10 ms·

VCs raise large funds from institutional investors (pensions funds, university endowments, etc.) called Limited Partners (LP). Typically, the VC (also known as

by SeoxyS 11y ago

VCs raise large funds from institutional investors (pensions funds, university endowments, etc.) called Limited Partners (LP). Typically, the VC (also known as General Partner, GP) contributes 1-5% of the fund out of their own pocket, with the rest coming from the LPs. VCs are paid in two ways: 1) Management fees. 2%/year of funds under management is common. (Over the ~10yr life of a fund, that's ~20% of the capital.) 2) Carried interest. This is a share of the profits on the fund before the money is returned to investors. The typical number here is 20%. So, let's imagine a fictional $1B fund. Here's how the numbers might work out. Y-0: Fund is raised. VC contributes $10M for 1% of the fund. Y-0: 2% management fees are used to cover expenses / pay VCs. Y-1~2: Fund invests in stuff, takes additional 2% management fees every year. Y-2~9: Fund is depleted for new investments. Continues to take 2% management fees every year. Y-10: Fund's last investments exit. Overall, the fund returns a 50% profit ($1.5B, with $500M in profit). VCs take $15M for their original contribution, and an additional $100M in carried interest. So far, they've also taken $200M in management fees (2% a year for 10 years). Total profit: $305M.

