Does It Make Sense for Investors to Pay Carried Interest?

When It Pays to Pay Carried Interest in Private Equity

For years, I have resisted paying carried interest to accelerators as a way to invest in start-up companies because I have thought about the decision incorrectly. Recently, a couple of smarter investors than me set me straight by getting me to focus on what really matters — the math.

Over the years I have resisted paying carry for two reasons, neither of which is very good. First, I get a lot of utility out of investing in startups. I like working with and talking to founders. If I put money into an accelerator fund, rather than investing directly in startups, I lose that utility.

But that logic is flawed. I don’t avoid paying money managers to help me find companies to buy in the stock market because I like picking stocks. I pay them to identify opportunities that make financial sense.

Second, I saw paying carry as akin to paying retail prices for clothing or furniture. And my parents always taught me that you should buy wholesale, not retail.

But that logic is also flawed. If you have to drive a long distance and give up a half a day of your time or pay for shipping or installation, buying wholesale isn’t much of a deal.

What Changed My Thinking About Carried Interest in Private Equity?

Recently some smart co-investors showed me an accelerator deal that they were going into. At first I blanched at the 35 percent carried interest and said no way would I go in. But then the investors showed me the math and got me to think about the opportunity differently.

This accelerator invests in 12 companies a year. It puts $50,000 into each company in return for 4.5 percent of the company. That means the pre-money valuation is $50,000/0.045 or $1.1 million before the carry. The fund has a 35 percent carried interest, so the effective pre-money valuation after carry is $1.1 million/0.65, or $1.7 million.

The right way to think about the investment is to think about whether I could create a portfolio of equally good companies in which I invested at an average valuation of $1.7 million.

If I look at the companies that entered the accelerator on the criteria I generally use to set valuation — the quality of the founding team, size of the market and traction to date, the companies in this accelerator look very strong. All of them have founding teams with considerable industry experience in the product markets they are entering. All of them have billion dollar-plus markets. The average revenue is $10,000 per month. I would generally value companies that look like this at considerably more than $1.7 million. After the accelerator fund managers’ carry, I would be investing in these companies at an average valuation 50 percent less than their market valuation.

To create a portfolio of twelve companies takes a lot of work. I generally invest in about four percent of companies that I am introduced to or that send me pitch materials. So to create a portfolio of twelve companies, I have to source and screen about 300 businesses. That takes me at least two hours per day of work six days a week. But with the accelerator, I am getting the same portfolio without any of that effort.

In short, if I can invest effortlessly in a portfolio of start-ups at a valuation roughly two-thirds of their market value, then I should make that investment. If the carried interest that is embedded in that investment calculation is a big, ugly 35 percent, I should ignore it.

Sometimes it pays to pay carry.

Carrying Photo via Shutterstock

Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.