Under The Hood: How VC Funds Operate (And How That Is Changing)


That is an article meant primarily for entrepreneurs and LPs (restricted companions i.e., these investing in a VC fund), albeit we predict it’s helpful for VCs too. Managing Companions are usually those managing the fund’s construction, so different members of the agency are not often uncovered to those phrases. So with out additional ado, listed here are the highest 10 objects below a enterprise capitalist’s hood.

1) Administration Price

Traditionally VCs have operated on a 2% administration payment i.e., 2% of the funds are used to run the fund yearly. That is on commitments i.e., a $200M fund received’t have all of it within the financial institution however use 2% of that quantity to run the fund. The cash is used to pay salaries, administrative, authorized prices, every little thing. Lately we now have seen an growing pattern to cost 2.5% charges. It’s both from very established funds that may cost extra, or funds that justify the lifecycle of the startups they spend money on has modified.

2) Carry

Carry is the proportion of earnings that GPs (basic companions i.e., the precise VCs within the agency) get. By and huge the norm has been LPs get 80%. Lately we now have seen a pattern in the direction of graduated carry, that’s, if a fund performs say 3x then the carry is 25%, if it’s 5x then it’s 30%. Once more, that is taking place extra solely in very established funds that may cost extra, or funds that may justify a particular purpose to take action.

3) European vs American Waterfall

Associated to the idea of carry is waterfall. European is when a GP returns your complete fund earlier than recognizing carry. American is when a GP returns all of the monies which were referred to as up thus far earlier than recognizing carry. If a fund performs nicely there is no such thing as a actual distinction, simply that within the American model GPs begin seeing carry earlier. The problem is when a fund does very nicely, returns carry however then takes a downturn, so there are extra returns on the finish. There are a selection of the way to address that which we won’t cover in this article for sake of simplicity.

4) Fund Life

The norm in the US is a 10–year fund. This means that at the end of 10 years the GP will have to liquidate any holding that remains. Of course this may never apply either if the firm has already exited all its positions – all startups sold or IPOed or the firm sold its shares to another firm. Many funds will have the option to extend the lifecycle say by a year or two, with LP consent. This is presumably for the specific situation where a large exit is imminent and doesn’t make sense to liquidate that holding in year 10. We have started seeing more funds do 12-year life, justifying that they are investing in longer-horizon startups.

5) Hurdle Rate

Hurdle is the guarantee that a fund will perform at a certain level, with associated financial penalties and/or rewards for meeting that. Hurdle is really something that PE and hedge funds talk about. In other countries hurdle in VC does come up, but in the US it’s not part of the norm.

6) Interest Rate

Interest rate in a VC fund you say? Yes, it’s basically when raising funds such that LPs that come in early get some benefit over LPs that sign up later. This is a concept found mostly in large funds that are fundraising for over a year. Yes VCs fundraising for a fund have typically a time limit, 12-18 months being the median.

7) Capital Calls

A $200M fund rarely has access to all that money upfront, it’s a matter of time. Some funds call it over 5 years, others longer. Recently we have noticed an increasing trend where funds call the bulk of the capital in 3 years, even 1 year. This is a matter of strategy and obviously puts more pressure on LPs.

8) Separate Entities

GPs and LPs are typically under separate entities. That way there is a separation to protect all sides. For instance, lawsuits on an individual startup, individual GP, or individual LP won’t necessarily affect the other groups involved in a VC fund.

9) Multiple Funds

At any given time a firm might be running multiple funds. Deciding which one investor where and the preference among the multiple funds is typically a business matter. Most funds will decelerate investing from a fund after year 3, stop altogether after year 5, keeping any reserves just for follow-ons.

10) Special Purpose Vehicles (SPV)

SPVs allow funds to do deals that are perhaps outside the core thesis, either in terms of stage, geography, or investment size. A classic case would be fund doing a SPV to write a bigger check into a company. Oftentimes there is a one-time management fee of 1-5% to cover all the setup and maintenance costs of the SPV. And there is also a carry typically between 10-30% on the SPV. Most funds will give discounts on both of these to LPs over non LPs.

Originally published on “Data Driven Investor,” am happy to syndicate on other platforms. I am the Managing Partner and Cofounder of Tau Ventures with 20 years in Silicon Valley across corporates, own startup, and VC funds. These are purposely short articles focused on practical insights (I call it gl;dr — good length; did read). Many of my writings are at https://www.linkedin.com/in/amgarg/detail/recent-activity/posts and I would be stoked if they get people interested enough in a topic to explore in further depth. If this article had useful insights for you comment away and/or give a like on the article and on the Tau Ventures’ LinkedIn page, with due thanks for supporting our work. All opinions expressed here are my own.

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