Basic, lesson 1 of 6
How a venture fund works
A venture firm raises a fund from outside investors, backs young companies with it, and earns a fee plus a share of the profits. Nearly all of those profits come from a few companies.
9 min, 3 checks
1LPs, GPs, fees, and carry
Limited partners (LPs) supply the money: endowments, foundations, pension funds, family offices, funds of funds. The general partner (GP) is the venture firm. It picks the companies, sits on boards, and decides when to sell. Funds usually run about ten years, investing in new companies for the first three to five.
The GP is paid two ways. A management fee, often around 2% of the fund a year, covers salaries and the office. Carried interest, often 20% of the fund's profits, is the real prize and only comes once LPs have their money back.
Worked example
A $100M fund that returns $300M
- 1Fees: 2% x $100M x 10 years = $20M over the fund's life (many funds step fees down later; this keeps it simple).
- 2Profit: $300M returned - $100M contributed = $200M.
- 3Carry: 20% x $200M = $40M to the GP.
- 4LPs receive $300M - $40M = $260M on $100M.
3.0x gross, 2.6x net to LPs. LPs judge funds on the net number.
Check 1
A $100M fund returns $250M in total. With 20% carry on profits, how much carry does the GP earn, in millions?
2The power law
Venture returns are not spread evenly. In a typical fund most companies return less than they cost or fail outright, and one or two winners return more than the rest combined. So each investment is judged by one question: if this works, can it return the whole fund?
Worked example
What exit does one company need to return a $100M fund?
- 1Suppose the fund owns 10% of the company when it sells.
- 2The fund's share must be $100M, so the company must sell for 100 / 0.10 = $1B.
A $1B exit just to return the fund once. That is why VCs pass on good businesses that cannot get that big.
Check 2
A $200M fund owns 8% of a company at exit. What exit value returns the whole fund, in billions?
Check 3
What does the power law imply about how a VC picks deals?
Terms in this lesson: Limited partner, General partner, Carried interest, Management fee, Power law, Venture capital.
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