The 2% vs. 20% Venture Fund Dilemma: Impacts on Founders and the Future of VC

We need to be able to put very large checks to work.

The option is that a 20% fund is getting significant exits.

The speed of AI right now is so fast.

Do they have the routes to help you get your next round of capital?

Almost like a billion dollars in fee.

The biggest benefit in a VCE is. Welcome back to the Venture Capital Podcast. This is John Bradshaw and Peter Harris. Peter is the partner and co founder of the University Growth Fund. I'm John Bradshaw. I'm a founder, codebase.com, appointment.com, and Peter has a special request for today's episode. So what is it, Peter?

I don't know if it's special request, but just some things I've been thinking about a lot. So I was chatting with one of my former students who runs a fund in the Bay Area and he made the comment that there's really only two kinds of venture funds today. There are 2% funds and 20% funds. And what he means by that is if you understand how VCs get compensated, it's through management fees, which is 2% annually, typically of their assets under management. So if you have $100 million fund, you're getting paid about $2 million a.

Year to run your operations.

So that's your management fee. And then the other side of it is your carry, which is where you're supposed to make all your money, which is about 20% of the profits. So if you take that $100 million fund, you turn it into, you know, 3 or $400 million, you return the 100 million, that leaves you a 2 to 300 million in profit, you get 20% of that. So you know, 40 to 60 million dollars. And that's where VCs are supposed to be making most of their money. And so, but, but the comment there is really about how venture funds, it's kind of a Tale of Two Cities a little bit and that you have.

These like absolutely monster mega funds.

So Andreessen and Sequoia Insight, Lightspeed and others that have raised, you know, multi billion dollar funds and then you have much smaller funds that are, you know.

In those, in the hundreds of millions.

And so anyways, the comment was like, you know, these really, really big funds, when you're managing tens of billions of dollars, that 2% actually becomes really, really large, really, really big numbers.

Right?

I mean, you're pulling down like almost, almost like a billion dollars in fee, right. And you're not really dividing it amongst that many people. So anyways, and then you've got these smaller Funds that are really chasing for that 20%. Because that even though you will have a good lifestyle as a VC off.

That management fee, you're not going to.

Like become a billionaire effectively.

Right?

You're not going to be like, you're.

Not going to reach like super, super wealthy outcomes.

So anyways, it was kind of interesting and so we had this discussion around, you know, why is that the case? And what's been interesting over the last several years is that there's been a.

Tremendous amount of money that has flown.

And funneled, been funneled into venture capital.

And growth equity and just like private markets.

And I think that's because it's kind of a circular loop where companies took longer to go public. And because they took longer to go public, a lot of the returns were generated when they were private. So it used to be like companies like Amazon went public and were valued maybe at $100 million, $500 million somewhere in that range. And you could ride that from a $500 million valuation all the way up to like, what are they worth today?

Like 2 trillion or something.

Right.

But a lot of that return happened.

In the public markets.

And today you look at the companies that are getting funded. OpenAI is a good example of this where they're valued at like $150 billion. Actually, I guess they're valued at like closer to $300 billion and they're still privately traded. So like all like 0 to 300 billion in value creation effectively has all.

Been captured by private investors.

And then that's created this feedback loop where if I'm a public or if I'm a private investor and I want to be. Well, if I'm an investor generally and I want to capture some of these returns, then I need to invest in the private sector. And then what that's done is more money's flown in. And then companies, because they can raise more money without going public because there's now more money, they do that and they extend out how much longer they're going to go public and then that, that's more value that, that can't be captured unless you're investing in the private market.

So that forces more money to come into the market.

So it becomes this, like this cycle. And we're now at a place where large managers of assets, right? So we're talking like endowments, pension funds, sovereign wealth funds, et cetera. They know that in order to capture the alpha that's being created in society in any given year, they need to have a very significant private alternatives asset. Pool, which has been really established by the likes of Yale and Harvard, who, as endowments, have outperformed everybody because they leaned super heavily on.

