One illustrative venture fund, carried interest computed three ways on identical cash flows: no hurdle, an 8 per cent hurdle with full catch-up, and the same hurdle without one.
Often not: many venture funds charge their 20 per cent carried interest from the first dollar of profit, where buyout funds usually carry an 8 per cent hurdle. On a venture timeline the difference is smaller than it sounds. In an illustrative 100 fund, an 8 per cent hurdle with a full catch-up is cleared at 1.71x gross and fully caught up at 1.87x; at 2.5x the manager earns 30.00 of carry with or without it. Only a hurdle without catch-up keeps protecting the investor, cutting the same carry to 17.12.
Worked in full in Venture Capital by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The question matters most to investors comparing a venture fund's terms with a buyout fund's. "No hurdle" reads like a concession; whether it is one depends on the catch-up, and on how long venture money is out before it comes back, which is what turns an 8 per cent annual rate into a multiple.
| Term | Value |
|---|---|
| Capital called, fees included | 100 |
| Calls in years 0 to 5 | 25, 25, 20, 15, 10, 5 |
| Share of distributions in years 6 to 10 | 5%, 10%, 20%, 40%, 25% |
| Carried interest | 20% |
| Hurdle (preferred return), compounding | 8% |
| Base case gross multiple | 2.5x |
Calls average year 1.75 and distributions year 8.70. The money is out for 6.95 years on average, against roughly four and a half in a typical buyout fund.
No hurdle: return all called capital, then 80/20 on everything after.
Hurdle, full catch-up: return capital, pay the 8 per cent compounding pref, then 100 per cent to the manager until it holds 20 per cent of all profit, then 80/20.
Hurdle, no catch-up: return capital, pay the pref, then 80/20 on the excess only.
In each year the pref accrues on unreturned capital plus unpaid pref, =(capital+pref)*8%, and each distribution is run down the tiers in order. With no hurdle the arithmetic collapses to one line: carry = 20% × (distributions − called) = 20% × (250 − 100) = 30.00 at 2.5x.
| Gross | Gross IRR | Carry, no hurdle | Carry, full catch-up | Carry, no catch-up | LP net, no hurdle | LP net, no catch-up |
|---|---|---|---|---|---|---|
| 1.25x | 3.26% | 5.00 | 0.00 | 0.00 | 1.200x | 1.250x |
| 1.50x | 5.98% | 10.00 | 0.00 | 0.00 | 1.400x | 1.500x |
| 1.75x | 8.34% | 15.00 | 4.23 | 0.85 | 1.600x | 1.742x |
| 2.00x | 10.42% | 20.00 | 20.00 | 6.39 | 1.800x | 1.936x |
| 2.50x | 13.97% | 30.00 | 30.00 | 17.12 | 2.200x | 2.329x |
| 3.00x | 16.95% | 40.00 | 40.00 | 27.57 | 2.600x | 2.724x |
Three things stand out. First, the hurdle with full catch-up only matters between 1.0x and 1.87x gross. Below 1.71x the manager earns nothing; by 1.87x the catch-up has handed back every dollar of pref, and from 2.0x the carry is identical to the no-hurdle fund. A venture fund that expects to return 2.5x gross loses nothing by offering one.
Second, the 1.71x threshold is the hurdle expressed as a multiple. 1.08 raised to the 6.95-year gap between average call and average distribution is 1.71. The same 8 per cent in a buyout fund with a 4.5-year gap is about 1.41x. Venture's long duration makes a standard hurdle a demanding multiple, which is one reason managers resist it: at 1.75x gross, a perfectly respectable outcome for some vintages, the no-hurdle carry of 15.00 falls to 4.23.
Third, without a catch-up the hurdle never stops working. At 2.5x the manager keeps 17.12, 11.4 per cent of the profit instead of 20, and the investors gain 12.88, or 0.129x of net multiple. That is the real concession, and it is rare in venture for the same reason it is valuable.
The investor's IRR tells the same story. At 1.75x gross the investor nets 7.05 per cent with no hurdle and 8.00 per cent with a full catch-up hurdle, exactly the hurdle: a catch-up structure is designed to land the investor on the pref until it is complete.
When a venture fund does offer a hurdle, three words decide its value: compounding, catch-up and basis. A compounding 8 per cent on called capital, as modelled here, is the strongest common form. A simple, non-compounding pref accrues less over a seven-year gap. A catch-up of 100 per cent hands everything back by 1.87x; a catch-up of 50 or 80 per cent stretches the band further up the outcomes. And a pref that accrues only on capital invested in companies, excluding fees, protects less than one that accrues on all called capital, fees included. Ask for the carry at 1.75x, 2.0x and 2.5x gross under the actual clause: three numbers that make the negotiation concrete.
Many venture funds have no hurdle, and with a full catch-up the omission costs investors nothing once the fund clears about 1.87x gross. The terms that move money are the catch-up and the carry basis, not the presence of an 8 per cent line in the LPA. Venture Capital computes the carried interest of one fund five ways on identical cash flows, and the free workbook for this case lets you switch the convention and watch the number move.
Convention, and the fact that with a full catch-up a hurdle changes little for a fund that does well. On the illustrative fund here, an 8 per cent hurdle with full catch-up gives the investors nothing extra at 2.0x gross or above: carry is 20.00 at 2.0x and 30.00 at 2.5x either way. It only protects them in the 1.0x to 1.87x band, the outcome a top-tier venture manager argues it should not be paid in anyway.
It depends on how long the money is out. Here calls average year 1.75 and distributions year 8.70, a gap of 6.95 years, and 1.08 to that power is 1.71: the hurdle is cleared at a gross multiple of 1.71x. A buyout fund with a gap of about 4.5 years clears the same 8 per cent at roughly 1.41x.
Much more. Without a catch-up the preferred return is never handed back, so carry is 20 per cent of the profit above the pref at every outcome. On the 2.5x fund that is 17.12 instead of 30.00, a difference of 12.88 or 8.6 per cent of the fund's profit; at 3.0x it is still 12.43.
Carried interest is computed five ways on identical cash flows in the workbook for chapters 13 to 16 of Venture Capital. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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