A premium carry ladder costs the investor little at 3x and a lot at 6x, and if the higher rate applies retroactively it creates a band where the investor is worse off when the fund does better.
Tiered carried interest charges a higher carry rate as the fund's multiple rises, and each rate applies only to the profit inside its band, like income tax brackets. On an illustrative 100 fund with 20 per cent carry up to 3x, 25 per cent from 3x to 5x and 30 per cent above 5x, proceeds of 600 pay 40.0 + 50.0 + 30.0 = 120.0 of carry, an effective 24.0 per cent of the 500 profit, against 100.0 at a flat 20. The investors receive 4.80x instead of 5.00x.
Worked in full in Venture Capital by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Premium carry is how top venture managers price their track record without raising the headline fee. Its cost depends on three drafting points: whether the rate is marginal or retroactive, whether the threshold is tested gross or net of carry, and on what denominator.
| Input | Value |
|---|---|
| Commitments | 100 |
| Carry on profit up to proceeds of 3x commitments | 20% |
| Carry on profit between 3x and 5x | 25% |
| Carry on profit above 5x | 30% |
| Tier test (base case) | total proceeds ÷ commitments |
| Total proceeds (base case) | 600 |
Carry = 20% × (MIN(P, 300) − 100) + 25% × (MIN(P, 500) − 300)+ + 30% × (P − 500)+
In Excel, with proceeds in B1: =0.2*(MIN(B1,300)-100)+0.25*MAX(0,MIN(B1,500)-300)+0.3*MAX(0,B1-500), for proceeds above the commitment of 100.
Step 1, the first band. Profit from 100 to 300 of proceeds is 200, carried at 20 per cent: 40.0.
Step 2, the second band. Profit from 300 to 500 is 200, carried at 25 per cent: 50.0.
Step 3, the third band. Profit from 500 to 600 is 100, carried at 30 per cent: 30.0.
Step 4, the total. 120.0 of carry on 500 of profit, an effective rate of 24.0 per cent. The investors receive 480.0, 4.80x, where a flat 20 per cent would have left them 500.0, 5.00x. The ladder has cost them 20.0.
| Proceeds | Flat 20% carry | Tiered, marginal | Effective rate | LP net, flat | LP net, marginal | LP net, retroactive |
|---|---|---|---|---|---|---|
| 200 | 20.00 | 20.00 | 20.0% | 1.800x | 1.800x | 1.800x |
| 299 | 39.80 | 39.80 | 20.0% | 2.592x | 2.592x | 2.592x |
| 301 | 40.20 | 40.25 | 20.0% | 2.608x | 2.607x | 2.507x |
| 350 | 50.00 | 52.50 | 21.0% | 3.000x | 2.975x | 2.875x |
| 400 | 60.00 | 65.00 | 21.7% | 3.400x | 3.350x | 3.250x |
| 500 | 80.00 | 90.00 | 22.5% | 4.200x | 4.100x | 3.800x |
| 600 | 100.00 | 120.00 | 24.0% | 5.000x | 4.800x | 4.500x |
| 800 | 140.00 | 180.00 | 25.7% | 6.600x | 6.200x | 5.900x |
Marginal tiers are smooth: the effective rate creeps from 20.0 per cent at 3x to 25.7 per cent at 8x and never reaches the top rate. Below 3x the investor pays nothing extra, which is the argument managers make for premium carry: it costs only in outcomes the investor would be delighted with.
Some agreements apply the higher rate to all profit once the threshold is crossed. That creates a cliff. At proceeds of 299 the investors receive 259.20; at 301 the 25 per cent applies to the whole 201 of profit, the carry jumps to 50.25 and they receive 250.75, 8.45 less for a better fund. Investors stay worse off than at the threshold until proceeds reach 313.33. At 600 the retroactive version takes 150.0, a further 30.0 on top of the marginal ladder. A cliff also gives the manager a reason to time or value exits around the threshold, which is the last incentive an investor wants to write into the agreement.
"Above 3x" can mean 3x of proceeds or 3x returned to the investors after carry. On a net test the 25 per cent tier starts when investors have received 300, which at 20 per cent carry takes proceeds of 350, a gross 3.50x. The 30 per cent tier moves from 500 to 616.67. At 400 of proceeds the net test charges 62.50 against 65.00; at 600 it charges 112.50 against 120.00, saving the investors 7.50. The denominator matters too: if the fund never calls its full commitment, a test on paid-in capital is reached sooner than one on commitments.
The figures are illustrative. Real ladders vary: some test a DPI multiple of paid-in capital, some combine a multiple test with an IRR test, and some apply the premium only to profits realised after the threshold date. Each is a different number on the same fund.
For the investor the useful number is the cost of the ladder at the outcome actually underwritten. If the fund is expected to return 3x and the realistic range runs to 4x, the premium tiers cost at most 5.00 on 100 of commitments; the drafting points above can cost more than the premium rate itself.
Quoting a tiered fund as "25 per cent carry" or modelling it at the top rate. On marginal tiers the effective rate at 4x is 21.7 per cent, not 25. The opposite error is worse: assuming tiers are marginal when the agreement says the higher rate applies to "all Profits". Read the definition before the rate. The hurdle debate, which is often the first point negotiated, matters less than these clauses on a venture timeline, as shown in whether venture funds have a hurdle rate.
The carried interest computed five ways on identical cash flows, and the clause read in three questions, are in the free workbooks for this book.
A carried interest rate above the standard 20 per cent, usually 25 or 30 per cent, charged by managers with strong track records, often only once the fund passes a multiple such as 3x. On a 100 fund with 20 per cent to 3x and 25 per cent above, the premium costs investors 2.50 at 350 of proceeds and 10.00 at 500, so it bites only in very good outcomes.
It must be defined in the agreement, and the difference is material. Tested on proceeds, the 25 per cent rate starts at 300. Tested on what investors receive after 20 per cent carry, it starts when they have 3x net, at proceeds of 350, and the 30 per cent tier at 616.67 instead of 500. At 600 of proceeds the net test saves investors 7.50 of carry.
Because a retroactive step-up creates a cliff. If 25 per cent applies to all profit once proceeds reach 3x, investors receive 259.20 at 299 of proceeds and only 250.75 at 301. They are worse off for every outcome up to 313.33, so the manager is rewarded for crossing the line and the investor is penalised for it.
This article is one calculation from 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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