It must be hiring season for venture capitalists - VC compensation talk has been coming up recently. If you're a partner, VC compensation is pretty straightforward - you get a piece of the partnership's profits, aka a "carried interest" in the fund. (See my presentation on VC 101 to dig in more on this.) But how can you provide the best incentives for your other investment staff? How can you get your analysts, associates, principals, and vice presidents to all contribute the success of the portfolio? In an ideal world, every person an entrepreneur talks to at a venture fund will have a stake in the entrepreneur's success.
I have the unique advantage of an inside view on non-partner compensation across multiple investment funds. There isn't one model established as best practice for the industry, but there are a few that are either common or make common sense. Not necessarily both at the same time. Here are the top three:
- Vested Interest. This model is very similar to stock options:
- The fund creates a small pool of "carry points" that can be issued to associates (or other non-partner staff.)
- An associate is a issued a set number of "carry points" each year. Like stock options, these points take four years to vest, have a one year cliff, and vest monthly or annually thereafter. They also disappear if unvested if/when the associate leaves the fund. Unlike stock options, the associate doesn't have to pay for them.
- Each year is considered a vintage year, and each year the associate gets another batch of points that will correspond to the deals made in that year. Associate kicking butt? Increase the size of their grant. Slacking off? Decrease it.
- The fund sets up the spreadsheet that keeps track of "vintage year" performance in addition to fund performance. (Most funds do this anyway.)
- Both during employment and after the associate leaves the fund, the associate gets payouts based upon their share of profitable, in-the-money (vintage year principal has been returned) exits.
- Phantom Carry. A less-common model that looks like cashless angel investing:
- For each investment, the associate is given a 'phantom investment' amount, as if they were a invisible angel investor in the deal. So this doesn't show up on the investment's cap table, but rather lives in the fund's back end accounting.
- The amount of phantom investment varies based upon the role the associate is playing. For example: Sourced the deal? You get $25K phantom carry. Helped close it? $15K. Just on the team at the time the deal closed? $5K.
- The fund sets up the spreadsheet that keeps track of "phantom carry" amounts assigned to each investment.
- Both during employment and after the associate leaves the fund, the associate gets payouts based upon the return for each individual investment.
- Exit Bonus. This popular model is most like a traditional bonus:
- The associate is given a share of carried interest in the current fund, and any future funds that the associate works on.
- When the current fund begins returning a profit during the asociate's employment, the associate receives distributions according to his/her carried interest.
- After the associate leaves the fund, they no longer receive any distributions.
Of these three, I believe that the vested interest model provides the best outcomes - the associate has a long-term incentive to provide ongoing support for companies, which benefits both the entrepreneur and the fund. The longer the associate is working at the fund to support the investment, the greater his/her reward (larger amount vested) based upon the company's success. The phantom carry model comes close to this, however, and is easier to administer. Though common, I believe the exit bonus model to be flawed - an associate or vice president in a three-year program is more incented here to find new deals as vs. to work towards the success of deals that may exit after they are no longer working at the fund.
Net-net: Entrepreneurs - don't be shy about asking if the associate that cold-calls you has an incentive for you to be successful! VC partners - there's a real competitive advantage in having your entire team work for your portfolio's success. The argument isn't to pay staff more, but rather to tie more compensation to portfolio success. A thoughtful approach here will be worth the overhead.
What other good approaches have folks seen? Ideas and comments welcome.
