How do VCs make money?

October 27, 2023

Many of you are maybe curious to understand the payoff or motivation for anyone to be a VC investor. So here goes. But before that, here is an excerpt from The Generalist, that will make sense later in the blog.

Venture capital can appear easy or hard, depending on your vantage. From one perspective, it’s a forgiving lark: a successful investor may only need to make one great investment out of fifty, provided that one is sufficiently world-bending. Few other professions make a virtue of a mere 2% hit rate. The Major League slugger that slumped to such a low would find themselves booted into retirement, while the slab-chinned hedge funder would be shunted into an elevator heaving a Bankers box. No other career allows you to be a rainmaker while creating such infrequent downpours.

VC firms in India are set up as Alternative Investment Funds (AIF) – usually Cat 1 or Cat 2 AIFs. The AIF will then have a Fund Manager or Investment Manager responsible for investment decisions. The monetary incentives for VCs involve two separate concepts – Management fees and Carry.

Management fee is the annual fee charged to investors (or LPs) in the fund. This is typically around 2% of the total funds drawn into the AIF bank account. This is quite important to understand – let’s take an example. Imagine a VC firm that raises around $ 100 million. The VC firm will not need all the money at once and will want to draw the money down in tranches. So, say the VC firm draws just $ 20 million in the first year, the management fee will be 2% of 20 million = $ 0.4 million for that year. Eventually, by year 3 or 4 of the VC fund, the investment manager would have drawn down $ 100 million completely, and at the time, the management fee would be 2% of 100 million = 2 million. So, the management fee is charged based on funds drawn.

You must be wondering – since VC funds have an 8-10 year lifecycle (we spoke about this in the previous blog), what happens once the VC fund deploys all capital in year 3, like the example we discussed? Do they still charge 2% every year after deploying 100 million? The answer is a bit nuanced and depends on the investors – but usually, once the fund is deployed, there is a gradual reduction of management fee every year until the end of the VC fund lifecycle – a reduction of 0.2%/year usually. However, the management fee does not go below 1% annually – as it is required for the running costs of managing the fund and portfolio.

Before moving on – I want to touch upon something we missed discussing in the previous blog. VC funds have a lifecycle of 10 years on average but deploy capital in new companies over the first 3-4 years. And then also use the next couple of years (until year 6) to double down on winners in the portfolio – meaning, if good companies from the portfolio are raising follow-on rounds, VCs invest in these companies from the corpus available to them to try and get better returns for investors. And over the next four years (by year 10), they will distribute returns to the investors.

Carry is the share of profit the VC firm gets to keep from the investments made – this is usually 20% of the profits made after the hurdle rate. So say, for example – a company in the portfolio raised about $10 million, and the VC firm ended up with a stake of about 15% (so the valuation was around 66 million). By the time the next few rounds of funding happened, the stake got diluted to around 10%, and the company was valued at around $2 billion. The VC fund exited the investment in year 7, and the total payoff after exiting this investment will be around $ 200 million. Now, this entire $ 200 million is distributed to LPs in the proportion of their investments in the fund until they meet the capital committed plus the hurdle rate. So until year 7, with a 10% IRR hurdle rate, the final accrued return comes up to around 95 million. (For simplicity, assuming the 100 million was drawn down in year 1.) So out of this 200 million exit, 100 million is returned as capital. And 95 million is returned as hurdle rate requirements. And then, the 5 million left is shared between the investors and the fund in a ratio of 80:20.

The thing to note here is that until the hurdle rate is met, the fund managers do not see a dime of returns or profits except the management fee.

Now, say another investment in the fund also took $10 million for about 20%, which values the company at $50 million. Eventually, the company raised more funds, and the holding of the VC fund came down to 15%, but at the time of exit, around year 10, the company was valued at $5 billion. That means the outcome for the VC fund is around 750 million. Since the VC fund had returned the hurdle rate and initial capital, this return of 750 million is shared between investors and the VC fund in the ratio of 80:20.

This entire model of management fee and carry is quite common across private equity funds and is called the 2/20 model – for obvious reasons. The examples we discussed above also is a testament to how difficult it is to be a VC and how unpredictable the life of a VC can be. The assumption is that the portfolio will have winners by year 10 that would return the fund + hurdle rate. This is why I keep speaking to everyone wanting to work in VC that this is a field that takes a lot of work to ensure there are high payoffs – and in a way, VC funds also follow Power Law like startup returns, only a fraction of VC funds make any carry. Here is a nice post from Inc42 on what we discussed in this blog.

We will discuss some technical nuances of deal-making in the next few blogs. Until then!

This is the fourth post by Dinesh Pai in the Venture Capital category. Dinesh heads investments for Rainmatter and is an avid blogger.

Investments @ Zerodha

Post a comment