Compensation
Talking about the thing that nobody talks about.
The other week’s post about “getting paid” was both the most popular Venture Upward post to date and the one in which we received the most (positive) feedback. And for good reason, compensation is the topic that everyone wants to talk about but nobody does. In particular, carried interest or carry is the most opaque aspect of venture compensation, so it’s worth shining a further light on the subject.
The first thing to understand is the General Partners at venture capital firms are naturally hesitant to give up carried interest, and for two reasons. One is pure economics, plain and simple, as it’s where the most upside in the business is, and so the powers want to keep it close to themselves. But the second rationale is that the payout is quite frequently after an employee has departed the firm, so there’s a mismatch between using this avenue of comp as a feedback and incentive mechanism for present-day performance. Along those lines, one recent survey found that only 11% of analysts and 39% of associates receive any carry at all!
Most often, when carry is granted it’s an assignment of interest in a specific fund’s partnership. In other words, you’re granted the economic benefit without the requirement to contribute capital, but only for one specific fund, almost always the one currently making new investments. So unlike the partners you don’t have the “privilege” of paying into the firm’s coffers, but also you’re not going to benefit anytime soon from the firm’s upcoming near-term liquidity event successes, like acquisitions and IPOs. You’ll have to wait until the new crop of companies that are being invested in today actually produce results many years from now. So you’ll just have to begrudgingly watch the folks that have been around for a while celebrate when the firm has a good year this year. As an aside, sometimes firms create what’s referred to as “phantom carry,” or bonus pools which synthetically mimic payouts which a fund would distribute if it was to actually assign interest without actually contractually legally doing so. This approach is effectively the same (though less tax-efficient) for employees, but obviously the firm wouldn’t be doing it if it didn’t benefit them, so caveat emptor. However, similarly this approach isn’t a bonus pool spreading the wealth of recent success, but rather prospecting for the future.
Unlike startups which try to pull wool over the eyes of prospective employees by framing equity option grants in terms of dollars instead of on a company percentage basis, I actually believe that thinking about carry in terms of “dollars at work” rather than percentage interest in a venture capital fund is actually the right way to approach it. Whereas with a startup the upside is unbounded, as a new employee the best way to compare apples to apples is what percentage of the company you’ll own at any given exit price; venture firms are structured differently in that they start at different sizes and are relatively bounded in performance. Put simply, assuming two VC firms’ prospects were the same (an assumption, I know), you’d rather have half the relative percentage ownership in a fund which is three times as big.
Framing your assignment as "carry dollars at work" allows you to compare achieving a net 2x return (above hurdle and after fees) in a vehicle from one job offer vs. the next that takes fund size into consideration. For example, 1/2 point (50 bps) of carry (out of a possible 100 points) in a $500M fund with 20% carry would result in $500K of carry dollars at work (500 x 0.2 x 0.005 = .5). Of course, many funds do not return capital, so that’s always a possibility. But the median 10 year old fund benchmark is currently sitting at just north 2x according to Cambridge Associates, so your current dollars at work assignment is a reasonable proxy as the size of the bonus which will come to you over a decade’s time.
There are a few points of consideration when looking at your carry compensation today (or lack thereof) and a possible new assignment coming from your firm or a new job offer. The first is vesting. Many firms effectively reduce the headline carry figure by making the vesting period longer than your expected tenure at the firm! As opposed to startup employees vesting schedules as a three or four year period; often even junior VCs are six, seven, or even eight years. This situation in part happens as a remnant from the senior investors’ vesting schedules being longer to match their expected tenure, but also as slight-of-hand to disenfranchise junior employees. Unlike startups’ Employee Stock Option Pools which are rigid in structure, assignments of interest in a VC fund are almost always bespoke. That means that they’re negotiable, and so I believe that typically there’s moral high ground and structural ability to right-size the vesting period when discussing with your employer.
The second consideration is around fund cycles. A VC firm’s transition from one fund to the next (usually every 1.5-3 years) is the natural time for the firm to reassess compensation for the entire investment staff. Accordingly, a new fund marks the usual time for non-partner VCs to receive a (new) assignment of carry. And other than when negotiating the carry piece of your original job offer, it’s the best time to respectfully ask about any compensation increase.
Lastly, there’s a tradeoff issue between cash and carry compensation. With startups where there’s nearly unlimited equity upside potential and employees are effectively brought up to market cash comp rates as the company matures, I usually advise new employees to push in job offer negotiations towards getting as much equity up front as possible sacrificing cash. In joining VC firms, it’s different. I had a mentor who is a half-generation further in his career than I am advise me that the degree that a VC firm is going to be flexible on carry for non-partner employees is actually rather low, and I’ve indeed seen that to be the case. Each firm is going to have a philosophy and an approach, and likely not going to deviate much from it, especially in the larger pyramid firms which manage a large staff of investment professionals. And in almost all of those cases, generous isn’t the word which comes to mind, especially before you’ve joined the firm and proved that you can be known for something. So for those reasons and the fact that the upside really isn’t unbounded, I’d actually counter-intuitively advise non-partner investors when negotiating or renovating their comp package to actually use whatever leverage you have to push for a larger W-2. Cash is here and now, and not something you have to wait ten years for that will only maybe materialize.
It’s worth seeking out compensation benchmark reports to see where your current package falls within the industry. The bigger the firm with more AUM, the more that you are going to get paid. There’s honestly no way of avoiding that fact, as there’s just more to go around. Another thing to look at is the trajectory of the fund sizes (hopefully getting larger) over time, which is an effective proxy that a growing pie will have more to serve as the firm develops, rather than a static firm whose spoils have already been carved up. Remember that a VC firm can be a zero-sum game in terms of comp… every dollar being paid to you is literally being taken out of the pockets of the partners. So the way to earn more is to deliver tangible results that noticeably increase the size of that pie.