How do venture capital firms make money?

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The second is Carry. I've actually recorded a separate video on carry or profit sharing, but I'll go into it quickly here, as soon as I get done with the management fee. So management fee typically is around 2% of a VC fund. And again, say the fund is like a 100 million dollar fund just to make things simple, a 2% management fee is $2 million annually to run the fund. And this goes to pay all the partners' salaries, all the support people, all the associates. Also pay for accounting, taxes, audits, real estate, coffees, anything you can think of that the fund management company has to pay for is going to be covered by the management fee.

At year four you're going to get a 1.8% management fee and the next year you are gonna get 1.6 and 1.4 and 1.2, 1%. They usually kind of stop at 1% because there is a lot of compliance and financial accounting costs, like you, any big sized fund is going to have to get an audit every year, and those audits are really expensive. And you also have to hire like a finance and accounting staff inside the fund. So it never usually drops below 1% until the fund end date, typically they're ten year funds in venture capital. So you can kind of visualize, like if you put this in a spreadsheet, they're in the, it's a successful fund that's raised three or four funds, at any given time, they will be collecting 2% on a couple of the funds in a management fee.

And then the other couple of funds might be just in total runoff mode. And it might be at like a 1% management fee. But that's a lot of fee streams coming in. It's one of the reasons people like to work in the venture capital industry. There's a lot of cash. There's a lot of fees. There's a lot of expenses to pay higher salaries floating around. So that's the management fee angle of this. Again, Carry, and I have a separate video on this, but very quickly, Carry is the profit participation that a VC firm gets to do.

Again, most are 20% carry, but if you are, you know, a super famous, very successful firm that has done very, very well, you might be able to get 30 or 35% carry. So again, you know, to the victors go the spoils and the big time funds can sometimes get better carry. But in my example, say you have a couple exits, you have a couple IPO's, you distribute the shares of the proceeds, and you've now distributed a hundred million dollars of additional profits after the hundred million dollars was distributed back, there were a hundred million dollars of original investment, you have a hundred million dollar gain.

As a partnership, you have 20% carried. That means you get the take home $20 million for the partnership.

But if the winners are big enough and that's what the VC firms are playing for, they can get multiples of their capital and they get to participate in that at a fixed percentage. Now, inside the partnership, the partners will typically take the lion's share of the carry. So you might have, you know, five partners dividing things up, and maybe together they take 80% of the carry. And then for all the junior people, all the support people, maybe the COO of the fund, they might split the last 10 or 20% of the carry amongst them.

You want everyone focused on making good decisions, being responsive to the portfolio companies, helping those portfolio companies be successful. So I like the idea of sharing some of that outcome with the rank and file. A couple of other things to note, you know, sometimes small funds like a $5 million fund, $10 million fund.

They might actually have a higher management fee. They might have a 3% management fee. And the reason for that is it's a much smaller base, right? Like 3% of 5 million, I think, my math is telling me it's only a $150,000 a year. And so if you're a big shot VC, that started his own firm or own seed firm and you have $5 million in manageable, you're probably taking a pay cut. You're probably actually working for free on the salary side because you're going to have over $150,000 of expenses. And so sometimes one of the partners will give a higher expense ratio to tiny funds. Also again, the super famous, prestigious, amazing returns firms, might also be able to negotiate a higher management fee, like a 3% management fee.

And then I think it's just really important if you're a founder listening to this, just understand that venture capitalists are going for the big home runs like, you know, a good venture Capitalist is going to take care and focus on every company they invest in. But sometimes they are just more focused on those one or two or three winners in their portfolios because they know that's going to deliver the bulk of the return to the limited partners and the bulk of their profit sharing or carry.