ryandrake 11y ago
So, overall a 2950% return over ten years. I know its a contrived example, but not too shabby if you're lucky enough to be in the club. Wish this scaled down. I'd gladly invest $1,000 today for $30,500 in ten years.
- sandstrom 11y ago
  This doesn't hold for all of them. As a group VCs, underperform many other asset classes. I think the well known firms tend to earn LPs good money, but aggregated it's bleaker. So although money-losing VCs still earn management fees (until they close down), earnings are lower than the example. https://hbr.org/2014/08/venture-capitalists-get-paid-well-to-lose-money https://hbr.org/2014/08/venture-capitalists-get-paid-well-to...
- tomp 11y ago
  The fees (management and performance) shouldn't be considered as "return on investment", but rather as "paycheck for work performed". The founded might as well invest $0 (e.g. if s/he has rich friends or a reputation that makes it easy for him/her to find seed capital), but still reap a lot of profits.
  - e12e 11y ago
    Agreed. On the other hand, is it really 100 times more work to manage an investment of 10 M than one of 100k? 1000 times more work to manage 1 bn than 1 m?
    - tomp 11y ago
      No, but pay isn't based on how hard the work is. It's based on the value provided, and/or on the influence the individual has; and somebody able to attract 1bn is much more influential than someone with just 1m under management.
      - carrotleads 11y ago
        why are VC's taking 200-300k+ as salaries when founders are expected to subsist on just above avg wage or around 100k?
        e12e 11y ago
        Because they can?
        carrotleads 11y ago
        I understand that but I can see fellow founders condemn other founders for taking an above avg salary or as was the case with the founders who took $6m [0] off the table during funding... Surely the Lp's should look at such high salaries as exorbitant.. [0] - Secret App that has since closed shop
        rargulati 11y ago
        Part of raising money from (most) LPs requires a bit of showmanship akin to that of Lawyers and Investment Bankers. This goes beyond the taking a "client" out to dinner. It's the expectation of living a specific lifestyle and the perceptions the wealthy have of those asking for money. Also, consider the amount raised (typically XX million+). That usually allows you to pay $200-300k salaries (though whether that's right / justified is a different conversation). As wealth changes hands over time, this expectation may change.
- nostrademons 11y ago
  It does scale down - remember, it's not just the initial capital, but also 10 years of work. There are many similar situations where you can get similar returns. My parents spent ~$1000 on programming/CS textbooks for me when I was a teenager, and it made me a whole lot more than $30,500 in additional wages. Pick the right technology platform today and you can spend a couple hundred bucks and end up with a few billion.
blueside 11y ago
spot on, known colloquially as the "two and twenty"
charlesdm 11y ago
One thing to consider is that this is the story when you join an existing VC firm as a partner. In a way, a lot of these funds are entrepreneurial ventures as well. It's not too hard, for 1-2 people who knows plenty of wealthy individuals, to raise a $25-50M fund. You'd be amazed at how much money is available in the world (pension funds, wealthy families, endowments, etc etc) So, the math tends to be a 2-20 (management fee / carry). Let's say this fund returns $100m over a period of 5 years: Fund size: $50M. Y1-5: Management fee (used for salaries + general expenses), 2%: $1M per annum (- expenses, e.g. secretary, travel, etc). To be divided between two partners. For a small fund, this is probably $200-300k per annum, per partner. Not bad, but not amazing either, given you just spent 1-2 years raising all that money. When the fund is liquidated, the fund managers receive 20% of the capital gain. They first return the $50m initial capital, and then get 20% of the $50m they made, i.e. $10M (split between both partners). Partners usually also invest some of their own money. It's rare to see funds where the principals don't have capital invested (this aligns incentives) Edit: same math applies to private equity funds, where deals tend to be less risky than in VC. (for the fund, not the acquired company)
- SeoxyS 11y ago
  > Partners usually also invest some of their own money. It's rare to see funds where the principals don't have capital invested (it tends to align incentives) Yes, though in my opinion, this is one of the dirty secret of the VC world. The GP contribution, after taking into account their fees, is essentially negative. Let's take a more generous example where the GP contributes 5% of the fund. After 10 years of 2% fees, the GP has put in 5% and taken out 20%, so their net contribution is essentially -15%.
  - chimeracoder 11y ago
    > Let's take a more generous example where the GP contributes 5% of the fund. After 10 years of 2% fees, the GP has put in 5% and taken out 20%, so their net contribution is essentially 15%. Unless I'm misunderstanding what you're saying, I think you're confusing the carry and the management fee. you can't add/subtract those percentages, because they're not representation the same base quantity (ie, they're percentages of different things). EDIT: Nevermind, I read "the GP has put in 5% and taken out 20%" as referring to a hypothetical carry of 20%.
refurb 11y ago
