A quick guide to misalignment of interest in Venture Capital

The LP-GP-Founder triangle of conflicts, and what we can do about it.

Let’s tackle the undeniable truth heads on —while venture funds have tried for many years to mitigate the lack of alignment with their limited partners and founders, a complete alignment of interest is still hard to come by in the industry. GPs are often found in the middle of a trilemma, with a hard to measure and hard to implement pareto efficiency.

We’ll jump into how all of it happens, but let’s first round up our key people.

Introducing your stakeholders

Limited Partners (LPs) — that is your pension funds, foundations, endowments, banks, insurance companies, family offices, funds of funds, and high net worth individuals. They invest money in GPs operating Venture Capital funds in order to generate outsized returns, diversify their portfolio of assets, or have exposure to a specific market or vertical. Often, a combination of the above — but also because it’s a lot of fun. This relationship, like all partnerships, is based on trust and respect, long term commitments, and transparency.

General Partners (GPs) — that is the Venture Capitalist, like yours truly. On a mission to invest in bright founders. GPs are VC fund operators, and are entrusted by LPs with the role of selector. We (GPs) invest in founders’ ideas, companies and vision. We are looking for high growth potential companies that can offer our LPs great risk-adjusted returns. We then take a mostly passive role in the company, monitoring and acting upon its challenges and opportunities to protect and optimize LP capital. GPs charge LPs an average of 2% management fee a year on committed capital, and 20% performance fee (carry) for this service.

Want to read this story later? Save it in Journal.

Founders — these are the rockstars of the bunch. Entrepreneurs building companies that defy the status quo, aiming for the stars with exponential growth and very little rest (sounds like you? HMU at daniel@meron.co). Founders raise money from Venture Capital funds in order to fuel the spaceship, and rightfully expect GPs to behave like co-pilots — stay around, answer when called upon, and enjoy the ride.

All this seems pretty simple so far. LP gives to GP who gives to Founder who delivers, or not. Well it is, until it isn’t. Things often get complicated, especially when the company is either doing very well, or very poorly. See, a GP is judged on his performance, which is measured by a few important metrics, most well known ones including TVPI (Total Value to Paid-in), and DPI (Distributions to Paid-in).

TVPI is a fund’s current multiplier, while DPI is how much liquidity it has generated back to its investors at a given time.

While these are not complex math operations, they bring about a lot of questioning at times of decision making, such as the ones we will describe now. Remember these are non-exhaustive, and plenty of times during a fund lifecycle will a GP be in a conflicting position. The ones I’ve decided to highlight for the purpose of this article come at fund initiation, fund management, and at times of liquidity events. I’ve called them:

• The Fund Size Conundrum
• The Follow-on Quandary
• The Write-off Flank
• The Acquisition Muddle

The Fund Size Conundrum

As discussed before, GPs get remunerated via management fees and performance fee (carry). While carry is usually how good GPs eventually build wealth, it is achieved only after quite a few years (usually 10 or so). Management fees, on the other hand, are perceived on a yearly basis, and are therefore what GPs are basing their salary and hence livelihood on.
This structure allows GPs and LPs to adequately adjust their incentives, benefiting from short term stability and long term capital appreciation.

In order to ensure full alignment, this fine balance must be maintained at all times. However, GP’s inherently are incentivised to raise a large fund, while adapting their strategy to the decided fund size. In effect, the higher the fund size, the higher the management fees in dollar amount. Funds historically then tend to raise larger and larger funds, all the while operating in the same ecosystem and positioning, with similar dollar requirements.

While GPs prefer larger fund sizes, LPs might want to reconsider. The basic math in venture is that given the high likelihood of write-offs and risk associated with investing in startups, in order to 3X a VC fund, a single investment should return the entire fund size. That simply means that the larger the fund size, the higher stake and exit size you have to shoot for. It also means a higher deployment pressure. GPs often mitigate that pressure by pushing more capital to founders, capital they don’t necessarily need, getting them to dilute more, spend more than necessary, and setting hard goals for their next round.
Small funds have less pressure on exit size in order to generate outsized returns, and less pressure on deployment velocity, creating a potentially more healthy growth trajectory for their companies. Moreover, as they can’t follow on forever due to limited capital, smaller funds GPs can create more co-investment opportunities for their LPs.

