Ebook Venture Capital Limited Partnership Agreements: Understanding Compensation Arrangements
A large body of theoretical and empirical studies concentrates on the relationship between venture capitalists (VCs) and entrepreneurs who run young companies, yet very little is written on the relationship between VCs and investors in venture funds. That is, there is a wealth of knowledge on how the venture capital industry creates its product (young companies), but not on how it governs itself or pays its own entrepreneurs venture capitalists.
In this Article, I examine the compensation of VCs. How VCs are paid is an important topic in its own right, especially because, as this Article demonstrates, an important part of their compensation is so opaque that it has largely escaped academic notice.
VC compensation practices also can inform our views of executive compensation in public companies. Executive compensation, particularly its opaqueness and low pay performance sensitivity, has been the subject of much recent scholarship. One popular view is that executive compensation arrangements reflect legal and institutional barriers to direct shareholder participation in negotiating executive pay. The question then arises: how do compensation arrangements look where investors can directly negotiate executive pay?
The study of VC compensation may present a unique opportunity to test hypotheses about executive pay. Unlike shareholders of public corporations, who must rely on boards to determine executive pay, venture fund investors negotiate compensation terms directly with venture capitalists at the time they sign limited partnership agreements. Venture fund investors are sophisticated and well counseled; due to securities laws restrictions, they are almost exclusively institutions and dardized, at least in its basic structure, which makes it possible to compare terms across multiple funds. This is harder to do when studying executive compensation in other industries. VC performance is also measurable and thus amenable to cross-fund comparison in a way that performance of executives of other firms is often not.
I use a hand-collected dataset of venture capital partnership agreements to analyze the structure and predictors of VC compensation. I supplement the study of agreements by interviews with numerous industry participants venture capitalists, managers of institutions that invest in venture funds, attorneys, and private investors and identify several new findings. First, the compensation of venture capitalists is comprised not only of management fee and carried interest, the two elements commonly identified, but includes a third element. This additional element is the value of the interest-free loan that VCs receive from limited partners.
The amount and term of this loan are specified through distribution rules determining when VCs receive their share of profits. A shift from the most popular distribution rule to the second most popular rule can affect VC compensation as much as or more than common variations in management fee or carry percentage. Because of this interest-free loan, VCs almost always capture a higher fraction of funds’ profits sometimes a much higher fraction than the nominal carry percentage, even before we consider the management fee.
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