I had a chat with a friend and fellow venture investor recently. He’s raising a fund and pitching lots of limited partners (LPs) to invest in it, which got me thinking about what LPs want.

In general, there are various types of limited partners: high-net-worth individuals, family offices, corporations, pensions, endowments, and more. LPs are motivated by different things. To understand whether your fund strategy is aligned with a particular LP, it’s important to understand their motivations.

In my conversations with LPs, I’ve noticed that returns matter to all LPs—but not always cash returns. Most people think that when a fund makes a distribution to its limited partners, it’s in cash. This is often the case. But general partners (GPs), who manage venture capital funds, can choose to distribute stock in a company to their limited partners. This is called an in-kind distribution. For example, if a company has an IPO and goes public, the GP can give the public shares to the fund’s LPs. The LPs can then choose to hold the stock or sell it based on their objectives.

Some LPs want their returns paid in equity. They want in-kind distributions. If a GP invested in a great early-stage company that will produce large profits and distribute dividends to equity owners, or that will continue to grow rapidly and increase in value, these LPs want to go along for the ride. They’re less interested in companies that have no clear path to profitability because they want to own assets for decades.

I’m not sure if this type of LP is in the majority or the minority. I suspect that most GPs target cash distributions (for a variety of reasons). If GPs target investing in companies that LPs can own for decades, I imagine that changes what companies GPs invest in and how they want the companies’ founders to grow their companies.

Imagine if the venture investors who seeded Apple or Microsoft distributed securities to their LPs and the LPs still held those shares today. Between appreciation and dividends, the returns would be amazing. So would the rate of compounding from the initial investment by the GP until today.

I wonder how many venture funds target in-kind distributions so their LPs can own the companies they’re investing in for decades?

I had a conversation with a friend about the difference between wealth and income. They’re not the same thing. I realized through this conversation that some people aren’t aware of the difference between the two.

Wealth is the value of the assets you own (minus your liabilities, or debts). Assets include real estate, personal property (art, jewelry, etc.), and equity (i.e., ownership) in public or private companies.

Income is the money generated from your labor, wealth, or ingenuity.

Money isn’t wealth. It’s more of a medium of exchange that facilitates trade. It allows you to buy goods and services.

One of the hardest concepts for people to understand is that you can have high income but not wealth. For example, if you make $1 million a year and have $999,999 of annual expenses, you’re not increasing your wealth.

Conversely, you can have wealth but not generate enough income to pay your living expenses, which depletes your wealth.

Wealth and income are different, and it’s important—especially for entrepreneurs—to understand why.

I spent time explaining to a friend how management fee recycling works for venture capital funds. Funds that recycle management fees can reinvest cash distributed to the fund into new start-ups. The alternative would be to distribute all cash back to their limited partners. For example, let’s say a fund invested $1 million into a start-up and received $1.5 million back after the company was sold. Depending on a variety of factors, a fund that recycles fees could deploy some or all the $1.5 million into a new start-up instead of returning it back to limited partners. If they don’t recycle, the entire $1.5 million would likely go back to limited partners.

Most funds have a ten-year life, meaning the goal is to deploy capital and return profits to limited partners within a ten-year window. And most funds have a management fee. This fee provides cash flow to pay operating expenses of the fund, such as salaries. The management fee is charged yearly, usually as a percentage of capital committed from limited partners. Two percent is what I’ve seen most funds charge, but it can be higher or lower. Two percent charged annually for a decade means that 20% of the capital committed by limited partners won’t be invested in start-ups.

The other venture fund fee is called carried interest. That’s a fancy way of saying profit sharing. The people managing the venture fund (general partners) split any profits generated with the limited partners. Twenty percent carry is what I’ve seen for most funds focused on investing directly into start-ups, but it can be higher or lower. Twenty percent carry means general partners get 20% of any profits earned. It’s important to understand that carry is usually earned after the initial capital is returned to limited partners. If the fund is a $10 fund, the general partners must return all $10 first; then any capital above that is eligible for carry. Said differently, the fund must be returned in its entirety before carry can be earned.

