The Math Isn’t Mathing: Misaligned Incentives and Broken Models

Venture capital (VC) has long been heralded as the driver of innovation and entrepreneurship, but the reality is far less glamorous.

Venture capital (VC) has long been heralded as the driver of innovation and entrepreneurship, but the reality is far less glamorous. For over a decade, the industry has underperformed its promise, delivering returns that frequently fail to exceed public market benchmarks. Even worse, the underlying dynamics of VC have evolved to prioritize fund managers’ income over the success of their investments or the companies they back.

The Kauffman Foundation, in their 2012 report We Have Met the Enemy…And He is Us, identified deep-seated issues in the venture capital ecosystem, highlighting the misalignment of incentives between Limited Partners (LPs) and General Partners (GPs). Today, those same dynamics are exacerbated by ballooning fund sizes and a shift in priorities from long-term value creation to short-term fee generation. As Jamin Ball outlines in his recent article Misaligned Incentives (Clouded Judgement), VC has shifted from a “20% game” (prioritizing performance-based carried interest) to a “2% game” (prioritizing guaranteed management fees).

This article explores:

1. The historical context of misaligned incentives from the Kauffman Report.

2. How the VC ecosystem has shifted further out of alignment over the past decade.

3. The risks this poses for founders, LPs, and the broader innovation economy.

4. Practical steps for realigning incentives in venture capital, particularly for LPs.

---

The 2012 Kauffman Report: A Stark Warning Ignored

The Kauffman Foundation, after analyzing two decades of investing in nearly 100 VC funds, presented a damning critique of the venture capital model. Among their findings:

• Underwhelming performance: Only 20% of VC funds outperformed public markets by more than 3% annually, and most of these were smaller funds launched before 1995.

• Large funds underperform: Of 30 such funds with over $400 million in committed capital, only four delivered better returns than publicly traded small-cap stock indices.

• Erosion by fees: The majority of funds failed to return investor capital after fees and carry.

• Extended timelines: Many funds stretched far beyond their intended 10-year lifespan, locking LPs into underperforming vehicles.

The report also highlighted troubling LP behaviors, including reliance on vintage-year narratives, misjudging internal rates of return (IRRs), and over-allocating to large funds. These dynamics created a vicious cycle where fund size, rather than performance, became the dominant driver of GP economics.

Kauffman called for radical reforms, including:

• Limiting investments to funds under $400 million.

• Requiring GPs to commit significant capital to their own funds.

• Increasing transparency around GP compensation and fund economics.

• Directly investing in startups to bypass fund fees and inefficiencies.

Despite these recommendations, the industry has moved in the opposite direction. Fund sizes have ballooned, and the misaligned incentives Kauffman warned about have only deepened.

---

What LPs Should Target

LPs must adopt a more strategic and disciplined approach to fund selection to address the systemic issues outlined in the Kauffman Report and exacerbated in today’s venture capital environment. The following guidelines can help LPs realign incentives and optimize their portfolios for meaningful returns:

Smaller Fund Sizes

Invest in funds under $400 million, where performance incentives are better aligned with long-term outcomes. Smaller funds:

• Have greater discipline in deal selection due to limited capital.

• Focus on early-stage startups with higher growth potential, rather than later-stage, safer bets that often yield lower returns.

• Allow GPs to dedicate more time and resources to their portfolio companies.

Higher GP Commitments

Require GPs to invest significant capital into the fund themselves. This ensures GPs have significant personal financial exposure and align their incentives with those of LPs. Funds where GPs have meaningful skin in the game demonstrate:

• Greater accountability.

• More selective investment decisions.

• A higher likelihood of long-term commitment to portfolio success.

Co-Investment Opportunities

Prioritize funds that offer co-investment rights. Co-investing allows LPs to:

• Avoid the 2% management fee and 20% carry on individual deals.

• Increase exposure to high-conviction investments without the broader risks of the entire fund.

• Gain direct insights into deal quality and fund manager strategy.

Transparency and Governance

Demand visibility into fund economics and governance. LPs should request:

• Detailed breakdowns of GP compensation structures, including management fees, carry distribution, and operating expenses.

• Insights into deployment strategies, including expected check sizes, deal stages, and timelines.

• Regular reporting on fund performance benchmarks compared to public market equivalents (PME).

Focus on Emerging Managers

Consider allocating capital to emerging fund managers with solid track records and niche strategies. Emerging managers:

• Are often hungrier to prove themselves, leading to higher performance incentives.

• Typically operate smaller funds, aligning with the discipline and focus LPs should seek.

• Bring fresh perspectives and access to untapped networks, particularly in underserved markets or verticals.

---

For Founders: Beware the 2% Game

While much of the focus is on LPs, founders must also navigate the evolving dynamics of venture capital. As Jamin Ball highlights, large funds often prioritize deployment speed over conviction, creating risks for startups. Founders should:

Ask Hard Questions: Understand whether an investor is playing the 2% game (deploying for fees) or the 20% game (investing for long-term success).

Avoid Overcapitalization: Raising excessive funds at inflated valuations may seem appealing but often leads to unrealistic growth expectations and difficulties raising future rounds.

Assess Investor Commitment: GPs managing large portfolios often have limited bandwidth, leaving struggling companies unsupported.

---

Conclusion: A Call for Alignment

The math behind large VC funds doesn’t add up. The shift from a 20% to a 2% game has created an ecosystem where GPs win regardless of performance, leaving LPs and founders to bear the risks.

LPs can reshape venture capital into a more disciplined and equitable asset class by prioritizing smaller funds, increasing transparency, and demanding better alignment.

For founders, the takeaway is clear: partner with firms that optimize for outcomes, not deployment. For LPs, the message is equally direct: invest in smaller, focused funds, demand higher alignment from GPs, and explore alternative models to maximize returns.

It’s time for the venture capital ecosystem to heed the Kauffman Report's warnings and realign its incentives for the future of innovation.

---

---

Learn More

Visit us at pegasusangelaccelerator.com

Venture Fellow Program
Designed for aspiring venture capitalists and startup leaders, our Venture Fellow Program offers deep insights into venture operations, fund management, and growth strategies, all guided by seasoned industry experts.

Emerging Angel Program
Break the mold and dive into angel investing with a fresh perspective. Our Emerging Angel Program provides a comprehensive curriculum on innovative investment strategies, unique deal sourcing, and hands-on, real-world experiences, all guided by industry experts.

Book A Meeting
Connect with Lucas Pols, Founding Partner at Pegasus Angel Accelerator.