Chris Sacca is on one of the greatest streaks ever for a venture capital investor. He’s been an early-stage investor in companies such as Uber, Instagram, Twitter and Kickstarter. He’s come out of nowhere to become one of the most well-known VCs on the planet because of both his investing prowess and his brash style (he’s the guy that’s always wearing the gaudy cowboy shirts).
He recently sat down for a podcast with Tim Ferriss to discuss his career and the state of the venture industry. One of the most interesting aspects of this interview has to do with Sacca’s views on the current 2&20 fee structure that so many VC funds employ (2% management fee and 20% of profits). This was Sacca’s very honest assessment of the risk-reward trade-off for both investors and those running the funds (emphasis mine):
This is a rigged game, right? And I’m just looking to make it even more rigged. For those who don’t know, venture capital is totally unfair. I mean, people give me their money; I draw a management fee off it, so they pay me to take their money and invest it for them. If I make money, then I pay them back the management fee and then after that we split the profits and I get a really big chunk of the profits.
And if I lose money, that’s fine. It doesn’t come out of my pocket. I keep my fee and my investors lose money. That’s how this industry works. That’s bananas. And at some point, it’s gonna break. It’s just an unforgivably unfair, rigged game that’s in favor of the venture capitalist. You’re cash flow positive from day one when you start a venture fund and your downside is incredibly limited by the structure of the fund.
Sacca is known for being a very outspoken guy, but this is a refreshingly honest admission from an investor who’s so well-known in the industry. The majority of general partners would never admit this in public, even though they all understand the truth behind it. The standard company line from most who participate in the 2&20 fee structure is that, “we’re aligning our incentives with our investors.” They fail to mention that the reason things are done this way is pretty much because it’s the way things have always been done.
What Sacca is really talking about here is the power of incentives on people’s actions, something that most people fail to appreciate. It’s obvious that people don’t always act in the most rational manner, but if you’re looking for the main reason why things are the way they are in the world of business you should always start with the incentive structure. This is especially relevant within the finance industry where incentives shape the way nearly every business and individual functions to some extent.
Sacca goes on to say that this type of fund structure allows him to take some risks that he likely would be unable to take if the deck wasn’t so stacked in his favor. He states that he can take more binary, all or nothing, bets on certain companies with the hopes of hitting it big, but the possibility of crashing and burning (although this is generally the premise of venture capital investing — many failures and a few home runs).
Essentially Sacca is saying that he is incentivized to swing for the fences because he doesn’t participate in any of the downside. Luckily, for him and his investors, this strategy has paid off handsomely for his funds. By his own admission, his current fund is probably the most successful venture capital fund in history from a return standpoint because of the early stage investments mentioned above.
It makes you wonder what’s going to have to happen to see changes in this incentive structure and make it break, as Sacca forecasts. I imagine it will probably involve the downside of swinging for the fences as many of these funds will strike out the further along we get in the cycle.
Listen to the entire podcast here:
Chris Sacca on being different and making billions (Four Hour Workweek)
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