Fund invests in stuff, takes additional 2% management fees every year. My understanding is that the 2% management fee only applies to funds invested. If they raise $1B, but it takes 5 years to make all the investments, they only get the full 2% in years 5+.
- foobarqux 11y ago
  It's usually committed capital. http://www.quora.com/Are-management-fees-based-on-committed-capital-or-called-capital http://www.quora.com/Are-management-fees-based-on-committed-...
- charlesdm 11y ago
  Not sure, but I don't think this is correct. I believe this to apply on the entire fund. If you put together a $50m fund, and haven't invested anything (you're working on sourcing deals) then you still need cash to turn on the lights. That's essentially what the management fee is for. You shouldn't be making money on your management fee. This gets 'abused' quite a bit when it comes to larger multi billion $/€ funds, but for smaller funds, this should definitely be the case. Also the reason why for larger funds management fees sometimes get pushed down to 1.5-1% Another thing that sometimes happens as well is that the fund partners get paid their carry when they liquidate an investment in year 3-5, before the entire fund is liquidated.
briholt 11y ago
Great explanation. Notice how the VC fees eat heavily into the LPs profits. $500M in profit netted only $200M after fees - leaving only a 20% return after ten years. The S&P500 would've easily beaten that rate. A VC firm needs to have a skyhigh IRR before their LPs get their money's worth.
- Alleluja 11y ago
  Simple fact is that VCs at large had worse returns than S&P 500 in the past 10 years: http://pando.com/2013/07/30/ouch-ten-year-venture-returns-still-lag-the-broader-markets/ http://pando.com/2013/07/30/ouch-ten-year-venture-returns-st...
- surfearth 11y ago
  This phenomenon is called the j-curve. Its not that the IRR needs to be sky-high, rather that the fair value of the fund's aggregate investments need to appreciate above the cumulative amount of fees drawn before the IRR can be positive. http://en.wikipedia.org/wiki/J_curve#Private_equity http://en.wikipedia.org/wiki/J_curve#Private_equity
ricardobeat 11y ago
50% over 10 years is less than the stock market average. Take away the fund management fees + interest, and investors get a measly 2% per year. Why would anyone put money in such a fund? Is this a realistic scenario or did you just use these numbers to round out the example?
- lisper 11y ago
  > Why would anyone put money in such a fund? For the same reason people play any lottery: they don't look at the expected value, they look at the outliers and think, "That could be me, but only if I buy a ticket."
  - GBond 11y ago
    s/"play any lottery"/"founding a startup"/g
- Dzidas 11y ago
  Diversification. VC most likely will be more risky or volatile and return of it won't be similar to S&P500. Main idea is to mix different asset classes - S&P500, VC, hedge funds, bonds and etc, to get smooth results during good and bad times.
- hebdo 11y ago
  The 50% return is just an input to the model, an assumption.
ptrklly 11y ago
I'd add a few points: 1) management fees typically decline after the first few years of the Fund, rather than staying at 2% for the entire 10 years. This is to reflect the fact that partners are expected to do more work during the sourcing and diligence portion of a Fund's life (typically defined as an "investment period" after which they're not allowed to make new investments), and that helping portfolio companies and helping achieve exits takes less time / staff / expense. The GP also typically raises subsequent funds once the investment period is over, the management fees of which helps to fund their overall budget. 2) On the carried interest often the VC fund can only earn that after they've returned a certain amount to Limited Partners (called a "preferred return", and typically ~8%; if they don't return an 8% IRR to LPs, they only get the management fee and whatever they earn on their own out-of-pocket contribution. In general I'd just add that this is a highly negotiated point for each Fund and differs from firm to firm and fund to fund. Source: I work as an advisor to investors who participate as LPs in VC funds.
- covercash 11y ago
  What's the advisor pay structure like?
- nostrademons 11y ago
  What's the relationship between VC funds, VC partners, and VC firms? Are funds typically associated with a specific GP, or are they associated with the firm as a whole? Does the firm offer only a single fund at a time, or does a brand-name VC (say, Sequoia, or Accel, or KP) have multiple offerings with different portfolio strategies? Also, is there a good way to find out who is about to start raising money for new funds, and where in the lifetime of their fund a particular partner might be? (As in, have they just raised money and are looking for the first couple investments, or is the investment period about to close and the fund's capital has all been invested?)
  - surfearth 11y ago
    Established venture firms may have multiple vehicles (e.g. a seed fund, main fund, or growth fund), but the majority of venture firms tend to invest out of one vehicle at a time (there may be a short period of overlap when new funds are raised). If you are not an active investor, getting quality access to information about funds can be difficult. I'd recommend the firm's website and crunchbase as free datasources. There are other, higher quality sources, but you need to pay for access (e.g. dow jones venture source).
robk 11y ago
There aren't that many billion dollar VCs out there. By volume most funds are far smaller, so management fees are less and carry is really dependent on gross multiples you deliver to LPs.