Let’s look at a hypothetical $100 million venture fund with a 10-year life cycle and a 2% management fee:

• Capital invested in companies: $80 million
• Capital to manage the fund: $20 million

Most funds aim to generate a 3x return (we’ll assume gross for simplicity) for their investors—$300 million for this hypothetical fund. Let’s run a few scenarios:

• If this fund doesn’t recycle fees, it must turn $80 million into $300 million. That means the general partners need a return of 3.75x the $80 million they invested into companies to achieve their 3x return target.
• If this fund recycles fees, they could end up deploying the full $100 million and need to triple the capital invested to achieve their target (3x) $300 million return.
• It’s possible to recycle to the point where the fund invests more capital into companies than was committed by limited partners. Imagine that the fund recycled enough to invest $115 million into companies. That’s $15 million more than limited partners invested in the fund. To achieve their 3x return target, they need to achieve a return of 2.6x the $115 million capital invested into companies.

From these three scenarios, you can see a range of 3.75x to 2.6x return on invested capital needed to achieve the same $300 million—3x return for a $100 million fund. That’s a big difference.

Venture capital is a power law business where one or two companies can generate a large portion of a fund’s returns. Recycling can allow general partners to place more bets on a single fund.

Fee recycling involves lots of nuances and details that I didn’t get into, but this is an important concept for fund managers (and even founders) to understand.

An investor shared details of a deal he’s been evaluating. He loves the sector, loves the founder, and loves the product. He hasn’t done the deal because he has concerns around the cap table—specifically, how much capital has been raised from investors in previous rounds and how much is being raised in the current round. The company has an enormous burn rate of around $400 thousand monthly, hasn’t achieved product–market fit yet, and doesn’t have much revenue from customers. Yet, it’s raising a third multimillion-dollar round of capital.

The major concern of this investor is the amount of dilution at such an early stage. The CEO-founder will own less than 20% of the company after the current raise. If the company can raise the current round, find product–market fit, and raise additional rounds of capital at later stages, the CEO-founder could have a small ownership stake in the company. This investor sees the CEO owning less than 10% as a real possibility. If that happens, it will take an enormous outcome and many more years for the CEO’s small equity position to have a major financial impact on his life. Rather than go down that path, the CEO might leave and pursue something else with a more attractive risk/reward ratio. That wouldn’t be ideal for those who invested in the company.

This isn’t the first time I’ve had an investor tell me this, and it likely won’t be the last time this year. Raising too much capital too early can cause lots of downstream problems if the company can’t achieve significant traction. This story highlights the excessive dilution problem and why investors are hesitant to invest when the founders don’t have material equity ownership in an early-stage company.

If you’re an early-stage founder, keep a close eye on your burn rate relative to company traction. If the traction isn’t there (i.e., you haven’t founder product–market fit), don’t be afraid to adjust the burn rate.

Today I spent time reflecting on past investments. I thought about what I did right and what I did wrong. I’ve done this before and made mental notes, but I realized that wasn’t consistently preventing me from making the same mistakes. Today I created a “lessons learned” doc to capture in one place all the learnings floating in my head.

I’m glad I did this exercise. Seeing everything I’ve learned in one place helped me pinpoint the areas I need to work on more.

I’m excited to add to this doc as I reflect more and use it to help me improve my evaluation of investments.

Over the last few years, I’ve had the opportunity to invest directly in start-ups as an angel investor, invest in venture capital funds as a limited partner, invest directly into start-ups as a Partner at a venture capital firm, and help organizations do their due diligence on direct investments into start-ups with strategic value.

I’ve learned a ton from all of it—but I’ve learned the most from investments when my personal capital has been on the line. This includes investments in funds and start-ups.

I learn best by doing, and in investing, “doing” means investing my own capital.

A venture capital investor shared this article with me. I won’t go into all the specifics of it, but it says that private equity fund managers are selling pieces of their firms to raise cash. Instead of investing by becoming a limited partner in the firm’s latest fund, some investors are seeking to buy part of the firm to gain exposure to the firm’s current and future investments.  

This isn’t new in private equity. Neuberger Berman started a division in 2010 to focus exclusively on this strategy. That division, Dyal Capital Partners, merged with Owl Rock Capital Group in 2021 to form publicly traded Blue Owl Capital Inc. Blue Owl just announced the closing of Dyal Capital Partners V, a $12.9 billion fund focused on taking ownership stakes in approximately 20 private equity firms.

