Epoch 18: Fees for Returns, or Returns for Fees?

Emerging vs Blue Chip Venture Capital

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Hello Avatar! Welcome back for another week of biotech analysis. Today is Sunday, which means this is our Building Biotech newsletter that is focused on discussing biopharma strategy topics. Today we are going to cover venture capital business models and returns.  For founders we often stress the importance of understanding who investors are.  These will become your partners go-forward.  After reading today’s newsletter you will have an understanding of different fund structures and the pros and cons of working with each.  For limited partners who invest in venture capital we will have some interesting data on median VC returns which will be useful for portfolio construction. 

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UNDERSTANDING VENTURE CAPITAL BUSINESS MODELS

Today we are going to dive into the topic of the venture capital business model.

Simply put, VCs raise funds from investors and use their expertise to identify promising young companies with the potential for explosive growth. In exchange for ownership stakes, they provide these startups with capital and guidance to help them navigate the challenges of rapid scaling.

Traditionally, venture capitalists operate under a fee structure known as the "2/20 model." This model has two key components. First, there's a management fee, typically 2% of the total capital under management annually. This fee is independent of the fund's performance and covers the VC firm's operational costs, like salaries and rent. Second, there's the carried interest, or performance fee. This is where the VC firm gets a share of the profits, usually 20%, but only after the fund surpasses a certain return threshold (hurdle rate). 

While this structure incentivizes VCs to pick successful startups, it can also create a potential conflict. On one hand the 2% management fee (which is typically used to pay salaries, travel and other OPEX) incentives fund managers to raise as much capital as possible, in order to maximize the fee.  One could argue for larger funds the returns do not actually matter if the managers are able to support themselves from the management fee alone.  On the other hand, the carry portion of the arrangement maximizes alignment where both parties profit with returns.

EMERGING VC vs. BLUE CHIP VENTURE CAPITAL