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The venture capital community is not the most inclusive, and new investors might find it hard to scout for the proper connections that would get them on the right track. Venture ecosystems such as Diffuse aim to help them build such connections, for a small price.
And that price is carried interest, a small amount that investors have to pay the ecosystem for the management of a fund. But here’s the thing: Carried interest is only created when the investor gets returns on an investment.
If you’re an investor new to the game and/or looking to join a venture ecosystem such as Diffuse, this will help you better understand the concept of a carried interest.
What is Carried Interest?
Carried interest, often referred to as the “carry” is a percentage of the profits gained from an investment that exceeds the amount contributed by a general partner to the successful partnership between an investor and an investee.
Carried interest is the compensation received by the general partner (usually an organization of investment managers that contributes anywhere from 1% to 5% of the fund’s initial capital) for managing a fund and making an investment happen. Carry can be paid over a set time period such as five years. An ongoing management fee is also paid to the general partner in the lead-up to a successful partnership.
Naturally, general partners will have a vested interest in the fund gaining profit from the beginning, when it hands in its investment in the fund. They also usually receive an annual management fee, often around 2% of assets.
Carried interest is seen by the law as capital gains and is therefore taxed at preferential capital gains rates. This is because general partners are regarded as organizations similar to enterprises, which treat portions of their returns from their business as capital gains, not exclusively as wages and salary.
However, general partners argue that they should be taxed in the same fashion as investment bankers. Bankers receive their compensation as wages, including the portion that is tied to a bonus system. This portion of their compensation is taxed at ordinary income tax rates.
How it Works
Let’s apply this to real-world scenarios:
In this hypothetical situation, an individual invests $100 thousand and pays a total of 20% carried interest to the Diffuse ecosystem. There are three outcomes that can be expected of this investment.
#1. In the first hypothetical outcome, the investor gets its invested $100 thousand in return.
In this case, the Diffuse ecosystem gets $0. This is because carry is only created when the fund generates profits. The investor only received the exact amount that is invested and no profits are gained, therefore the general partner gains nothing. This is called a break-even.
#2. In the second hypothetical outcome, the investor gets 10x its investment in return.
In this case, the investor gets total exit event proceeds in the amount of $1 million from its original investment of $100 thousand.
If the fund generates a total profit of $4.5 million, then the carry to be paid to the Diffuse ecosystem will be $180 thousand. Total Investor proceeds will then be at $820 thousand, out of the $100 million it received in return.
#3. In the third hypothetical outcome, the company receiving the investment fails.
In this worst-case scenario, the Investor loses his invested $100 thousand. Consequently, the Diffuse ecosystem gets $0.
Why it Matters to You
Carried interest works to an investor’s advantage because it eliminates the risk of failure associated with early stage investing. If returns don’t pan out from an investment, the investor won’t have much to lose from a general partner.
On the other hand, the investor will have all to gain from connecting with a general partner. Hence, a carried interest results in an almost ideal scenario for any investor looking to get its hands on a private equity fund or a hedge fund.
For better or for worse, Investors need to weigh the potential cost against the assumed benefits they see in the fund, including the general partner’s expertise and what they can contribute to it. Investors need to consider whether or not general partners can add enough value to the fund to justify the carried interest that they could potentially earn.
In many ways, investors can see carried interest as a better deal compared to paying a more short-sighted upfront commission charged by broker-dealers. And that’s exactly what the Diffuse ecosystem offers: a low-risk, friction-free alternative to finding and managing a worthwhile investment.
Join the ecosystem and become a Lead Investor here.
If you’re new to venture capital, know that it will require more than just having the money to burn. In order to succeed, you need to put in the time to build your network, stay on the prowl for top opportunities, and bet on the right horse when you can.
Read on and learn how to pick a winner from the crowd.
Impact versus Activity – A Compromise
What is your goal for investing? Entrepreneur-turned-VC Mark Suster once suggested to startup hires, ask yourself: Is it time for you to earn or to learn? This is useful advice for investors, too.
If you want some quick payback, pick a company that you think will deliver the greatest financial impact, have the right team, can build right and fast. This is not to say that learning startups don’t make good investments, too; early stage ventures are especially fluid and will likely switch, from earning to learning and back, as they mature with time.
The key here is to find a venture that aligns closely with your own goals. Visualizing helps! Develop a cross-chart of impact (x-axis) and activity (y-axis), and then rank your choices accordingly. Once you have seen and weighed your options, choose the one that maximizes utility for you.
