Council Post: Skin In The Venture Capital Game

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Michael is Co-Founder and General Partner of Szalontay Flash pointAn international technology investment firm.

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“If you don’t take a risk to stand up for your opinion, you are nothing.”

-Nasim Nicholas Taleb

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Venture capital (VC) is a complex business with probability theory at its heart. Basically, you’re swinging for the fences with a wide spread of possible outcomes and returns, just like in baseball – from home runs to strikeouts.

“Skin in the game” refers to a VC manager’s vested interest in his fund. Since private equity and VC funds are essentially structured as partnerships, the manager’s participation in equity risk is determined by the commitment of the fund’s general partner (GP) as a share of total commitments. Historically, the GP commitment was 1% for tax reasons, as this was the minimum requirement set by the IRS to receive favorable treatment. Fund,

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The fund management business is prone to agency conflicts because the interests of the manager may diverge from the economic interests of its investors. This is mitigated to an extent by fiduciary duties imposed through regulation; However, “skin in the game” creates greater alignment — especially on the downside — and is the simplest and most straightforward tool for ensuring that a VC manager acts in the best interests of all of his limited partners.

To understand how “skin in the game” affects VC manager behavior, we need to look at the math of their investment strategy. In its most basic form, the total return generated by the fund is defined as the sum of the mathematical expectation of all the bets made by the managers. Their strategy determines the key variables in this equation and can be assessed through its effect on the expected return formula:

, Number/Size of Bates: At one end of the spectrum is spray and pray – aiming to maximize the number of bets to the detriment of the quality of each bet – with the expectation that a handful of bets will compensate for the loss. The other end of the spectrum is extreme selectivity with some carefully placed large bets aimed at minimizing losses, which has traditionally been the model for private equity players.

, Risk/Return profile for each bet (Best described by a probability function of expected outcomes): The accuracy of the profile is a strategic choice. Most managers seek their competitive advantage by improving their understanding of risk using better information with the aim of skewing results toward better return per unit of risk. Examples include: specialization (industry, geo or other), focus on follow-on (where you benefit from watching investment performance over time) and using “Big Data” in the investment process, data Enhancing the quantity of input and/or the quality of the evaluation function.

, Setting a target return on each bet: In its purest form, this is through the selection function. Managers may target 100x returns for each investment and in the process accept a high probability of failure. Targeting marginal returns generally reduces the potential for loss. Ultimately, the manager’s strategy defines how much total risk they take and what target return they expect for each unit of risk.

Let’s compare the behavior of two extreme VC managers

Manager A plays only with his money – full skin in the game. They may or may not have a strong appetite for risk-taking depending on their background. Risk tolerance is determined by the dollars of loss they are willing to risk for every dollar of expected gain.

Manager B is funded entirely by third-party limited partners – zero personal skin in the game. As a result, the second manager has an option-like payoff, where their option premium is the opportunity cost, while they capture a portion (typically 20%) of the profit through interest incurred. As a result, manager B is prone to minimize the opportunity cost by making decisions quickly to the detriment of risk assessment, maximizing the number of bets. They aim for higher target returns by accepting higher risk.

An example from the textbook describes manager B being predisposed to choose an investment with a 10% chance of a 100x return over an investment with a 50% chance of a 20x return, even though the mathematical expectation for both is 10x. . It’s like playing in a casino with someone else’s money. Such behavior is tempered only by the opportunity cost and potential damage to the manager’s reputation, affecting his future ability to raise funds and swing again.

How much skin in the game is necessary to keep the VC manager honest and ensure that his risk tolerance is rational? The mathematical answer needs to consider the value of reputation. The insightful answer seems to be that the VC industry underestimated the importance of skin in the game for a while, but is finally catching up. GP commitments have been rising steadily over the past decades and are now in the range of 2%-5% for 80% of firms.

However, there is another side to every coin. If the GP commitment becomes too large, the GP may pursue its own interests even when they conflict with the interests of the partnership. Many GPs rely on the income earned to exit their commitments and on previous Wealth, And that can get trickier in a tough market environment. Incidentally, I saw a situation like this happen in the 2008 crisis, as a semi-captive fund manager’s GP impoverished the fund, rejecting further investments in a larger market because it would have defaulted on the GP’s commitment. Could have

In my personal opinion, the optimal participation is around 10%. It aligns interests while providing sufficient freedom to the manager to take risks. After all, as Nassim Nicholas Taleb rightly quips in his book skin in the gameOpinions only matter if you put your money where your mouth is.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice related to your specific situation.

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