The almost universal revenue model for a VC firm is fees plus a share of the profits. Firms charge “management fees” as a percentage of assets on a quarterly basis. GPs share in profits (called “carry” or “carried interest”) when the fund sells stock.
Fees cover current expenses for the fund and employees. As an incentive and to create alignment with LPs, carry shares the long-term profits.
Additionally, a fund will often pay its own formation expenses (legal, accounting, etc.). These formation expenses are not considered part of the management fees.
Here are some other things to note.
Fees
- Amount. The market has anchored management fees at 2% with smaller funds having more at times. Larger funds will sometimes charge management fees less than 2%. SPVs can have lower or no management fees.
- Step Down. When a fund charges more than 2% management fee, there will often be a decrease in fees as time passes. Often fees will decrease over time to make the fees average 2% over the expected life of the fund. Also, there can be a step down when the investment period ends and/or when a GP raises a new fund.
- Percentage of What? VCs usually charge fees as a percentage of funds committed by LPs. You want to avoid the situation of the percentage of dollars invested. This other structure could be an incentive to invest too quickly which may hurt quality.
- Smaller Base of Capital. If a fund lasts for 10 years and pays an average of 2% management fees each year, that is 20% of the fund. The GP can only invest 80% of the original capital raised.
Carry
- Amount. Usually carried interest is set at 20% of profits. Can be up to 30% in rare cases. The lore is that the 20% came from the split the captain of whaling ships received. SPVs can be as low as 10% depending on the situation.
- Hurdle Rate. You may have a hurdle rate on other alternative investments but it is not common in VC.
- Timing. There are variations of when to pay carry. Should you pay from the first dollar of profit? Or should LPs receive their capital back before a GP gets the first dollar of carry? What if there is positive cashflow which appears to be profit early on in the life of a fund, but later the fund recognizes losses? Should the LP have a clawback right to collect from the GP? This topic area is known as the waterfall and requires precise legal language and well-honed spreadsheets.
- Vesting. GPs will often have some of the carried interest at risk if they leave the fund early. These vesting schedules can vary by seniority, relationship to the fund and tradition.
- Tax. The US taxes income from capital at a lower rate than income from labor. VCs structure carried interest as a profit on the GPs interest as an owner in the fund. As an owner, you pay the lower tax rate on income from capital. The same GP may also be an employee paid from the management fee income. GPs pay tax on this labor income at a higher rate. Funds are careful not to mix these two deals to ensure favorable tax treatment.
This “2 and 20” pricing model is common across hedge funds, private equity and many stages of VC. In the hedge fund world, there has been a movement to push back on fees as funds scale. And some question if venture funds should charge lower fees when they get larger.
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