What is a management fee?
Traditionally, the GP (i.e. the fund manager) is compensated through a combination of a “management fee” and a “carried interest”. The management fee is an annual percentage of the funds committed to the VC that is used to pay the salaries and overhead of the GP. Expenses associated with creating and operating the fund, however, will normally be borne by the LPs (that is, is over and above the management fees). Most VC firms will charge a management fee ranging from 2% to 2.5% per year though some firms charge no fee at all. Larger funds may also see the fee decrease after 4-5 years and/or only apply to invested capital at that point.
What is a carry?
VC fund managers look to the carry (also known as the “carried interest”, “promote”, “back end”, etc.) as their primary form of compensation. The carry is the GP’s share of any profits realized by the fund’s investors, and can run from 15% to 30% but will typically be 20%. That is, after the LPs have received all of their invested capital back from the fund, 80% of any future distributions will be paid to the LPs while 20% will be retained by the GP (together with the management fee, this is often referred to as the “2 and 20” model).
Some funds may also have a “hurdle” rate, which is a rate of return that must be realized by the LPs before the GP will earn a carry. In other words, the LPs must first receive all of their invested capital back plus an annual percentage return (e.g. 8%) before the GP will receive their 20% of any remaining distributions.
For investors in venture funds, it would also be salient to ask when the carry is collected and whether it is net of management fees and expenses: though rare, some funds will collect the carry as funds are paid out (e.g. on the exit of a portfolio company); however, that creates the potential that the GP collects a carry before LPs have received their invested capital back. LPs should be looking for funds where they first receive all of their invested capital back before a GP is permitted to calculate its carry. This will also ensure that the carry is only calculated net of expenses and management fees.