Founders, the ball is in your court. Choosing to partner with a small fund will get you more bandwidth from the GP, as he probably has fewer portfolio companies, and because you probably represent more of his fund on a percentage basis. Partnering with a large fund also comes with great advantages, as they often carry a more well-known brand, and have deeper pockets to support you. That decision is a function of what you expect, what you need, and how you can structure your round.

The Follow-on Quandary

Let’s imagine the (hopefully) likely scenario in which a portfolio company of the fund performs extraordinarily well, and raises a few subsequent rounds of financing.
The GP, naturally, will want to capitalize the most on the company. This very well might be, after all, the winner in their portfolio. But there are a few ways to do it, and each comes at a price.

The best for their existing LPs is probably to keep their full pro-rata in the company (until which stage is a good question, which we might want to address in a later post). The GP would be using her positioning to bring the most value to her Limited Partners, as the company shows great promise. It is a long term call, that will bear fruit in many years. While that sounds pretty straightforward as a decision, the GP has other conflicting incentives. These are linked to current performance and fundraising.

The best decision for the GPs current performance and future fundraising might very well be to not invest full pro-rata. Back to the TVPI (multiplier) math, re-investing in a company means buying new shares at the new nominal price, meaning having a multiplier of 1 on the new money at time of investment. As (hopefully) the fund’s TVPI stands above 1, buying at nominal price dilutes the fund’s performance. A 3X current carried value on an investment could very well drop to 2X or less overall should we re-invest. GPs currently fundraising for a subsequent fund (which they often are), could consider optimizing on short-term TVPI. Moreover, they could offer these pro-rata rights to prospective investors in order to show access, opportunity, and more importantly build a first professional relationship.

The best decision for the founder could be none of the above. In competitive rounds, the fight for an allocation is bloody. Lining up for that stake could be great new financial investors, strategic angels, and/or corporates, all looking to add new value to the company. A founder might prefer to give it to someone who can offer a particular expertise, a different address book, and fresh deep pockets.

The Write-off Flank

Unfortunately during a fund’s lifetime, companies will experience struggles that leave little space for hope. The reasons that can lead a startup to be in this position are many and I wouldn’t dare enumerate them here, but their outcome is all the same — a last stand. And there comes a major dilemma for your GP — do we let the company die, or do we inject more capital in the hopes of a recovery.

The LP wants an objective investment decision. LPs don’t like write-offs, but they are part of the game they agreed to play, with full knowledge of its challenges. Whether the news make them cringe or not, the LP will always benefit long term from sane and balanced investment decisions, so that is what they naturally and rightfully expect from the GP. In a perfect world of venture, the GP will understand his sunk cost, and re-evaluate the investment on its face value, merits and prospects.

The GP has an incentive to keep the company alive. First of all, it’s not fun to write-off a company. It means stopping to support fantastic entrepreneurs that put everything on the line. There is a psychological barrier to abandoning something we hold dear, and in this case there is also a metrics barrier.
In effect, while a company is alive, the equity the fund holds keeps its TVPI up. A write-off, and the residual value drops, dropping the TVPI along with it. What that means is that the GP, particularly in times of fundraising for subsequent funds, has an incentive to keep companies alive, pouring more LP money in them and burning out entrepreneurs, even if they know that they are underperforming and likely to die. Ever heard the phrase “throwing good money after bad?”, well now you know why that happens more often than it should.

Founders, I won’t pretend I know better than you what you should hope for in this scenario. Letting go of one’s dream is heartbreaking, and there are people who rely on you for their livelihood. Yet you have to determine whether it makes sense to pursue it any further. And your GP might very well support you again in building your next dream.

