Economics of a VC Fund

The following tip of the week is from podcast Ep42: Raising a VC Fund (Jonathan Struhl):

On today’s show we covered a lot of ground on both the mechanics & philosophy behind a venture fund. Of course, we recapped the nature of both management fees and carry. I wanted to take todays tip and recap how each work and also provide an example of how the economics would play out. Let’s start with…

Management Fees: John discussed how the typical management fee is a 2% annual fee on committed capital to pay all expenses, overheard, etc. So, if a fund has $10M in committed capital at a 10-yr life, then the total amount carved out of the fund would be $2M at the outset of the fund. That’s 2% * $10M * 10 yrs = $2M. So, in this example $8M would be deployed/invested in startups. However, as John mentioned, the managment fee often steps-down after the investment period. So, if investments are made for the first five years of the fund, then a 2% management fee will apply for the first five years, and in his case, it reduces to 1.5% for the remaining five years. So, in this example, the total capital carved-out for the $10M fund would be $1.75M over the duration of the fund and $8.25M would be deployed on investments.

Let’s move on to…

Carried Interest: The standard here is 20% and this value only applies to the profits for a fund. So, if the fund is successful, then 80% of the profits will be returned to LPs and 20% is returned to the fund managers. And, in some cases, there is a hurdle rate before this applies. Let’s say the hurdle is a 5% internal rate of return on investment, which would mean that the fund managers only receive a carry if the fund returns more than 5%. Last thing on carry, which we’ve mentioned in episode 2 with Chris Yeh, is that if a carry is paid, then the managment fees are returned to the LPs. So the fund managers, at the end of the period, do not get paid both management fees and carry. It’s one or the other.

So, from the example of the $10M fund, w/ $1.75M in mgmt fees and $8.25M deployed in investments, let’s assume, round numbers here, that the fund returns $60M, which is a 6x the fund-size. The profit here is $60M – $10M invested = $50M profit. At 20% carry, the carried interest is $10M. But this amount is reduced by all the management fees before being paid back to the managers. They don’t receive both mgmt fees & carry. So, if they had been paid $1.75M in mgmt fees, then the amount distributed to them is $10M – $1.75M = $8.25M. So the LPs would receive the balance of $51.75M and the fund managers $8.25M.

Investment Split: If the fund is making initial and follow-on investments out of the same fund, which is most common, then they will often withold 40-60% of the capital for follow-ons. While a minority of the portfolio companies will never receive a follow-on, the amount required in order to maintain a pro rata, for example, is likely going to be a much higher dollar figure due to the increase in valuation. So, in this example w/ a fund where $8.25M is deployed on startups, around $4M will be earmarked for initial investments and around $4M will be reserved for follow-ons.

That’ll wrap up the episode for this week. Thanks again to Jonathan for such a thorough overview of his experience as an emerging fund manager. And best wishes to Indicator Ventures Fund One.