectory of your portfolio companies, this is not only extremely rewarding work, but also leads to more consistent and outsized returns, both for your LPs and for your partnership.
In other words, you will eventually end up paying yourself a whole lot more.
Oliver Holle is managing partner at VC firm Speedinvest.