Venture Capitalists' Personal Investment in Their Funds: Understanding the Implications

Do venture capitalists (VCs) put their own money in their investments? This is a question that often arises in the context of venture capital operations. While the majority of a venture capital fund's capital typically comes from institutional investors, high-net-worth individuals, and other sources, VCs often do contribute a portion of their own money. This practice, known as 'skin in the game,' underscores the alignment of interests between VCs and their limited partners (LPs).

What Constitutes 'Skin in the Game'

General partners (GPs) in venture capital firms generally make some commitment of the total fund size, often around 2-3%. This contribution serves as a form of 'skin in the game,' a term used to describe the financial stake that the GP has in the fund's success. By putting their own money at risk, GPs demonstrate their confidence in the investments and the prospects of the companies they fund.

This practice is common in the industry and is often required by limited partners and the Institutional Limited Partnership Association (ILPA). LPs look for this commitment to ensure that the manager of the fund is fully aligned with their objectives. The shared risk and reward incentivize the GPs to work diligently throughout the lifespan of the fund, from the initial investment to the eventual realization of gains.

The Economic Incentives of Skin in the Game

VCs are compensated in multiple ways:

Management Fees: A typical 2% management fee is charged annually, not linked to the performance of the fund. Carried Interest: This is a 20% share of the fund profits, usually after a hurdle rate is met. General Partner (GP) Stake: This can be pro-rata with the fund multiple, aligning the interests of GPs with those of the LPs.

In an ideal scenario, where the fund performs exceptionally well, the carried interest is sufficient to align the interests of the LPs and GPs. However, there are often hurdle rates that must be achieved before carry can be taken. For example, a 6-8% hurdle rate means the fund must double in size before any profit is shared with the GPs. This ensures that the GPs have a strong incentive to work hard to achieve higher returns.

What Happens Without Skin in the Game?

If the fund is performing poorly and is unlikely to meet the hurdle rate, the LPs still want the GPs to work hard to maximize returns. Without personal investment, GPs may not have the same incentive to invest considerable effort, potentially focusing elsewhere or on more profitable ventures. This is particularly critical given the high turnover in the venture capital industry.

Ultimately, a GP's track record of successfully returning capital to investors is a significant factor in their ability to raise capital for subsequent funds. Therefore, while skin in the game may not be a primary motivator, it plays a crucial role in aligning the interests of all parties involved.

Delving deeper into the economic mechanisms provides a clearer understanding of the rationale behind the practice of personal investment by VCs and its impact on the overall performance and success of venture capital funds.