Assessment of Risk
Risk is obviously one of the controlling factors, not only early stage investing, but in investing in general. You can dive into riskier investments, if your portfolio is well-diversified. Higher risk, of course, brings higher returns.
Risk is not limited only to financials. When investing in early stage ventures, it can also refer to product-market fit, readiness to scale, taxation and regulation, and so on.
So, should your goal then be to avoid risk altogether? Not necessarily, for success does not equate to risk aversion. Instead, find the right investment fit:
- Is this the right kind of product or service today? How about 10 years from now?
- Does my portfolio allow for an investment this risky?
- Might regulatory issues arise once the product is rolled out in the market?
- Should I need to, will I be able to take a safe exit from this investment?
If you answered “yes” to all these questions, you are looking at a high-potential investment.
Developing the Right Models
Are you one of those funders who can reliably use gut instinct to pick investments? It’s a skill and discipline that comes with wisdom and years of experience in trial and error experimentation.
For less savvy investors, financial models are the next best thing. But which models do you need to find those elusive unicorn investments? Have these two key figures on hand:
Reduce uncertainty in your investment and run the numbers to generate two key figures:
- The probability of success of the startup. You can calculate this by taking a close look at your investing prospects. Is the venture timed right with current conditions? What milestones have they achieved? What is the response of the market so far?
- The profit/loss, if the startup succeeds/fails. Assess the trend in their financial performance vis-a-vis their long-term financial outlook.
Once you have these metrics, you can then reduce certain uncertainties in your investment.
Effectiveness of the Team
The startup’s concept might be extraordinary and their numbers may exceed your expectations, but in every case, it comes down to the people behind the venture.
Besides your working relationship or the combination of skill sets among the team, there is the high opportunity cost: Investing in one means that you cannot invest in another that may present a stronger proposition. So, look beyond the numbers and consider if the founders have what it takes to take the idea straight to the finish line.
While there is no fool-proof way to determine whether you’re placing your bet on the next Google or Facebook, this guide provides some useful guidelines on how to separate the wheat from chaff. Talk to us about finding a venture that’s the right fit for your investing strategy.
Many might consider investing in early stage companies a high-risk venture. After all, without a steady revenue stream or a customer base or even a stable product, entrepreneurs face the potential for failure every single day.
Is early stage investing right for you?
Venture Investing as an Asset Class
As an investor, you look for not just profits but also a good mix of growth and value in your ventures. Diversification is your go-to strategy for minimizing investment risk, combining different asset classes in your portfolio.
Think of early stage investing as yet another asset class; as investment targets, startups possess similar characteristics and are subject to the same laws and regulations. At the outset, founders would be trying to create proof of market and getting traction – refining the product, maybe putting together a small sales team, and soft-launching with some early customers to demonstrate product-market fit.
Especially with today’s technologies, startups have been known to attempt to scale before they’re ready. But even though the typical early stage company may not always be ready to build their growth machine, neither is it impossible, if they know where to start and have the right guidance and expertise.
Still, not void of risk, this stage of investing tends to be protracted and may require several financing options.
There are two ways that venture capitalists normally invest in early stage startups: either via a priced equity round or by convertible securities:
Investing in a priced equity round
Those investing in later-stage startups (Series A or later) mostly go for this option. Here, the venture and the investor mutually agree on a dollar amount for the value of the company. This “pre-money valuation” is based on the funding needed, in order to achieve the next goal.
Usually, startups use more than one investor for the job, and the funder who contributes the most towards this round also takes point on future investments and sets the direction for the company.
Investing in convertible securities
Because it doesn’t require agreement on pre-money valuation, convertible securities present a simpler financing option and is the more common way to invest in early stage ventures. Instead, the startup simply offers their investors a convertible note. In other words, they take out a loan, usually on fixed terms, with the interest rate subject to further negotiations.
At the end of the term, the investors can decide whether they want to be paid the principal amount plus accrued interest or to settle for equity (shares) in the company.
Adding New Asset Classes to Your Portfolio
Should you add an early stage venture asset class to your investment portfolio? Consider these factors:
#1. Number of early stage ventures in your asset class
Early stage ventures behave similarly and deliver similar risk and return. If your portfolio already contains one or two asset classes, adding one more can be beneficial. What matters here is not the number, but the extent of diversification.
