Escalating Carried Interest for Venture Investors

In a typical venture fund, the venture capitalists (VCs) have a 2% annual management fee and earn 20% of the profits (called 2 and 20). That is, 2% of the value of the fund (e.g. $2 million per year for a $100 million fund) is used for salaries, office space, administration, and other expenses for a period of time (e.g. seven years) before shrinking and eventually disappearing. Then, assuming the fund is successful, the VCs receive 20% of the money generated after the investors get their principal back, including the money spent on management fees (e.g. turning a $100 million fund into $300 million in returns results in the VCs getting $40 million in profits, or carried interest).

Now, the ultra successful VCs know that there’s much more opportunity in earning a larger piece of the profits, and they often command 30% of the carried interest, while waiving management fees because they’re confident and have already been successful (e.g. this would be 0 and 30). Well, last month I heard of another wrinkle that I hadn’t encountered before: escalating carried interest for clearing higher return hurdles. Meaning, if the VC returns even more money, they’d get an even higher percentage of the profits. In the example I heard, the institutional investor received 70% of the profits after the fund returned five times the capital (e.g. a once a $100 million fund generates $500 million in returns, the VCs would get 70% of everything past that instead of 20 or 30%).

For venture investors with a strong track record, and amazing returns, the opportunity to make even more money comes from escalating percentages of carried interest based on results.

What else? What are some more thoughts on escalating carried interest for venture investors?

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