DISRUPTING THE TRADITIONAL VC PROFIT SHARING MODEl
Weaving in Philanthropy yet Achieving The Same Outsized Returns for LPs
At Transform Capital, we are building a movement to inspire philanthropy in venture capital. It takes a village to drive change. When we say “we”, we are not just referring to us, it also includes our Limited Partners (people who invest in our fund) and portfolio founders.
We will be sharing how we are disrupting the traditional VC profit-sharing model to weave in philanthropy without sacrificing our Limited Partners (LPs) profits and how our “village” plays a part in this endeavor.
THE TRADITIONAL PROFIT SHARING MODEL
General Partners (GPs) at VC firms earn a carried interest (share of the profits) for their efforts. In most cases, profits are split 80/20, 80% to the LPs and 20% to GPs.
How It Works
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100% of all cash inflows (e.g. when a portfolio company exits) go to the LPs until the cumulative distributions equal the original capital invested.
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Thereafter, any cash flows in excess of distributions made in the above step (if any) are considered profits and are distributed 80% to the LP and 20% to the GP. This is often referred to as an "80/20 split".
THE TRANSFORM CAPITAL PROFIT SHARING MODEL
At Transform Capital, our General Partners (GPs) have committed to donating 50% of our carried interest (share of the profits) to philanthropic causes picked by our LPs. As such, the profits are split 80/10/10, 80% to the LPs, 10% to the Foundation and 10% to GPs. The Foundation then directs funds to the non-profits of our LPs’ choosing.
Because we (LPs & Transform General Partners) strive to donate to philanthropic causes as soon as there’s a cash distribution, our LPs receive distributions in parallel with the Foundation.
How It Works
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Every time there’s a cash inflow (e.g. when a portfolio company exits), 90% of it goes to LPs and 10% goes to the Foundation where LPs can select which non-profits receive the donation. This 90/10 distribution continues until the cumulative distributions equal the original capital invested.
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Thereafter, any cash flows in excess of distributions made in the above step (if any) are considered profits and are distributed 80% to the LP, 10% to Foundation and 10% to the GPs.
COMPARING TRADITIONAL vs TRANSFORM CAPITAL MODEL
Here’s an example that illustrates a $5M investment from a Limited Partner and how the cash inflow is being distributed via the two different models.
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Years 1 & 2 - The left bar represents the Traditional model and the right bar represents the Transform Capital model. LP invested $5M over the first 2 years, as shown in the dark grey bars.
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Starting from Year 3, you’ll see cash inflows that are paid out to the LP (Yr3-$1M, Yr4-$1M, Yr5-$2M, Yr6-$1M). The light grey bars show cash inflow to the LP for the payback of the original capital invested. Donations are made to the Foundation every time there’s a cash inflow event as shown in the yellow segments. This only happens in the Transform Capital model. The LP then directs which non-profits receive the donation from the Foundation.
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Starting from Year 7, the LP has received 100% of the original capital invested (light grey) and started to earn profits as shown in green. Only at this point, the General Partners also start to earn their carried interest (share of the profits) as shown in blue. As you can see, the profit earned by Transform Capital General Partners are less than the traditional model because the partners have committed to donating 50% of their profits to philanthropy.
HOW DOES THE RETURN DIFFER IN BOTH MODELS?
Based on the above $5M LP investment, here is a comparison of the two models:
Traditional Model | Transform Capital Model | |
|---|---|---|
Profit Sharing - LP | 80% | 80% |
Profit Sharing - VC | 20% | 10% |
Profit Sharing - Foundation | 0% | 10% |
LP Profit | $20.8M | $20.8M |
Donation made by Foundation | $0 | $2.6M |
VC Profit | $5.2M | $2.6M |
Multiple on Invested Capital (MOIC) | 4.16 | 4.16 |
Internal Rate of Return (IRR) | 28.97% | 28.61% |
* Note: There is a negligible difference of 0.36% in IRR. This is because our LPs are willing to delay their principal payout by a little so that the foundation can receive donations sooner.
CONCLUSION
We believe that the Transform Capital model is a game-changer. In the Transform Capital model, we continue to earn outsized returns and return the same amount of LP Profit and MOIC as the traditional model.
By sharing a portion of our General Partners’ profits and partnering with LPs that are willing to delay their principal payout by a little, together we can make substantial donations to our philanthropic foundation which distributes the funds to non-profits picked by our LPs. The result is a WIN-WIN solution for all and a new enlightened VC model where business becomes a driver for making consistent positive change in our world.