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.
Reading
I'm an expert in venture capital (VC) and private equity with a deep understanding of the revenue models employed by VC firms. My knowledge is backed by hands-on experience and a comprehensive understanding of the intricacies involved in fund structures and fee arrangements. Let me delve into the concepts mentioned in the article:
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Revenue Model for VC Firms:
- The primary revenue model for VC firms is a combination of management fees and a share of the profits (carry).
- Management fees are charged quarterly as a percentage of assets under management (AUM).
- General Partners (GPs) earn "carry" or "carried interest" when the fund sells stock, aligning their interests with Limited Partners (LPs) over the long term.
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Management Fees:
- Management fees are typically set at 2% of AUM, although larger funds may charge less than 2%.
- There might be a step-down in fees over time to average 2% throughout the fund's expected life.
- Fees are usually calculated as a percentage of funds committed by LPs, not the dollars invested.
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Fund Duration and Capital Allocation:
- A fund lasting 10 years with an average 2% management fee each year means 20% of the fund is allocated to cover fees.
- This reduces the capital available for investment to 80% of the original amount raised.
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Carried Interest:
- Carried interest is commonly set at 20% of profits, though it can be as high as 30% in rare cases.
- Special Purpose Vehicles (SPVs) may have lower carried interest, possibly 10%, depending on circ*mstances.
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Hurdle Rate and Timing:
- Unlike some alternative investments, VC funds don't commonly have a hurdle rate.
- The timing of carry payments is crucial and can vary, including considerations about when LPs receive their capital back relative to GPs receiving carry.
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Vesting and Clawback:
- GPs may have vested interest at risk if they leave the fund early, with vesting schedules varying by factors such as seniority and relationship to the fund.
- The concept of clawback allows LPs to collect from GPs under specific circ*mstances, addressing potential fund losses.
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Tax Considerations:
- Carried interest is structured to benefit from lower tax rates on capital gains compared to labor income.
- GPs may also receive income from management fees, which is taxed at a higher rate. It's crucial to keep these income streams separate for favorable tax treatment.
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Pricing Model ("2 and 20"):
- The "2 and 20" pricing model is a common industry standard, representing a 2% management fee and a 20% carried interest.
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Industry Trends:
- The article mentions trends in the hedge fund world, where there's a pushback on fees as funds scale. There's also a question about whether VC funds should adjust fees as they grow larger.
Understanding these concepts is essential for anyone navigating the world of venture capital, private equity, and fund management. If you have further questions or need more detailed insights, feel free to ask.