On alts.

So now everybody's like, we need to.

Have a huge alts thing, right?

But we have so much money that we need to. And we have limited time and limited people. We need to be able to put very large checks to work.

And.

And in the old days, you could put it into very large mutual funds.

In the public markets.

And so there were, There were mechanisms and avenues for a large endowment to be able to, like, allocate $100 million to a hedge fund or a mutual fund. Today, if you want to play in the private space, you're writing a, you know, you need to write, like, 100 million, $200 million check into a venture fund. And so really, these funds, regardless of what they say, have really kind of become asset managers. And what they sell is not necessarily, like, outsized returns. What they really sell is the ability.

To put 100 to 200 million dollars to work.

Because there are other funds that are, like, aggressively chasing alpha, trying, you know, 20% funds. The math doesn't work, right? If you're a seed fund and you raise, you know, you have one L.P.

That'S $200 million, $100 million, right?

You're basically, you don't have a fund. You're just, like, part of this LP and beholden to them, essentially. So you don't really want that. So you got to kind of. So, like, and you don't really want to have a $500 million seed fund because it's really hard to get fund.

Returners off of that strategy.

And so you have to raise a smaller fund, which means by default, you've.

Cut out a lot of these much larger fund managers.

So anyways, it's just, like, fascinating to me all the things that are happening. I'm curious, John. I had this. I. I asked one another founder that.

We both know recently, this question of.

Would you rather, as a founder, take money from a 2% fund or a 20% fund?

And why.

And how would you. How would you think about that 20% fund? Why is that?

Because the assumption is that a 20% fund is getting significant exits in their portfolio.

So even if you're a 2% fund is too. So 2% funds are all the brands that you would, you know, know and love, right? Sandreeson, It's Sequoia, it's benchmark. It's, you know, all these big funds. Maybe not benchmark, because I think Benchmark.

Is actually, wouldn't a 20% fund have more exits.

There?

That'd be like the top 25% quartile.

I mean, maybe it's probably actually more likely that a 2% fund has more.

Exits.

And a 20% fund.

Okay, well then I'd stand corrected.

Like they have one or two really.

Big winners, I think.

I mean, in that case, that'd be the 2%. You want. You want the. I think the biggest benefit in a VC is do they have the routes to help you get your next round of capital? Will they be a blocker? Like, I mean, I think some funds, they may just say we don't. We, you know, we, we do or don't maintain a pro rata. But I think the big aspect is if your company's dying, do they help you get an exit that way? Or if you're doing really well, do they help you get, you know, outsized returns? Yeah, like that's, that's how I would pick a vc outside of just, hey, here's a check. Assuming you have a choice.

Yeah.

So it's interesting, this other founder, his perspective was you do something, you know, you target people that are in the middle. So if you target like funds that are too small, they're frankly like too small to be really that helpful. So you want them to have like a certain amount of like size and expertise so that they can actually be helpful. But once they get too big, it's like, you're not getting Andreessen.

He's not coming to sit on your board.

Right.

You're getting some like junior VC that's.

Going to sit on your board who doesn't necessarily have much expertise or experience.

Or whatever, but they have, they have a whole team that is specifically one helping you get enterprise contracts and to helping you with exits. Yeah, like that's their main goal. And because they're, they're with the fund, they can probably knock down doors that you couldn't otherwise. Again, I, I don't know how valuable they are.

Yeah. And I don't know how valuable at the end of the day those, those services end up actually being. But yeah, they promise a lot.

Right.

And I do know founders that have.

Raised from those different groups that speak highly of them.

But you know, I guess it's just one of those things of the person that actually sits on your board. You probably are not getting the attention.

Right.

And yeah, they've got a bunch of ancillary services, but they're all, I don't know, I would expect them to Be a little bit more like mercenaries.

Right.

I think their services are worthless.

Somebody that's, like, highly, highly tied to.

The success of your business.

Right.

