Train Asked on September 7, 2015 in Other.
For angel funds, venture capital funds and other investment partnerships, there are often complex formulas for how the individuals involved in managing investments make money.
Angel investors typically make investment decisions regarding startups without paying others to manage their money. Therefore, the return on their investment usually won’t involve paying any intermediaries. This can make a startup investment more attractive than alternative high-risk investments that usually involve paying a broker, money manager or another financial intermediary.
There’s a growing trend for angel investors to come together and invest as a fund. Typically, these funds make investments ranging from $100,000 to $500,000 at one time and occasionally are supplemented with private investments from individual angels. These funds tend to be small in size, which makes it difficult to afford full-time investment professionals to manage the fund. Nevertheless, a significant amount of time is spent on meeting organization, decision coordination and due diligence required to manage these bands of angels and fulfill the promise of the angel fund model.
Therefore, more often than not, angel funds have one or more investment professionals–often working part-time–paid as managers for the fund. Their compensation involves cash and a bonus tied to the fund’s performance. The exact nature of this compensation is related to the fund’s origins. If the fund was initiated by its managers, the compensation is usually more substantial and tied closely to the performance of the investments the fund makes. If the fund was initiated by angels who subsequently hired a manager to handle the meeting coordination, the compensation formula is skewed toward cash rather than performance bonus.
Venture Capital Firms
Warren Buffet famously describes some investors as the “2 and 20 crowd.” This refers to the formula that has become popular among many investment funds–particularly hedge funds that invest in the stock market, but also venture capital funds that invest in private companies–when compensating fund managers.
The investment management fees are calculated as 2 percent per year of the total size of the fund plus 20 percent of the upside return. Some venture capital firms with specialized skills or outstanding reputations can justify fees of 3 percent and 25 percent to 30 percent of the upside, but most tend to charge fees in the “2 and 20” range. The fees are paid by their investors, often called limited partners. This means that a $500 million fund generates $10 million in fees per year, even before it’s earned any of the upside returns. That’s enough to pay generous salaries to several partners, associates and support staff.
Since the real legwork for most venture capital firms is done by associates and other non-partner investment professionals, such as vice presidents and principals, it’s actually more helpful to study their compensation.
The typical associate earns an annual salary of $100,000 to $200,000. That amount is usually higher for associates based in competitive markets, such as New York City, or those working for larger funds. In addition, some funds allow associates, VPs and principals to earn some of the upside of the investments the fund makes, often called a carried interest or “carry.”
Most VC funds encourage associates to find attractive deals that get funded to increase their salary or their carry. It’s not unusual for associates and non-partner professionals to toil for many months or years before successfully finding a deal that gets funded, let alone one that gets funded and achieves liquidity for the investors. Evaluating performance of non-partner professionals is very difficult if the returns are only realized many years later, often after the associate has moved on to another job. This leads to a culture that many entrepreneurs complain about: The associates have the power to say “no,” but not “yes.
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1) Invest in a domain you know. One of the best ways to reduce risk is to understand the market that startup operates in. This will provide you with a better sense when projecting the potential success of the venture. Make sure that the business has a scalable model so that it can grow to a level in which you will be able to get your money back as an investor.
2) Drill into the track record of the founders. The people behind the company are the most critical factor, especially for early stage companies. This is mainly due to the fact that products need to be iterated several times until they are able to find where they fit in the market. Just like Jim Collins’ book “From Good To Great”, it is all about having the right people sitting in the right seat. Eventually they will end up finding the right direction. Here you want to focus on their background story (previous companies, education, etc.) and what type of value they bring to the table.
3) Diversify your investments. Instead of putting all your eggs in the same basket make multiple investments. This will increase your possibilities of success and will also help to reduce the risk involved. It will also increase your chances of getting your money back with some returns at a liquidity event such as a public offering or an acquisition by another company. In the end, these investments are for the long run so try to be patient.
4) Join an equity crowdfunding platform to get access to deal flow. If you are struggling to find deals, the best way to remedy that is to go online. By registering on investment platforms you will be able to navigate different deals. Especially if you are new to startup investing, you may want to see as many deals as possible before pulling the trigger. It is important to learn about the market before making any type of investments.
5) Examine the monetization strategy. The first dollar is what really matters. As an investor it is critical to see how the company is going to be able to scale down the line. The startup in question needs to be charging for its service at a reasonable price. There is no point to investing in a company that cannot sustain itself financially so a clear path to monetization is key.
6) Explore the market. It is absolutely critical to see what competition the startup has and what kind of competitive advantage they have been able to put in place in order to beat everyone else in the race. The competition could acquire the startup instead of cloning their work, so investigating the appetite in the market could be beneficial. Moreover, you want to make sure that the startup is operating in a big market. The founding team should be focused on customer development and they should definitely listen to what clients are saying. Feedback is key in the event the startup needs to pivot or iterate the product until they get it right. The specific idea is not as important as the team’s approach, and the size of the market.
7) Investigating the financials. Calculating projections to 5 years is almost impossible but the founding team should be able to at least showcase the roadmap of how they want to build the story towards becoming a profitable company. It is very interesting at this point to review the burn rate of the company and if what they are doing with their money actually makes sense.
8) Research their use of funds. As an investor, you need to understand what, why, and how the startup intends to spend the money. Having a good idea of what to do in this section would give you a better sense when testing the entrepreneur’s vision. In addition, review the salaries and see how much the founder intends to pay himself/herself. For a seed round, the absolute maximum salary should be $150,000 (depending on the amount raised and the experience of course). Also, try to understand if the funds that the startup is raising would be enough to accomplish important milestones that could help the company to either become profitable or to raise additional rounds of financing.
9) Review the legal documents. Look at the articles of incorporation, by-laws if available, investor agreement, subscription agreement, term sheet, etc… This step is all about getting familiar with how the company is structured and who is involved (directors, investors, advisors). Additionally, here is where you want to pay special attention to how the startup has structured the deal and what percentage of ownership in the company you are receiving for the amount of money that you are investing.
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Entrepreneurs need to solve real problems with enduring competitive advantages in large markets. Often businesses have the potential to have a high impact on a small group of people, which makes the prospect of investment return difficult. Investors respond to well-researched entrepreneurs who know the market intimately and can demonstrate why their business will be successful. Often entrepreneurs are so excited about their idea or product that they do not have a believable pathway to meaningful market share. Events like Startup Weekend are great for entrepreneurs to cut their teeth and practice the entrepreneurial process. There is also the chance that some of the really interesting concepts have commercial promise.
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