#2. Liquidity issues
Unlike with other investment products, it’s not so quick to sell shares, which is why most funders prefer convertible securities over priced equity investing. But however you decide to invest, what is important is that you clarify as early as possible in the engagement the terms of liquidity.
#3. Tax implications
Startup founders, especially during the initial stages of operation, may not yet concern themselves with taxes and its impact on profits. But as an early stage investor, you need to be aware of the tax implications, as they will affect your own profits later.
With high risk comes high returns. If you invest in an early stage venture and it succeeds, the payoff for both you and the founders will have been worth the gamble. Ask us today about an early stage investment that could be the right fit for you.
What we do
Early stage investing (pre-seed, seed, and Series A) is wildly inefficient. About 98% of investment is made by non-professional investors (friends, family, and angels) – quite the ad hoc and sporadic affair. This inefficient system is rigged to reward the dedicated and expert pro investors while leaving the non-pros out in the cold, blind to the potential opportunities and returns.
At Diffuse, we want to fix this. We believe more smart investment yields more successful entrepreneurs, which leads to more innovation and societal growth. But we have to start with the dollar bills. Diffuse deconstructs venture capital and then diffuses the work to a global network of experts to scalably and intelligently deploy capital into early stage startups.
That’s a lot to unpack. Let’s start with…
The trouble with Micro VCs
Most early stage professional investors are venture capital funds (“micro VCs”) with $50 MM or less in assets under management (“AUM”). Normally, 1-2 General Partners (“GPs”) raise money from their Limited Partners (“LPs”) and the GPs have full discretion over the fund’s investments. These GPs are usually either former entrepreneurs or good at raising money (i.e., former investment bankers).
I’m Kenny, and I know a thing or two about micro VCs because…I am one. I co-founded a fund with some experience operating in a startup and raising money, but none in venture investing. To paraphrase my Ma, when I point a finger, it’s with three pointing back at me.
Reinventing the Wheel
All early pro investors need to do three tasks: find investment opportunities, underwrite them, and raise money. (I’m ignoring fund operations because it doesn’t add value.) Each of these three things requires specific skills…and I’ll describe them glibly. Finding investment opportunities means going around and having your butt kissed. Underwriting means digging into data and spreadsheets. Raising money means kissing other people’s butts.
The odds that one person can do all three of these well are…low…yet micro VCs with 1-2 GPs try to do it all. Why? Well, GPs are building their track record to raise later, larger funds. But that requires unique brands, approaches, and capital sources. So, they reinvent the wheel.
They travel a lot to meet entrepreneurs even though that’s wildly inefficient and a terrible return on their time (ignoring future funds). They choose which investments to make using their own underwriting approach that largely consists of gut feel and heuristics. They raise money from the folks that already trust them (unless they’re really lucky).
I know because this is exactly what I did.
If the goal is to maximize returns for your investors, then this approach strikes me as kind of…dumb. It also doesn’t scale well because…
If you’re good, you stop doing it.
Let’s assume you’re one of the GPs that crushes it. Your first fund had $10 MM AUM, the second $20 MM, and the third $100 MM.
Now…you’re no longer an early stage investor.
You simply cannot, and should not, write a $200k check anymore. It’s a poor use of your time and doesn’t move the needle for your fund’s return. The only way to justify doing so is for the pro rata rights so you can cut bigger checks in later rounds. That’s not early stage investing. That’s mid-stage investing, where a tactic happens to be buying a seat at the table with small initial checks.
Your deals come from different sources (there is a lot less finding a diamond in the rough no one has heard of), your underwriting is based on actual financials not the back of an envelope, and you’re raising money from institutions not individuals. It’s a different business.
The Agency Problem
Not only are you now in a different business, but you also have different incentives.
VCs get paid with two different types of fees.
Management fees are normally charged as a percentage of assets under management (AUM). This is to cover employee overhead and the industry standard is about 2% per year carried interest (“carry”). You can think of as a profit sharing. Normally, it’s set at 20% which means, if your investors make a profit of $100, the VC keeps $20 of it.
In an ideal world, the LPs would want the GPs to only be paid with carry and no management fee, so everyone’s interests are aligned. The key word is “ideal.”
When two people are running a $10 MM fund, the management fee isn’t going to make anyone rich and they care deeply about the investor’s returns because that’s their track record. When two people are running a $100 MM fund, they’re each probably pulling down over $1 MM in income per year. The carry can be huge, but they’re going to get rich either way. Their real incentive is to not suck so they can raise another fund.
