My recent post gave rise to a host of questions around the issue of recycling. What does it mean? How do you do it? And what are the implications for venture investors? I attempted to respond in a Tweetstorm, but recycling is a complicated issue that warrants a more thorough discussion.

When Limited Partners (LPs) invest in a venture fund, they agree to pay an annual Management Fee on committed capital, usually on a declining scale over a 10 year period. In total, these fees amount to around 20% of an investors’ commitment, which implies that LPs only get to put 80% of their investment dollars to work because of management fees. This makes most LPs pretty unhappy – and it should. LPs generally expect to have 100% of their investment working for them, and best practice is to invest up to around 120% of committed capital when possible. Enter the concept of recycling.

Recycling can happen when a fund exits an investment, and rather than distributing the proceeds to LPs, reinvests all or part of the funds in portfolio companies. This sounds pretty easy, but in practice is quite hard, especially for Seed stage venture funds. By definition, Seed stage funds invest very early in a company’s life, meaning that time to exit can be 7-10 years, or more. Further, as a seed fund with higher cash-on-cash return expectations than later stage funds, IA Ventures doesn’t have much time for a company to exit before its other successful investments become too high-priced to warrant later stage capital. This is because a successful seed company often grows into an attractive Series A and perhaps Series B investment from the seed investor perspective, meaning a potential return on a new investment of 5-10x capital invested at each stage. We reserve for this likelihood, and this represents one of the bedrocks of our life-cycle approach to investing. But beyond the Series B, it is often challenging to get comfortable with 5-10x upside from that point, especially for “hot” companies that may be priced in the hundreds of millions of dollars by the Series C round