Two weeks ago I started reading Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist. The book, which I’ll write about in a future post, has a section on the economics of a venture fund. Many entrepreneurs that haven’t been around the venture capital and venture-backed startups world don’t have a good understanding of how venture funds work.
Here are a few generalities of the economics of a partner in a VC fund:
- Funds are often setup in a 2/20 manner meaning 2% of the fund annually goes to the management fee and 20% of the profits (carry) go to the partners (after the principal and management fees are paid back)
- Most partners in VC funds in the last decade haven’t received a carry check since funds have had a negative return on average
- With a $100 million fund, and 2% management fee, the firm has $2 million per year to operate during the first seven years of the fund, and a lower amount in the later years as the fund (hopefully) wraps up
- With a $2 million/year management fee, four partners (usually one partner for every $25 – $50 million in fund size), the partners might each take home $300k salaries and have $800k left for associates, admins, office space, legal, travel, etc
- Funds that do well, put their money to work quickly, and raise another fund because of quality investments, can have their management fees and salaries stack up (imagine raising a $100 million fund, investing the majority in four years, raising a second $100 million fund, and now have $4 million/year management fees to work with, $600k in individual salaries, etc)
- Carry (profit) from a fund might work as follows: invest a $100 million fund ($20 million went to management fees over 10 years and hopefully $20 million in exits occurred early enough to also be invested before the fund ended), generate $300 million in proceeds from successful investments (3x cash on cash), return the first $100 million back to the investors, earn 20% of the remaining $200 million ($40 million) as profit, and split it amongst the partners ($10 million each). Another bonus is that carry is taxed as long-term capital gains and not regular income.
As you can see, the economics of being a successful venture capitalist are very desirable, hence the high demand for the limited number of positions. Most VCs come from a banking background and a decent percentage come from an entrepreneurial or operating experience background.
What else? What do you think of the economics of a partner in a VC fund?