You are likely familiar with the concept of equity in your own company. You own a piece of the pie and that ownership converts to cash when you sell the business. Venture capitalists have a similar mechanism for their compensation called carried interest, or simply carry.
Carried interest is the share of profits that investment managers receive from the fund’s performance. It is the performance fee.
In a standard venture capital fund structure, the General Partners (the VCs) raise money from Limited Partners (the LPs). The VCs invest that money into startups. If those startups exit successfully, the profits are split.
The industry standard for this split is usually 20 percent to the VCs and 80 percent to the LPs.
How the Math Works
#It is important to understand that carry is calculated on profits, not total revenue. The Limited Partners usually must receive their initial investment back before the VCs see a dime of carry.
Here is a simplified example.
- A VC firm raises a $100 million fund.
- Over ten years, they invest in various startups.
- Through acquisitions and IPOs, the portfolio returns $300 million in total.
First, the $100 million principal is returned to the LPs. This leaves $200 million in pure profit. The VCs are entitled to 20 percent of that profit. In this scenario, the carry would be $40 million.
This structure ensures that the investors (LPs) are made whole before the managers (VCs) are rewarded for performance.
Management Fees vs. Carry
#There is often confusion between management fees and carried interest. They serve two very different purposes.
Management Fees These are annual fees charged to the fund to cover operational expenses. This pays for office rent, salaries, legal costs, and travel. A typical fee is 2 percent of the total fund size per year. It is a guaranteed income regardless of how well the startups perform.
Carried Interest This is the upside. It is variable and depends entirely on the success of the portfolio companies. It takes years to materialize.
Management fees keep the lights on. Carried interest creates wealth.
Why This Matters to Founders
#Understanding carry is vital because it explains the behavior of your investors. It dictates the risk profile they are willing to accept.
If a VC fund only returns 1x or 2x the original capital, the carry is negligible or non-existent. The VCs might spend ten years working for a modest salary via management fees while missing out on the big payout.
To generate significant carry, VCs need massive exits. They need home runs.
This is why investors might pressure you to grow faster, spend more, or aim for a larger market than you originally intended. A small, profitable business that pays dividends might be great for you, but it often does very little for a VC’s carried interest.
When you sit across the table from an investor, remember that their compensation model relies on your company becoming an outlier. They are incentivized to push for the moonshot because that is the only way the math works in their favor.