They call this the agency problem and it’s a rampant issue in every corner of financial services (and beyond).
The Walled Garden
VC is not rocket science. VCs try really hard to make it seem like it is.
I truly don’t understand why VC has such mystique. When we spun up WLV, I didn’t realize I wasn’t supposed to be able to. It wasn’t until business school that I saw first hand the fascination my fellow classmates had for the space. It’s one of the most popular tracks for new MBAs across the globe and there are a lot of sharp elbows vying for every entry-level position. Part of me thinks we have a culture of rooting for the underdog so venture gets a halo effect from the entrepreneurs they work with.
A much more cynical part of me thinks that by the time you figure out how things work under the hood…you’re in the walled garden…and it’s pretty damn comfortable. You can press the advantage of your network and create some serious wealth for yourself. Why upset the applecart?
What does this mean for an Investor?
There are really two types of early stage investors: pro and non-pro.
Good news! Capital allocation inefficiencies are great for shrewd investors! All you have to do is spend all of your time learning about startups, networking with founders, and gaining deep domain expertise and you’ve got a pretty good shot at above average returns.
That sure is a lot of work though.
A non-pro Investor is anyone who doesn’t invest in early stage ventures full time. Think high net worth individuals with jobs and a family. This is the vast majority of Investors since it’s rather rare to find someone with the inclination and financial security to handle the poor micro VC economics for the first few years to build a track record.
Non-pros want to access early stage investment opportunities…but they don’t have the time or expertise to do it themselves. Their options are limited. They can invest in micro VC funds…but we just discussed the issues therein. They can also use one of the investing platforms which aggregate a number of opportunities, but that still requires they have the ability to separate the wheat from the chaff.
If only there was another way.
As already stated, Diffuse is a way to intelligently and scalably deploy capital into early stage startups. That ideal is the north star by which we navigate. Our Ecosystem is made up of expert Lead Investors who source and diligence deals and then secure co-investment allocations for Diffuse. Hence, intelligent. Our Syndicators then reach out to select investors who can then invest alongside the Lead. We free the expert investors from having to raise money from individual investors (a terrible use of their time). Hence, scalable. As an added bonus we do so in such a way that everyone cares first and foremost about helping the company they’re investing in.
So how does it work?
Everyone in the Diffuse ecosystem works for carry. We all only make money if the company succeeds and the investor profits. We don’t charge individual investors management fees and profit on the size of our capital pool.
Deconstructing Venture Capital
In a previous episode of this manifesto (scroll up a bit), I talked about how all micro VCs have to excel at the same tasks. We use carry to incent experts to do each task. Rather than sourcing deals by traveling to conferences and creating our own network of Entrepreneurs, we give carry to Originators who already have strong networks (why reinvent the wheel?). Rather than becoming an expert in all things startup, we recruit Lead Investors who earn carry for performing the diligence, writing the first check, and giving Diffuse an allocation (which in turn gives them investment leverage). Rather than raising capital ourselves, our Syndicators earn carry for any part of the allocation they place.
How does this solve the problems?
Recall micro VCs tend to try and reinvent the wheel and do all the tasks with their small team. Now they can specialize in the part of early investing they’re best at. If it’s sourcing deals, Diffuse gives them expert Leads to make the investment. If it’s underwriting a deal, we give them leverage. If it’s raising capital, we can give them high potential fully vetted deals. Heck…they can even change which role they fill on a deal-by-deal basis.
If you want to invest in early stage startups without dedicating your life to it, we’re your way in. Our diligence standards are incredibly high and we only accept the most promising opportunities into the Ecosystem. As always, only invest what you can stand to lose, since early stage venture is crazy risky, but you can rest assured you’re investing on the back of an institutional-grade process.
Yes, we still charge you carry. But there is no management fee, which means everyone involved only makes money if you do.
The Big Why
Early stage startup investing today is a pretty terrible experience for all involved. Not least of which is the Entrepreneur, who has to spend an obscene amount of time navigating the previously mentioned ad hoc and sporadic investing landscape…when they should really be building an earth-shattering enterprise.
We want to free capital to flow to the best Entrepreneurs so they are empowered to drive innovation and improve the world we all live in.
Learn more about how to invest, syndicate, and raise with us.
More about Diffuse: