Blurred Lines

Navigate towards the center of influence.

The business model of a proverbial widget factory is quite clear. Assembly workers make the widgets and are considered a cost center. The salespeople who generate the orders from the sales channel are the revenue center. In any typical company, the revenue center yields the power in the organization. And especially in lean times, the cost center is subject to perpetual scrutiny for further cost reduction while attempting to maintain the same output.

Moving to professional services, say a strategic management consulting firm, the model is quite the same. Essentially just a powerpoint slide factory, the line-level consultants (analysts through principals, or however they’re titled) are the assembly cost center. The partners responsible for business development are the revenue center. Almost always, the latter enjoy an outsized portion of the spoils. I recall at my first job out of college, I observed that one of the relatively junior partners sold a big contract for the firm, yet he never really seemed to do any real slide factory work… he was exempt from the scrutiny around cost center efficiency. That realization really stuck with me.

Transitioning to the realm of private equity and venture capital, the distinction becomes murky. Under the standard '2 and 20' compensation model—comprising 2% management fees and 20% carried interest—our firms essentially earn in two ways: annual fees charged to Limited Partners (LPs) for managing their investments, and performance compensation from successful exits. Initially, this would position LPs as our customers. However, the substantial returns from successful exits would alternatively suggest that the founders, to whom we must sell our expensive capital, could also claim that role.

This dual-revenue structure poses the perennial question: who is the real customer in venture capital?

Over the course of the past two decades that I’ve been a VC investor, there has been a perpetual debate about this topic. And along that timeline, as VC firms increasingly have positioned themselves as “founder friendly,” the at least publicly marketed sentiment is that the entrepreneur is the customer.

At my previous firm before starting NextView, I had one of the more senior partners hold an offsite with a subset of us junior investment team where he lectured us for an hour+ about how our LPs are our customers. When I returned back to the home office, a different senior and longer-tenured partner adamantly refuted everything to me that was said in that talk. So the debate rages internally inside firms, too. (Incidentally, that first partner was asked to leave the firm within just a couple of months, for reasons perhaps only partially unrelated to that incident).

In reality, there is conflict here, because there are indeed two ways that VCs make money.

Of course, actions speak louder than words, and you can see this tension play out in how firms behave. Some VC shops are geared towards asset accumulation. And some firms are more performance-oriented, often even at the expense of jeopardizing AUM maximization.

With two revenue-sources, our clear-cut widget factory model around cost and revenue centers begins to break down… or at least the lines become blurry. Is the revenue center the partner who just convinced the star serial entrepreneur to take our term sheet versus a competitor’s, or the partner who ran the fundraising process landing a few new large LPs? Similarly, defining the cost center is challenging: is it the team of associates conducting market research at industry events, or the investor relations team strategizing quietly across the other side of the office?

Further complicating these polar ideas is the fact that not all founders end up making money for a VC firm, only a smaller subset do. Just like in the widget factory, you can have unprofitable customers; the same is certainly true in venture capital. However, whereas you can immediately run some figures to identify and subsequently negotiate the terms of the unprofitable customers in the widget factory, the challenge with venture is that you won’t know who the profitable customers are for a decade! (Note that private equity and even some VCs elegantly fix this problem by charging all portfolio companies for services, but that’s certainly a minority).

As a result, in a founder-as-customer orientation, because of the delayed performance feedback cycle, what activities and therefore people are viewed as a cost center rather than a revenue center isn’t necessarily based on reality, but rather on the perception of current reality. That makes the model of a VC shop blurrier still.

What, then, are the ramifications for up and coming VCs? All organizations are political by definition, but VC firms are especially so in the short term. That is, until performance over the long term ultimately rules for those who hold onto their seat. If the reality is blurry how proximate you are to revenue, then the mere appearances of such matter. As a junior investor that means be aware of the political winds afoot within your firm to ensure that you’re able to keep tenure until you establish yourself with performance. Second, understand where along the spectrum your firm falls, either towards asset accumulation or performance orientation. One framework to think about is to ask if you're perceived to be part of a revenue center (good!) or a cost center (not so good). As our industry continues to contract, the closer you are to revenue, the more valuable your role is.