I thought it would be useful to demystify how VCs make money. Here is a short explanation.
First, VCs get capital commitments from limited partners (i.e., investors). Let’s say VC1 has a $100mm fund. That means that it has capital commitments from investors of $100mm. Capital is called when needed for investment, fund expenses or management fee. Importantly, VC1 does not collect all the money in advance and then invest in short term securities. And, VC1 does not reinvest capital returned (with very few limited exceptions) – VCs are not hedge funds! All capital returned from investment gets paid out.
Second, the General Partner of VC1 is the entity that runs the fund (let’s call it GP1). Importantly, GP1 will have also committed investment capital to VC1. So, in this respect, you can think of GP1 as a limited partner. It literally has an investment share in the fund just like any other limited partner. And it literally has to pay in $$ when VC1 makes a capital call. Now, there are interesting ways for the GP to fulfill its portion of a capital call using “fee waiver”, but I am not going to address that here. Perhaps I will in another post.
Third, VC1 pays GP1 a management fee (via a separate fund management entity – again, to make this post simple I am not going to elaborate on the fund management entity here). Typically, that might be 2% of committed capital per year paid quarterly. So, for VC1, that would be $2mm a year. That is a hefty sum (and over the life of a fund, can amount to a large amount of management fee; most funds have a life of 10 years and the management fee often ratchets down after 5 years). VC1 use that money to pay salaries of the investment professionals, other staff, office expenses, office leases, due diligence expenses, etc. For a large fund (and I consider $100mm to be large although it really is not – Cayuga Venture Fund is much smaller than $100mm), the management fee can result in sizable salaries.
Fourth, GP1 is entitled to a carried interest in fund profits. The amount is typically 20% of profits. In its simplest form, think of profits as amounts returned to the fund in excess of capital commitments. Therefore, the returns from the sale/IPO of the fund’s portfolio companies must clear capital commitments before GP1 gets any carried interest. So, if VC1 invests $3mm in Portfolio Company 1 (PC1) and PC1 is sold later and VC1 gets a return of $15mm on the investment, all that return goes back to the investors assuming that the fund is not yet cleared (note that some GPs actually take their carried interest on a deal by deal basis and this can result in the dreaded claw back – again, a topic for another post). If VC1 has a bunch of exits of its portfolio companies and total capital commitments are 100% returned, then GP1 gets its 20% of ongoing profits and the owners of GP1 (real warm bodies like me) split up those points.
So, in summary, how do VCs make money:
1. salary paid from management fees. Just like paying the portfolio company management team for doing its job.
2. return on investment from the GP investment share. This is one area that is often overlooked by people not familiar with venture capital. The GP is a real investor and gets a return of capital when there is an exit event and at the same time as other investors.
3. carried interest kicks in after the fund is cleared (again, there are some different payment schemes that apply, but GP1 is only entitled to keep 20% of profits; so, the safest bet is not to take any profit share until the fund is fully cleared).
Hope this demystifies VC compensation a bit. I have taken a few liberties to keep this as simple as possible. There is actually a great deal of complexity when operating a live fund.