The Acquisition Muddle

💸 Money time. An offer comes your way to acquire the company. No matter what comes next, time to rejoice - there is real value to what you, the founders, have been building all those years.
Now to the numbers — there is a high likelihood, if the past is any indication (and it usually is), that the proposal doesn’t exceed $100M. One hundred million dollars is a whole lot of money if you for a second take a step back from all the craziness that startups, Silicon Valley and Tel Aviv pound in our heads. So what now? Let’s see.

What LPs would want is probably to get some liquidity back. While some of them are less liquidity oriented, most investors in funds say goodbye to money for very long periods of time, without seeing any of it back. They crave cash results and liquidity. It allows them to manage their cashflows and use the liquidity to make new investments, whether in venture or else. Selling is never bad, and although it can always be better, it improves DPI. But does it improve it enough for the GP?

What GPs would want is a much larger exit. Coming back to fund size and exit sizes, GPs play a game of outliers, where mid-sized outcomes are not interesting. If they are a $200M fund, hold 15% in your company and you sell for $100M, your exit didn’t even return 10% of their fund. From a fund economics standpoint, they’d rather have you push ahead and aim for the moon, well aware of the risk that you fall to zero. A risk they are fully willing to underwrite. But are you?

Founders, your call. You’ve struggled all those years, have seen more ups and downs than you can count, through blood sweat and tears. You’ve built and led a team, formed great dynamics, culture and DNA in your company, and you finally got an out. And a great one no less. Founder, my advice if I may (and I’m fully conscious that this may bite me in the a** one day), is go with your guts. For once in this insane journey, disregard everyone around the table and call the shot. Sell if you will, build if you will, but don’t let someone else’s economics impact how you measure your own success.

So What

While alignment of interest in the venture world is many times a complex issue, the best way to handle that reality is to understand each other’s KPIs and incentives, choose well our partners for the adventure, and implement proactive measures for governance.

At Meron Capital, we have been thinking about such measures a lot. On top of the most well-known and implemented mechanisms in venture, such as GP commitment and carry, we believe there are additional concrete steps which GPs should take to further enhance alignment:

• The iterated prisoner’s dilemma realization: The LP-GP-Founder relationship is a multi-round game. We learn and understand each other’s behavioral tendencies and that each decision impacts the next. An LP might not re-up on his investment for the following fund, and a founder’s best company might very well be the next one. We remind ourselves of that when approaching new complex challenges.
• Best practices from adjacent industries: In strategic controlling, there is an exercise called strategic mapping. It consists of laying down the company’s strategy on key dimensions (financial, people, resources, etc.), and linking each objective with its adequate KPI in order to reduce as much as possible adverse effects — As close as we’ll get from pareto optimality.
• LPAC Involvement: We are now building a strong LPAC (LP Advisory Committee) for our fund II. While in general an LPAC is quite passive, we aim to involve our members as often as possible and have them hold us accountable for the decisions that we will make throughout the lifetime of the fund. We hope that increasing the level of oversight of other stakeholders will prevent one-sided decision making.
• Deal handoffs: The partner within the fund who is not responsible for the investment will make the call for any new capital injection in the company. Although obviously not neutral, having the non-board partner look at the investment opportunity will add some objectivity to the decision making.

My partner Liron and I form one of the youngest team in venture in Israel. We have much to bring and even more to learn. And we’d love your help:

LPs — what best practices have you observed that made you feel more confident in your alignment with the GP?
GPs — what have you implemented in your fund to alleviate conflicts?
Founders— you are the most creative problem solvers around, any ideas? How would you want your investor to behave?

At the end of the day, when we are confronted with tough decisions, I believe it to be our duty as GPs to uphold the highest standards of ethics and diligence. Towards our LPs who allow us to exist, and towards our founders who allow us to thrive.

A special shoutout to Amit Kurz, Amin Ben Saad and Alexandre Berda for lending me their expertise, and a big thank you to all the friends, family and colleagues who went through this article and came back with invaluable feedback. You rock.