Axios’ Dan Primack on ‘the most polarizing startup that exists’ – gpgmail

Hello and welcome back to Equity, gpgmail’s venture capital-focused podcast, where we unpack the numbers behind the headlines.

This week was a bit special. Instead of meeting up at the gpgmail HQ to record the episode, Kate and Alex met up in muggy Boston at Drift’s office, where we linked up with Axios’s Dan Primack. And since we were feeling chatty, we went a bit long.

After checking in with Primack (he has a newsletter and a podcast), we first dealt with the latest from Tumblr. In short, Verizon Media is selling Tumblr to Automattic for a few dollars. How did Verizon wind up owning Tumblr? Ah. Well, Yahoo bought it. Later, after Verizon bought AOL, it bought Yahoo. Then it smushed them together and called it Oath. Then Verizon decided that it didn’t like that much and renamed the group Verizon Media. But Verizon doesn’t want to own media (besides gpgmail, of course), so it sold Tumblr to Automattic, a venture-backed company best known for operating WordPress.

That’s a lot, I know. What matters is that Yahoo bought Tumblr for more than $1 billion. Verizon sold it for around $3 million. Now, Automattic now has a few hundred new employees and a shot at juicing its userbase before it goes public.

After that, we lamented that the WeWork S-1 had yet to appear. This was a tragedy, frankly. We had expected to spend half the show riffing on WeWork’s financials, alas…

So we turned to some normal material, like Ramp’s recent $7 million raise to take on Brex, and, SmartNews’s recent round, which gave it an eye-popping $1.1 billion valuation.

We ran a bit long because we were having fun, fitting in some conversation surrounding the notes from the SEC regarding the now-dead and then-fraudulent Rothenberg Ventures. More on that here if you want to get angry.

And finally, Vision Fund 2. It’s been a big source of interest for everyone on the show, and we expect whatever the second-act Vision Fund winds up becoming to be a big damn deal. The fund will invest in more than just consumer marketplaces, in fact, it’s eyeing more AI businesses and even biotech. That should be interesting.

All that and we have a lot more good stuff coming. Thanks for listening to the show, and we’ll be right back.

Equity drops every Friday at 6:00 am PT, so subscribe to us on Apple Podcasts, Overcast, Pocket Casts, Downcast and all the casts.

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How young VCs bootstrap new venture firms – gpgmail

We spend a lot of time talking about new funds, and new startup venture raises, but we spend little time talking about the cash flow challenges of running a venture fund. Let’s change that today.

Starting a new venture fund is extremely challenging. In addition to just the monstrous task of fundraising — which can take as long as two years in some cases to lock down all the limited partners (LPs) on the same terms — the economics for a debut fund are often just terrible.

Take a sort of starter $20 million seed fund with two general partners using the industry’s oft-quoted (but not really all that common) “2 & 20” compensation model. This hypothetical fund rakes in $400,000 a year in management fees (2% of $20 million) to cover all costs of the fund: office rent, staff costs, legal fees, tax preparation and accounting services in addition to the travel and entertainment costs of trying to woo founders. Whatever remains is split between those two GPs as their salaries. It’s not uncommon for new partners to make $50,000 — or even nothing — in the early years of a new firm, which is one reason the industry is stacked with ultra-wealthy individuals.

For young financiers looking to break into the industry, the situation is bleak, which is one reason why fund managers have gotten very creative around how to structure their management fees in order to bootstrap a venture firm in its early years.

These sorts of fund details are often kept tight-lipped, but thanks to the Mike Rothenberg case, we now actually have real data from a new firm and how it structured its fees for asset growth. From discussions with others in the industry, the models that Rothenberg Ventures used are reasonably available for investment managers looking to build new franchises.

All data for this analysis comes from Exhibit A — the Expert Report of Gerald T. Fujimoto, a forensic accountant who evaluated Rothenberg Ventures as part of the SEC’s lawsuit against Mike Rothenberg (Case No. 3:18-cv-05080). The exhibit was filed July 29, 2019. gpgmail did not attempt to verify the work of the forensic accountant, since this analysis makes no claims about Rothenberg Ventures, but uses the data for illustrating how funds are structured in today’s work.

