Dividing the Pie: How Venture Fund Economics Work [Part I]

Note: This article is the fifteenth in an ongoing series on venture fund formation and management. To learn more about managing a fund, download this free eBook today Venture Capital: A Practical Guide or purchase a hard copy desk reference at Amazon.com.

Venture Fund Economics: Carry and FeesBefore we dive into the details on how the economics work on an early stage venture fund, let’s cut right to the chase. Running an early stage venture fund is not an easy way to get rich quick. In fact, it’s probably the most amount of work for the least amount of income in the world of private equity.

Early stage venture funds tend to be small in scale which means the compensation is necessarily small in scale. A typical early stage fund will have less than $100M in assets under management versus $1B+ for later stage private equity funds. Compensation to fund General Partners (GPs) grows with scale. And that’s one big reason why most successful VCs and private equity professionals attempt to raise larger and larger amounts of capital each time they raise new funds. It’s all about the big payday, and bragging rights at the country club!

Don’t get me wrong, with a couple lucky outcomes, you can make good money with a small venture fund, but you won’t be buying a private jet with your profits. Before you devote the next 10+ years of your life to raising a venture fund and then managing the fund to its end-of-life, it helps to understand how the economics of a fund work for the GPs. With this {article, chapter} we will discuss a range of topics, including management fees, carry, GP commitments, fund expenses and expected financial outcomes on funds that range from middle of the pack returns to top quartile returns.

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Ham, can you explain the two key components of compensation in a venture fund -- management fees and carry?

Let’s start with the management fee. This is an annual fee that covers the salaries and organizational expenses of a venture firm. A typical early stage fund will charge an annual management fee of around 2%. This fee is based on the total amount of capital committed to the fund and typically applies only to the portion of the money that has been put to work. In the case of a $50M fund, the management fee will be 2% of that total, which works out to a theoretical maximum of $1M annually assuming the entire fund was invested.

In most cases, this level of management fee will be in place for a limited time period.  For example it might just apply for the first 5 years of the fund. This is the time period in which new investments are made and most of the follow-on investments occur. After the first 5 years, the 2% fee is usually based on the remaining invested capital (i.e. the amount of capital the fund has invested in active companies in the portfolio.) Over the life of this $50M fund, the fund will pay out in the neighborhood of $7.5M in management fees. That represents 15% of the fund’s original committed capital.

What is the right percentage for a management fee? Should it be 2%? It depends on a number of factors. For very small funds, say $20M in size, a 2% fee results in a $400K annual management fee. That should be enough to meet your fund’s organizational expenses and pay very modest salaries to the GPs. But, in small funds, it’s not unusual for the management fee to be a bit higher at 2.5%, reflecting the extra work associated with investing in the smallest deals and youngest companies. The converse is true for large funds. At $1B in size, a large venture fund would pay out $20M in annual management fees. In that case, you might see management fees set closer to 1.5%, or if set at 2%, subject to more time or other restrictions.

The management fee on a small venture fund will help you keep the lights on and pay your bills, but you won’t get rich on those fees. The real returns for a VC come from the profits paid out on the overall returns from your investments. A percentage of a fund’s profits are paid to the GPs, and this payment is called carry or carried interest. This percentage tends to vary between 15% and 30% for most venture funds, with 20% being typical, and lower carry associated with higher fee funds and higher carry associated with low fee or no fee funds.

Before a fund pays out a dollar of carry to the GPs, it must first return all of the capital committed by the LPs. Let’s explain this concept using the following example.

  • We raise $50M for our venture fund, and set the carry at 20%

  • After 5 years, a portfolio company is acquired and the fund gets $40M returned

  • The entire $40M will go to the LPs and the fund returns 80% of their capital

  • Soon after, another company is acquired and we get $20M returned to the fund

  • Of that $20M, the fund returns $10M to the LPs

  • The fund has now returned all of the original $50M to the investors

  • The remaining $10M will be divided as follows:

    • 80% to the LPs and 20% to the GPs

  • That means $8M goes to the LPs and $2M goes to the GPs

  • Once the capital return “hurdle” has been reached, any capital returned to the fund through future exits will be distributed to the LPs and GPs using this same 80/20 split.

 

Here’s one final note on the level of management fees and carry. If you are a new VC, it can be difficult to raise a first time fund. It’s not unusual for an LP who becomes your anchor investor to ask for better terms than the rest of your LPs. In exchange for the reduced fees, this anchor LP will make introductions to other potential LPs and help you market the fund to raise your desired level of capital. That will save you a ton of time and is probably worth the reduction in your overall compensation from the fund. Similarly, it is not unusual for new GPs (or very aggressive established VCs) to offer to forego fees and take all their compensation in the form of (a higher rate of) carry so that in effect they are putting their money where their mouth is and not asking to be paid as money managers unless they actually generate a profit.

What level of capital commitment to a venture fund do LPs expect from the GPs?

Reading between the lines, what you are really asking is how much skin in the game should each GP have in the fund? If I am an LP, I want to know that all of the GPs are going to be working hard to make sure the fund is a success. If the GPs are making a lot of money from management fees, that doesn’t work for me. I want their motivation to be strongly aligned with my expectation for top quartile returns from a venture fund.

With that said, GP commitment is typically in the low single digits because, unlike the LPs who are often representing third parties and institutional money, this money is coming out of personal GP funds. Even at moderate fund sizes these low single digit percentages can add up quickly. In the past, the GP commitment for most funds was in the 1%+ range. So, for example, with a $100M fund, the GPs would be expected to contribute $1M. If you have four GPs on a fund of that size, the capital commitment works out to $250K for each GP. For a new venture firm with young GPs, that might represent a significant amount of their personal investable assets.

Let’s look at another example. Suppose the GPs are entrepreneurs who cashed out big time from a previous startup they founded. If their net worth is north of $50M each, and they are only committing $250K, they don’t have enough riding on the line. In a scenario like that, LPs might expect their capital commitment to be more like 10% of the fund, but in return, the GPs might request more carry to reflect their proprietary experience and connections.

In Part II of this article we'll explore the level of investment returns LPs expect from a venture fund and some ways to improve the rate of return.

Want to learn more about managing a fund? Download this free eBook today Venture Capital: A Practical Guide or purchase a hard copy desk reference at Amazon.com.