by SeoxyS 11y ago

ryandrake 11y ago

So, overall a 2950% return over ten years. I know its a contrived example, but not too shabby if you're lucky enough to be in the club. Wish this scaled down. I'd gladly invest $1,000 today for $30,500 in ten years.

sandstrom 11y ago
This doesn't hold for all of them. As a group VCs, underperform many other asset classes. I think the well known firms tend to earn LPs good money, but aggregated it's bleaker. So although money-losing VCs still earn management fees (until they close down), earnings are lower than the example. https://hbr.org/2014/08/venture-capitalists-get-paid-well-to-lose-money https://hbr.org/2014/08/venture-capitalists-get-paid-well-to...
tomp 11y ago
The fees (management and performance) shouldn't be considered as "return on investment", but rather as "paycheck for work performed". The founded might as well invest $0 (e.g. if s/he has rich friends or a reputation that makes it easy for him/her to find seed capital), but still reap a lot of profits.
- e12e 11y ago
  Agreed. On the other hand, is it really 100 times more work to manage an investment of 10 M than one of 100k? 1000 times more work to manage 1 bn than 1 m?
  - tomp 11y ago
    No, but pay isn't based on how hard the work is. It's based on the value provided, and/or on the influence the individual has; and somebody able to attract 1bn is much more influential than someone with just 1m under management.
    - carrotleads 11y ago
      why are VC's taking 200-300k+ as salaries when founders are expected to subsist on just above avg wage or around 100k?
      - e12e 11y ago
        Because they can?
        carrotleads 11y ago
        I understand that but I can see fellow founders condemn other founders for taking an above avg salary or as was the case with the founders who took $6m [0] off the table during funding... Surely the Lp's should look at such high salaries as exorbitant.. [0] - Secret App that has since closed shop
      - rargulati 11y ago
        Part of raising money from (most) LPs requires a bit of showmanship akin to that of Lawyers and Investment Bankers. This goes beyond the taking a "client" out to dinner. It's the expectation of living a specific lifestyle and the perceptions the wealthy have of those asking for money. Also, consider the amount raised (typically XX million+). That usually allows you to pay $200-300k salaries (though whether that's right / justified is a different conversation). As wealth changes hands over time, this expectation may change.
nostrademons 11y ago
It does scale down - remember, it's not just the initial capital, but also 10 years of work. There are many similar situations where you can get similar returns. My parents spent ~$1000 on programming/CS textbooks for me when I was a teenager, and it made me a whole lot more than $30,500 in additional wages. Pick the right technology platform today and you can spend a couple hundred bucks and end up with a few billion.

blueside 11y ago

spot on, known colloquially as the "two and twenty"

charlesdm 11y ago

One thing to consider is that this is the story when you join an existing VC firm as a partner. In a way, a lot of these funds are entrepreneurial ventures as well. It's not too hard, for 1-2 people who knows plenty of wealthy individuals, to raise a $25-50M fund. You'd be amazed at how much money is available in the world (pension funds, wealthy families, endowments, etc etc) So, the math tends to be a 2-20 (management fee / carry). Let's say this fund returns $100m over a period of 5 years: Fund size: $50M. Y1-5: Management fee (used for salaries + general expenses), 2%: $1M per annum (- expenses, e.g. secretary, travel, etc). To be divided between two partners. For a small fund, this is probably $200-300k per annum, per partner. Not bad, but not amazing either, given you just spent 1-2 years raising all that money. When the fund is liquidated, the fund managers receive 20% of the capital gain. They first return the $50m initial capital, and then get 20% of the $50m they made, i.e. $10M (split between both partners). Partners usually also invest some of their own money. It's rare to see funds where the principals don't have capital invested (this aligns incentives) Edit: same math applies to private equity funds, where deals tend to be less risky than in VC. (for the fund, not the acquired company)

SeoxyS 11y ago
> Partners usually also invest some of their own money. It's rare to see funds where the principals don't have capital invested (it tends to align incentives) Yes, though in my opinion, this is one of the dirty secret of the VC world. The GP contribution, after taking into account their fees, is essentially negative. Let's take a more generous example where the GP contributes 5% of the fund. After 10 years of 2% fees, the GP has put in 5% and taken out 20%, so their net contribution is essentially -15%.
- chimeracoder 11y ago
  > Let's take a more generous example where the GP contributes 5% of the fund. After 10 years of 2% fees, the GP has put in 5% and taken out 20%, so their net contribution is essentially 15%. Unless I'm misunderstanding what you're saying, I think you're confusing the carry and the management fee. you can't add/subtract those percentages, because they're not representation the same base quantity (ie, they're percentages of different things). EDIT: Nevermind, I read "the GP has put in 5% and taken out 20%" as referring to a hypothetical carry of 20%.

refurb 11y ago

Fund invests in stuff, takes additional 2% management fees every year. My understanding is that the 2% management fee only applies to funds invested. If they raise $1B, but it takes 5 years to make all the investments, they only get the full 2% in years 5+.

foobarqux 11y ago
It's usually committed capital. http://www.quora.com/Are-management-fees-based-on-committed-capital-or-called-capital http://www.quora.com/Are-management-fees-based-on-committed-...
charlesdm 11y ago
Not sure, but I don't think this is correct. I believe this to apply on the entire fund. If you put together a $50m fund, and haven't invested anything (you're working on sourcing deals) then you still need cash to turn on the lights. That's essentially what the management fee is for. You shouldn't be making money on your management fee. This gets 'abused' quite a bit when it comes to larger multi billion $/€ funds, but for smaller funds, this should definitely be the case. Also the reason why for larger funds management fees sometimes get pushed down to 1.5-1% Another thing that sometimes happens as well is that the fund partners get paid their carry when they liquidate an investment in year 3-5, before the entire fund is liquidated.

briholt 11y ago

Great explanation. Notice how the VC fees eat heavily into the LPs profits. $500M in profit netted only $200M after fees - leaving only a 20% return after ten years. The S&P500 would've easily beaten that rate. A VC firm needs to have a skyhigh IRR before their LPs get their money's worth.