Below is a recreation of the fund structures as reported in the SEC’s case against Mike Rothenberg. Rothenberg Ventures raised a series of four venture funds with fee structures that vary widely from the traditional 2 & 20 model, which assumes a 2% annual management fee for each of the 10 years of a fund’s life (further extensions beyond 10 years don’t usually offer significant fees, although every fund is structured differently). That equation means that management fees generally represent 20% of a fund’s committed capital.

Source: SEC v. Michael Rothenberg (Exhibit A)

For the firm’s debut fund, Rothenberg entirely eliminated the slow and orderly parceling out of fees in lieu of a one-time 17.75% fee upon the closing of the $2.6 million fund. That meant an immediate infusion of about $470,000 into the firm, but no continual fees thereafter. This sort of heavy upfront payment is not uncommon in the industry, although it is less common to have literally the sum total of management fees for a 10-year fund paid out entirely on its first day.

From an LP perspective, this sort of fee structure indicates that the firm almost certainly would have had to raise additional funds almost as soon as the first one closed, since the fees of future venture funds would be needed to cover the management costs of the first fund in its later years.

In short: This is what a bootstrap looks like in venture capital.

Now, continuing to the second fund (2014), we see a bit more of a traditional parceling out of fees over the course of the fund, although still with a heavy upfront skew. The fund pays out the typical 20% of invested capital in total, but 80% of that amount was paid out in the first two years. Again, the implicit assumption with this sort of bootstrap is that the firm will succeed and raise additional capital (and therefore management fees) to keep the operation going.

We then see the same pattern in the 2015 fund, with fees having a normal structure, but then with more aggressive upfront payouts required. So while the fund had a flat payout every year for its management fee, two years of that fee was to be paid out immediately upon close. Similarly, the administrative fee was flat — but paid out entirely in the first year of the firm’s operation.

Finally, the fourth fund (2016) returns to a more typical, flat fee structure at 2.5% per year with no provisions for upfront payment.

Why does this all matter? Let’s go through a back-of-the-napkin exercise of what these numbers really meant for the operations of the fund:

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Data from SEC Case, Exhibit A

As we can clearly see here, all of those management fees upfront really did give the firm far more resources in the early years than it might have otherwise had. Over the first three years, the firm had access to roughly $5.1 million in fees, whereas with a traditional 2% annual structure, the firm would have had access to just $1.2 million. Of course, that bootstrap comes at a cost in the later years, when the firm would have more resources to manage the fund.

Nonetheless, those upfront payments helped the firm tremendously punch above its own weight. With its $1.2 million of fees in year one, it essentially had the resources of a $60 million fund — yet it had only raised $6.7 million. It similarly punched above its weight the next few years as it raised new funds with aggressive upfront fee schedules as well.

Of course, there’s a heavy burden with this approach — it’s a bet-it-all strategy that leaves little room for error (such as a series of failed investments) that might make future fundraising hard. It’s a rocket with no ejection seat, but when it works, it can compress the time to venture fund leader dramatically — maybe even by as much as a decade.

Ultimately, VCs like to bet, and they certainly like to bet on themselves, which is why these sorts of cash-flow optimizations are prevalent for new firms. No one assumes that their firm is going to fail. Plus, these sorts of management fee structures are also among the few tools a non-wealthy individual can use to even get a new fund underway. For new fund managers and for others considering jumping into the VC industry, a nuanced understanding of the risks and opportunities of mortgaging future dollars for present spend is critical — not only for one’s integrity and stress levels, but hopefully to avoid those SEC investigators and forensic accountants, as well.

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The SEC wants disgraced VC Mike Rothenberg to cough up more than $30 million – gpgmail

Nearly three years ago, gpgmail reported on suspected fraud committed by Mike Rothenberg, a self-described “millennial venture capitalist” who’d made a name for himself not only by eponymously branding his venture firm but for spending lavishly to woo startup founders, including on Napa Valley wine tours, at luxury boxes at Golden State Warriors games and most famously, hosting an annual “founder field day” at the San Francisco Giants’s baseball stadium that later inspired a scene in the HBO show “Silicon Valley.”

The Securities & Exchange Commission had initially reached out to Rothenberg in June of 2016 and by last August, Rothenberg had been formally charged for misappropriating up to $7 million on his investors’ capital. He settled with the agency without making an admission of guilt, and, as part of the settlement, he stepped down from what was left of the firm and agreed to be barred from the brokerage and investment advisory business with a right to reapply after five years.