I’ve been closely watching the world of buying stakes in private equity firms for a few years, and I have some thoughts:

• It was only a matter of time before this trend reached larger venture capital firms. It’s starting to happen more now, as evidenced by Thrive Capital’s recent news.
• This approach could provide emerging venture capital fund managers with the runway needed to continually execute on their strategies.
• Venture capital fund managers early in their firm’s life cycle see selling part of their firm as having a negative connotation. This leads to many VC firm founders having a bootstrap entrepreneur mentality and the industry being a cottage industry (there are other reasons for this too).
• As more established VC firm founders realize liquidity by selling parts of their firms, more founders of smaller firms will be open to taking capital in exchange for equity so they can grow their firms.

It’s often seven or more years before a start-up has a material liquidity event such as an IPO or acquisition. Founders should be comfortable with a journey of that length if they want to pursue entrepreneurship.

I recently had a chat with a venture investor who considered starting his own venture capital firm. One of the main reasons he hasn’t is the realization that it will commit him long-term. It will likely take twelve to twenty-four months to raise the fund. Funds usually have a ten-year life cycle, so once he begins investing that capital into start-ups, he’s committed to managing the fund for a minimum of ten years. That’s an eleven-year-plus commitment he’s not willing to make. Instead of writing larger checks from a VC fund, he plans to write small angel checks. He’s putting more of his own capital at risk, but he wants to preserve flexibility over the next decade.

This investor has deep domain experience and a strong network in a particular sector. Any early-stage founder he works with will get a tremendous amount of help and is more likely to achieve product–market fit.

Listening to this got me thinking. I wonder how many seed-stage venture investors (current or aspiring) who could help companies find product-market fit avoid starting a venture capital fund because of the decade-long commitment.

The California Public Employees’ Retirement System (CalPERS) recently announced a $1 billion commitment to back emerging private equity managers. The goal is to foster more innovation and entrepreneurship in the investment industry by backing the next generation of managers. CalPERS, with around $440 billion of assets as of June 2022, is a juggernaut in the investment industry and can drive change.

The announcement references private equity, but this is a big deal for the venture capital industry. Venture capital is a subset of private equity and should receive some of these dollars.

Many studies have shown that emerging managers generate alpha, and the CIO of CalPERS recognizes this. This quote from her stood out to me:

It’s not about a diversity play. . . . It’s about generating alpha in a more thoughtful way, and leveraging partners we will work hand in glove with.

Can’t wait to see the impact that CalPERS’s commitment has on early-stage venture capital.

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Last week, Fred Wilson shared his predictions for 2023. Fred’s a well-known VC and general partner at Union Square Ventures. His thoughts on start-ups in 2023 were of interest to me. A few points that founders should take note of:

• 2023 will be a tough year for start-ups. As money-losing companies, many avoided raising in last year’s difficult environment. They’ll be forced to raise this year as their cash dwindles.  
• VCs have ample capital to invest but will be more selective. Companies with product–market fit, strong teams, and good unit economics will be able to raise. Start-ups that don’t have these things will struggle to raise, regardless of valuation, and many will fail.
• Valuations will return to the levels of 2015 or so. Seed rounds will be around $10m, Series A rounds around $15–$25m, Series B rounds around $25–$50m, and growth rounds capped at 10x revenue.
• Lower valuations will lead to flat rounds, down rounds, inside rounds, and lots of structure in the rounds. CEOs and boards should accept the pain of lower valuations over a lot of structure.

Fred’s predictions come from someone who’s seen a few VC cycles. Things won’t necessarily play out just as he’s said, but his predictions are something for founders to be aware of.

I’ve had chats with a few founders in the last week about their next funding round. Many have accepted the current valuation environment but haven’t processed what impact a down round or one with lots of structure will have on the cap table and start-ups overall.

I’m of the opinion that Q1 will set the tone for 2023. If the rate of decline in public markets we saw in 2022 persists, Fred’s predictions are more likely to be accurate. If public markets are flat to slightly up, I think conditions for start-ups could be slightly better than Fred predicts.

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