Alleluja 11y ago
Simple fact is that VCs at large had worse returns than S&P 500 in the past 10 years: http://pando.com/2013/07/30/ouch-ten-year-venture-returns-still-lag-the-broader-markets/ http://pando.com/2013/07/30/ouch-ten-year-venture-returns-st...
surfearth 11y ago
This phenomenon is called the j-curve. Its not that the IRR needs to be sky-high, rather that the fair value of the fund's aggregate investments need to appreciate above the cumulative amount of fees drawn before the IRR can be positive. http://en.wikipedia.org/wiki/J_curve#Private_equity http://en.wikipedia.org/wiki/J_curve#Private_equity

ricardobeat 11y ago

50% over 10 years is less than the stock market average. Take away the fund management fees + interest, and investors get a measly 2% per year. Why would anyone put money in such a fund? Is this a realistic scenario or did you just use these numbers to round out the example?

lisper 11y ago
> Why would anyone put money in such a fund? For the same reason people play any lottery: they don't look at the expected value, they look at the outliers and think, "That could be me, but only if I buy a ticket."
- GBond 11y ago
  s/"play any lottery"/"founding a startup"/g
Dzidas 11y ago
Diversification. VC most likely will be more risky or volatile and return of it won't be similar to S&P500. Main idea is to mix different asset classes - S&P500, VC, hedge funds, bonds and etc, to get smooth results during good and bad times.
hebdo 11y ago
The 50% return is just an input to the model, an assumption.

ptrklly 11y ago

I'd add a few points: 1) management fees typically decline after the first few years of the Fund, rather than staying at 2% for the entire 10 years. This is to reflect the fact that partners are expected to do more work during the sourcing and diligence portion of a Fund's life (typically defined as an "investment period" after which they're not allowed to make new investments), and that helping portfolio companies and helping achieve exits takes less time / staff / expense. The GP also typically raises subsequent funds once the investment period is over, the management fees of which helps to fund their overall budget. 2) On the carried interest often the VC fund can only earn that after they've returned a certain amount to Limited Partners (called a "preferred return", and typically ~8%; if they don't return an 8% IRR to LPs, they only get the management fee and whatever they earn on their own out-of-pocket contribution. In general I'd just add that this is a highly negotiated point for each Fund and differs from firm to firm and fund to fund. Source: I work as an advisor to investors who participate as LPs in VC funds.

covercash 11y ago
What's the advisor pay structure like?
nostrademons 11y ago
What's the relationship between VC funds, VC partners, and VC firms? Are funds typically associated with a specific GP, or are they associated with the firm as a whole? Does the firm offer only a single fund at a time, or does a brand-name VC (say, Sequoia, or Accel, or KP) have multiple offerings with different portfolio strategies? Also, is there a good way to find out who is about to start raising money for new funds, and where in the lifetime of their fund a particular partner might be? (As in, have they just raised money and are looking for the first couple investments, or is the investment period about to close and the fund's capital has all been invested?)
- surfearth 11y ago
  Established venture firms may have multiple vehicles (e.g. a seed fund, main fund, or growth fund), but the majority of venture firms tend to invest out of one vehicle at a time (there may be a short period of overlap when new funds are raised). If you are not an active investor, getting quality access to information about funds can be difficult. I'd recommend the firm's website and crunchbase as free datasources. There are other, higher quality sources, but you need to pay for access (e.g. dow jones venture source).

robk 11y ago

There aren't that many billion dollar VCs out there. By volume most funds are far smaller, so management fees are less and carry is really dependent on gross multiples you deliver to LPs.