And this gets back to the 2% versus 20%. You get somebody, you raise money from a 2% fund, and if you succeed or fail, it kind of doesn't matter.

That much to them.

Right.

Because they're. They. They're pocketing, you know, the 2% and they're good and making just obscene amounts of money. And then on the 20% side, like, they live and die on your success.

Right.

To a certain extent.

And so maybe they're a little more committed.

I don't know.

I think. I think probably the answer is you. You try and take both.

Right.

Because to your point, brand matters. If Sequoia leads your round, you're pretty.

Much guaranteed to raise your next round.

You may not raise the round after that, but your next round's kind of guaranteed.

It's like if YC invests in you, people who could not raise in Utah that happen to get into YC then raise at a 20 to 30 million post money valuation, and it blows my mind.

Yeah, yeah.

They raise it like 20. Like two to three times what the market rate is.

Yeah. If they would. If they could, if they raised in Utah, they'd probably 2 to 5 million in post money.

Yeah.

And then they go through YC and then, voila, you're worth 20 million in three months.

Yeah. Yeah.

You're looking. You have a few hundred bucks in mrr. Good job.

Yeah, well, I mean, everyone's kind of.

Looking for signal, right? So.

I mean, I think YC is definitely one of those cases where every single individual YC company, for the most part, is overvalued, but every single class.

Of YC companies is probably undervalued.

So I think the strategies where the funds come in and they just invest.

In every single one make a lot of sense. I think trying to pick and choose is challenging.

But what is YC? Are they at 2% or 20%?

I think. I don't know. I would say probably 20%. Under. Under Gary Tan's leadership. I think under prior leadership, they were trying. They were moving more to a 2% fund with their opportunity funds and so forth.

But.

But they've shut a lot of those down.

Yeah.

And that's why I think they're probably.

More of a 20% fund today.

What are Utah funds?

I think most funds in Utah are 20% funds. I think. Look, every VC, for the most part.

Aspires to be a 2% fund.

That's just reality. Because it's kind of easier, right? And it's also really hard. It's hard from the. So the easy part is the return threshold drops from generating a 3 to 5x fund to generating like a 1 and a half to 2 and a half x fund. So that part is easier. The part that's hard. And this gets back to your earlier question, like who gets more exits is that you need to be a fund that is in every single big deal.

Where you can write a big check. Right?

So, you know, we were in a deal where we invested and some of these larger funds that frankly 2% funds, found out about the round and they hadn't been included and they were upset and they went back and kind of.

Shoved another $200 million down the throat of the.

Because they need. They also have this problem of, you know, the LP gives them $200 million and then they aggregate that up to $3 million, $3 billion in AUM. And then they need to deploy that into companies that they have a high degree of confidence will return. And so then they're looking for companies.

Where they can write a hundred million dollar check, right?

And this is actually like one of the fascinating things about Thrive, Thrive Ventures and what Jared Kushner's done is he's. He's kind of like fully embraced this and gone to LPs and just said like, look, you need to put a.

Billion dollars to work.

I will help you put that billion dollars to work in like three or three to five of the all time.

Best brands out there.

Right?

And we'll facilitate that.

So it's like we're going to do databricks and we're going to do OpenAI and we're gonna do. And we're gonna write like very, very big checks at very high valuations and we're going to lead these rounds and just own it. And that message is like really resonated with both sides of that transaction. The companies where it's like, great, I got this big check, I get one line on the cap table, super easy to deal with. Everybody likes Jared. And then the LP side, they're like, great, I just funneled that through and make my return. So anyways, it's just kind of a fascinating situation. One of the things that I thought was also interesting about this is I read this article by this other guy and he was making the case that secondaries now are becoming a more legitimate.

Way in which you can exit your investment.

And maybe the evolution of venture is that the pre seed seed stage funds sell at the Series B and the Series B sells at the Series D.

And the Series D sells to crossover.

Funds or when they go public. And so that's how you get liquidity up and down the chain without having.

To wait 30 years.