Now, comes the money part. Following a forensic audit conducted in partnership with the accounting firm Deloitte, the SEC is seeking $18.8 million in disgorgement penalties from Rothenberg, and an additional $9 million civil penalty. The SEC is also asking that Rothenberg be forced to pay pre-judgment interest of $3,663,323.47

How it arrived at that math: according to a new lawsuit filed on Wednesday, the SEC argues that Rothenberg raised a net amount of approximately $45.9 million across six venture funds from at least 200 investors, yet that he took “fees” on their capital that far exceeded what his firm was entitled to during the life of those funds, covering up these “misdeeds” by “modifying accounting entries to make his misappropriation look like investments, entering into undisclosed transactions to paper over diverted money, and shuffling investments from one [f]und to another to conceal prior diversions.”

Ultimately, it says, Deloitte’s examination demonstrated that Rothenberg misappropriated $18.8 million that rightfully belong to Rothenberg Ventures, $3.8 million of which was transferred to Rothenberg personally; $8.8 million of which was used to fund other entities under his control (including a car racing team and a virtual reality studio); and $5.7 of which was used to pay the firm’s expenses “over and above” the management and administrative fees it was entitled to per its management agreements.

We reached out to Rothenberg this morning. He has not yet responded to our request to discuss the development.

It sounds from the filing like there’s not much wiggle room to fight it. According to the SEC’s suit, the “Rothenberg Judgment” agreed upon last summer left monetary relief to be decided by a court’s judgment, one that “provides that Rothenberg accepts the facts alleged in the complaint as true, and does not contest his liability for the violations alleged, for the purposes of this motion and at any hearing on this motion.”

In the meantime, the lawsuit contains interesting nuggets, including an alleged maneuver in which Rothenberg raised $1.3 million to invest in the game engine company Unity but never actually bought shares in the company, instead diverting the capital to other entities. (He eventually paid back $1 million to one investor who repeatedly asked for the money back, but not the other $300,000.)

Rothenberg also sold a stake in the stock-trading firm Robinhood for $5.4 million, says the SEC, but rather than funnel any proceeds to investors, he again directed the money elsewhere, including, evidently, to pay for a luxury suite during Golden State Warriors games for which he shelled out $136,000.

In a move that one Rothenberg investor finds particularly galling, the SEC claims that Rothenberg then turned around and rented that box through an online marketplace that enables people to buy and sell suites at various sports and entertainment venues, receiving at least $56,000 from the practice.

In an apparent effort to keep up appearances, Rothenberg also gave $30,000 to the Stanford University Athletics Department (he attended Stanford as an undergrad) and spent thousands of dollars on ballet tickets last year and early this year, says the SEC’s filing.

Regardless of what happens next, one small victor in the SEC’s detailed findings is Silicon Valley Bank, a sprawling enterprise that has aggressively courted the tech industry since its 1983 founding. Last year, at the same time that Rothenberg was agreeing to be barred from the industry, he made a continued show of his innocence by filing suit against SVB to “vindicate the interests of its funds and investors,” the firm said in a statement at the time.

The implication was that SVB was at fault for some of Rothenberg’s woes because it had not properly wired money to the correct accounts, but the SEC says that SVB was defrauded, providing Rothenberg a $4 million line of credit after being presented with fabricated documents.

A loser — other than Rothenberg and the many people who now feel cheated by him — is Harvard Business School. The reason: it used Rothenberg Ventures as a case study for students after Rothenberg graduated from the program. As we’ve reported previously, that case study — funded by HBS before any hint of trouble at the firm had surfaced  — was co-authored by two professors who had a “significant financial interest in Rothenberg Ventures,” as stated prominently in a curriculum footnote.

Presumably, those ties gave confidence to at least some of the investors in Silicon Valley and elsewhere who later provided Rothenberg with money to invest on their behalf.

You can read the SEC’s 20-page motion for disgorgement and penalties below, along with the 48-page report assembled by Deloitte’s forensic accounting partner Gerry Fujimoto.

SEC vs. Mike Rothenberg by gpgmail on Scribd

Forensic report re Mike Rothenberg/Rothenberg Ventures by gpgmail on Scribd

Additional reporting by gpgmail’s Sarah Perez.

Above: Rothenberg Ventures during better days.

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