VCs take a paycut

To attract LP money, VC firms adjust their fee structures as fundraising competition heats up

The fundraising market is downright cutthroat for VCs. According to numbers from the WSJ, the percentage of VC firms actively seeking capital that have successfully closed new funds has fallen to 30.8% so far this year, down from 68.4% in 2008 and 81.6% in 2007.

A nose-dive in the value of endowments and pensions funds coupled with a move to more conservative investment approaches at these LPs means the money going to the VC industry this year could be cut in half. So far, firms have raised a total of $20.4 billion, compared to $58.2 billion for all of 2008, according to research firm Preqin.

Add to the mix the fact that 1999, VC’s boom year, just dropped out of the 10-year return calculations, pushing the average return for VC funds from 34% last year to 14% this year, and you have one heck of a tough negotiating position.

Nonetheless, venture investors aren’t quick to throw in the towel. The tough economic situation has hardly impacted the number of the firms on the hunt (435 so far this year compared with 452 and 445 for the entire year in 2008 and 2007, respectively). That means there’s quiet fight for survival, and the competition has VC firms sweetening their deal terms.

Typically, venture firms charge a 2% annual management fee based on the total dollar amount of the fund, plus 20-30% of the profits made when portfolio companies are sold or go public. While the profits, or “carried interest” constitute the bulk of a firms’ revenue, the management fee alone on a $700 fund can mean $14 million revenue for a firm, before any returns are calculated.

The WSJ reports that Opus Capital, which is trying to raise a $250 million fund, recently cut its carried interest fee from 25% to 20%. Battery Ventures similarly cut theirs from 25% to 20% until it returns three times its capital, at which point a 30% rate kicks in. Highland Capital Partners, which closed a $400 million fund last week, and Draper Fisher Jurvetson are also incorporating performance-based hurdles into their carried-interest fees, according to the WSJ's sources. Greylock Partners, which closed a $575 million fund (beating its $500 million goal) this year, bases its management fee on a yearly budget that investors must approve, instead of the standard 2%.

We reported these tough negotiating conditions back in April when CalPERS' head honcho, California controller John Chiang faced off against Sequoia’s Mike Moritz in a bit of onstage negotiation. Responding to a question about defaulting on cash calls, Chiang said “We're not defaulting, we're re-negotiating. [...] In the alternative investment space, there was not tremendous quality, but, you know, we see quality and we want to build long-term solid partnerships—maybe you want to re-evaluate [gesturing toward Moritz]—and it gives us the ability to negotiate fees. It became very standard on the two and twenty and for a lot of these investments people weren’t deserving of two and twenty.”