Isn't that happening a lot more at least with local funds and I'm not going to mention names, but when the next round of funding comes, they pull their chips off the table so they at least get their 1x guaranteed and then the rest of it they continue to ride.

Yeah, I don't know very many funds that have done that, but we've also know one fund that has done that really well, particularly in 2021, and ended up having incredibly high performance, not just.

On a multiple or IRR basis, but.

On an actual dpi, like cash return back to investors because they were willing.

To take chips off the table early.

And just say like, look, we got in so early that like our returns here are phenomenal and we're just going to exit it. We'll roll a little bit over so.

We can continue to capture upside.

But you know, it was funny, I was talking to one of the partners there and he was like, we've never regretted selling even if the stock continues to go up. Like locking in great returns is great because at the end of the day, especially for seed funds, usually your LP base is a little bit smaller and those distributions are really meaningful. And so if you can accelerate the time to like returning cash back to.

Your investors.

It ends up being like this really, really interesting competitive advantage that.

Allows you to raise new funds and bigger funds faster.

And I think that model will be really interesting. The other thing tied to that that I was having a conversation with another friend of mine today about was this idea that. And we're going to talk about this in another episode, a podcast episode. But like the speed of AI right.

Now is so fast that you have.

So many companies that are scaling incredibly fast and that allows like you don't have to wait like a decade for.

A company to get to a billion dollar status. You don't have to wait five years.

Like it's happening now in a year or two years.

Right.

And once a company hits like billion or multi billion dollar valuation level, there's lots of typically lots of buyers for that.

And so you can exit.

And so like it's not outside the realm of possibility that as a fund what you do is you sprinkle a lot of bets and hope that one of these grows really, really fast.

And within three years, returns your fund.

And you immediately sell on secondary markets.

Return cash, and then raise another fund and rinse and repeat.

It seems like secondary funds, at least in the past 10 years, have decreased. I think, I think the thoughts are increasing. Like, you think they're increasing?

Oh, yeah, for sure.

Okay. Because from my view, like, the, the, the secondary funds I know have just stopped doing secondaries.

So there is a huge amount of.

Money flowing into secondaries right now, I.

Think because of OpenAI.

I mean, because of a lot of things. I think one of the areas that, like maybe you're not seeing is one, there have been a lot of fund secondaries, so people selling out an entire portfolio on the secondary market.

I've seen a few of those come across desks.

Huh.

I've seen a few of those come across desks and we'll be like, hey, I need to liquidate my portfolio. Here's all my assets. What do you want to buy?

Yep. Yep.

I'm not supposed to be seeing those, but I'm seeing those.

It's because you're a big deal, John. The other thing though, those are, those are a little bit bigger in private equity than they are in venture, but.

They'Re, they're still pretty big on both.

The other thing on secondaries is that like some of the funds that you and I know, that we're doing secondaries, frankly, we're not doing the right secondaries, in my opinion.

They're doing like super early stage secondaries.

Which is challenging, but where there's still a lot of money flowing is in.

The later stage secondaries.

Yeah, the open eyes, the, the data bricks, the.

Right, but, but it, Right, but if you're, if you're not a stripe, if you're not an open AI, if you're not a Facebook, the secondary market, I think is drastically different. It's. That's where I look at it. It's dried up some.

Yeah, maybe. I don't know. Well, it's definitely dried up compared to 2021. Like everybody could like, take some chips off the table today. Yeah, it's. It's a little more challenging for people.

To take chips off the table.

That, that's true.

And I'm looking at, looking at since 2015.

Yeah.

I think if you're not have these big outsized IPOs, these like private secondary markets or, or other options in that space, you know, an alt. N alt nasdaq, it makes less and less sense.

Yeah.

Yeah, that's fair.

All right.

All right, well, let's wrap up this episode. If you guys have any more questions on this topic, leave them in the comments below. Peter I will follow up with a later show and thanks for watching. Go to www.bc and we will see you guys next time. Thanks.

Thanks.