Split the manager's take into fee profit and carried interest at four outcomes, and the incentive of a small fund looks very different from that of a large one.
A VC firm earns two things from a fund: the management fee, which pays the running costs and leaves a margin, and carried interest, a share of the profits. On an illustrative $100m fund charging 2 per cent for five years and 1.5 per cent for five, the fees total $17.5m, of which $3.5m is left after running the firm. If the portfolio returns 3x gross on the $82.5m invested, the 20 per cent carry is worth $29.5m, nearly nine-tenths of the manager's take.
Worked in full in Venture Capital by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The split matters to the investor more than the total. A manager whose income is mostly carry is paid for performance; one whose income is mostly fee profit is paid for raising capital. Which of the two you are backing is a matter of fund size, and it can be computed from the term sheet and a sensible cost budget.
| Input | Value |
|---|---|
| Fund size (commitments) | 100 |
| Management fee, years 1 to 5, on commitments | 2.0% |
| Management fee, years 6 to 10, on commitments | 1.5% |
| Carried interest, whole fund, no hurdle | 20% |
| Running costs per year, years 1 to 5 | 1.6 |
| Running costs per year, years 6 to 10 | 1.2 |
| Share of fee profit and carry to the two partners | 80% |
| Carry received, year | 9 |
| Discount rate for present values | 10% |
Fees = size × (2.0% × 5 + 1.5% × 5); invested = size − fees
Fee profit = fees − running costs
Carry = 20% × MAX(0, invested × gross multiple − size)
In Excel, with size in B1, fees in B2 and the gross multiple in B3: =0.2*MAX(0,(B1-B2)*B3-B1).
Step 1, the fees. $2.0m a year for five years and $1.5m for five: $17.5m. That money is not invested, so the portfolio receives $82.5m.
Step 2, the fee profit. Running costs of $1.6m a year while the team is investing and $1.2m in the harvest years total $14.0m. The fee profit is $3.5m over ten years, $0.35m a year on average, before the partners pay themselves.
Step 3, the carry. At 3x gross the $82.5m becomes $247.50m. The investors first get their $100m back; the $147.5m above it is profit, and 20 per cent of it, $29.50m, is carry. The investors keep $218.00m, 2.18x net.
| Gross multiple | Proceeds | Carry | LP net TVPI | Manager's take | Carry share | Per partner | Per partner, today |
|---|---|---|---|---|---|---|---|
| 1.0x | 82.50 | 0.00 | 0.83x | 3.50 | 0.0% | 1.40 | 0.86 |
| 2.0x | 165.00 | 13.00 | 1.52x | 16.50 | 78.8% | 6.60 | 3.07 |
| 3.0x | 247.50 | 29.50 | 2.18x | 33.00 | 89.4% | 13.20 | 5.86 |
| 5.0x | 412.50 | 62.50 | 3.50x | 66.00 | 94.7% | 26.40 | 11.46 |
Two things stand out. First, at 1x gross the fund loses its investors 17.5 per cent and the two partners have earned $1.40m each over a decade, $0.14m a year: on a fund this size, failure is genuinely expensive for the manager. Second, the carry is back-ended. Most of a partner's $13.20m at 3x is carry that arrives around year nine, so at a 10 per cent discount rate the whole package, fee profit included, is worth $5.86m today, less than half its nominal value. Carry starts once the portfolio clears 1.21x gross, the multiple at which $82.5m grows back to the $100m committed. The full bridge from gross to net is in what gross multiple a venture fund needs to return 3x net.
Fees scale with the fund; costs do not. A $500m fund does not need five times the team of a $100m fund.
| Fund size | Fees | Running costs | Fee profit | Carry at 3x | Fee profit share of take |
|---|---|---|---|---|---|
| 50 | 8.75 | 10.5 | −1.75 | 14.75 | negative |
| 100 | 17.50 | 14.0 | 3.50 | 29.50 | 10.6% |
| 250 | 43.75 | 24.5 | 19.25 | 73.75 | 20.7% |
| 500 | 87.50 | 39.5 | 48.00 | 147.50 | 24.6% |
At $50m the fee does not cover a professional team, which is why small first funds often charge 2.5 per cent or have partners working unpaid. At $500m the managers earn $48.00m before a single exit. That is still under a quarter of the take at 3x, but it is the quarter they keep if the fund returns 1x, and it is the reason a manager's interest in raising a larger successor fund is not the same as the investor's.
The cost budgets are illustrative assumptions, not market data. Real firms also commit 1 to 2 per cent of the fund themselves, which earns the investors' return, and often share fee income from several overlapping funds, which lowers the cost borne by each.
Reading "2 and 20" as 2 per cent a year plus 20 per cent of returns and stopping there. The fee is not income: on a small fund most of it is spent on running the firm. And the carry is 20 per cent of profit above the commitment, not of proceeds, so at 2x gross on invested capital it is $13.00m, not 20 per cent of $165.00m. Comparing managers on the total fee load, rather than on how much of their income depends on performance, misses the incentive the terms create.
The worksheet on what the manager takes at four outcomes, and the fee and carry engine behind these numbers, are in the free workbooks for this book.
On the illustrative $100m fund with two partners sharing 80 per cent of the economics, each earns about $0.14m a year from fee profit, and carry of $11.8m each if the fund returns 3x gross on invested capital, paid around year nine. That carry alone is worth about $5.0m today at a 10 per cent discount rate. At 1x gross there is no carry at all and the partner has earned $1.40m over ten years.
It depends on fund size. On a $100m fund, fee profit after running costs is $3.5m against $29.5m of carry at 3x gross, so carry is nearly nine-tenths of the take. On a $500m fund with costs that grow more slowly than the fee, fee profit is $48.0m against $147.5m of carry, a quarter of the take, earned whether or not the fund performs.
With carry on whole-fund profits above the commitment and no hurdle, the manager earns carry once proceeds exceed the $100m of commitments. Because only $82.5m is invested after fees, the portfolio must return 1.21x gross on invested capital before the first dollar of carry. A preferred return would push that point further out.
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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