How are VCs paid?

[4.7.12 Addendum: Many of the management company details are now available on a SEC web site. More details here.]

Here’s how VC firms are paid.

When VCs raise funds, they are paid in two ways. First, they get a commission on gains they produce for the fund, which is usually 20 percent and is called “carried interest.” Second, VCs receive a set fee, to run the business, while they and their investors await a future good payday from investment gains. Usually, a VC firm collects annual fees that amount to 2% to 2.5% of every dollar it manages (after 10 years, those funds end and the fees stop).

What many don’t know (including many VCs) is that these fees are transferred to a separate legal entity, called a management company. This is the entity that pays out expenses (salaries, rent, travel, legal, etc.), hires and fires employees, and owns “the franchise.” It is where the power is.

What is left over after expenses is the management company’s profit. The “franchise owners” of the firm divide this up among themselves. Usually, a small group of partners are the franchise owners, and often, it is just one or two individuals (usually, the founders). Very important to know is that usually one person has voting control of the management company; that person is truly the “Chief Partner”. This person usually owns the firm’s trademark.

The management company financials are a closely guarded secret. Very few partners get to see it. Most are kept in the dark. It sounds odd, but there is a top-secret “firm within the firm.”

The existence of the management company has a few implications. First, the Chief Partner cannot be fired without his/her consent. Every other partner at a VC firm can be, including the ones who have worked hard to earn pieces of the management company. So, a partner at a venture firm is usually an employee-at-will. They can be fired at any time.

So, why does this all matter to entrepreneurs? Well, we’re living in a time when it is very hard to raise new funds, unless a VC is in Facebook or another very exciting and already-large company. And, that fact affects start-ups in two ways.

First, if a firm cannot raise more money, then that firm obviously will not be able to make new investments. So, entrepreneurs should try to understand where VCs are in their current fund. Ask the VC how much of their current fund has been invested and reserved for existing investments.

Second, the lack of a fresh fund can complicate life for start-ups already backed by a VC firm. An entrepreneur’s Board member may leave his/her VC firm, or get fired. Here’s why. Without a new fund, fees to the management company decline as old funds’ fees expire. So, a Chief Partner may want to trim expenses. The most expensive cost? Partners. So, a firm may lay off partners. In other situations, the next-gen partners may leave and start a new firm, knowing that it is nearly impossible to restructure the management company since the Chief Partner doesn’t have to comply.

So, an entrepreneur can suddenly find that his/her sponsor at a VC firm is no longer there.

Entrepreneurs can overcome this reality in two main ways. They can out-perform, so that even if their champion is no longer on their Board, they can point to clear metrics. Another way is to build good relationships with other partners at that VC firm, particularly the Chief Partner.

Now, a VC firm’s culture varies from one to another. The Chief Partner may delegate authority so that all partners have a voice in an investment decision–or, he may allow input from others, but in reality, is the one making the decisions. Entrepreneurs need to know that when they pitch a firm. Who is the Chief Partner and do the other partners have power? The best way to find about both is to speak with other entrepreneurs who have pitched that firm. In my opinion, 80% of venture firms have a collegial decision-making process.

I want to point out that this type of ownership structure is usually the norm in other asset classes. LBO firms, hedge funds and funds-of-funds (firms that raise a fund to invest in other funds) nearly always are structured like this, too. So, founders at VC firms haven’t come up with a new structure. This is the standard which their lawyers tell them to adopt.

Last, I want to share why we at Kepha have tried to simplify our system. This is admittedly self-serving, but I think it’s important for entrepreneurs to know about it. Eric and I are equal partners on the carried interest, the management company profit, and the management company votes. We’ve assigned zero economic value to the management company, and so, when Eric joined the management company, he received his shares for free. So, we are equal partners and equal owners.

Why did we decide on equality? First, we believe the entrepreneur is our customer. It is one of our Operating Principles. We think the best way to serve entrepreneurs is with the best people possible. The best people, in turn, demand and deserve great economics. So, we want to offer a great compensation package to field the best team we can for our entrepreneurs and investors.

Second, we believe early stage investing is best practiced as a team sport. By having shared economics, we together have a strong incentive to have all of our companies succeed. So, an entrepreneur doesn’t get just one person’s set of contacts and energy–he/she gets the entire partnership.

Note that our CFO is a Partner–he receives a piece of the carried interest and management company profit. Among VC firms, a small number of CFOs get the former and only a select handful get the latter. So, he too very much wants our companies and Kepha to succeed.

We certainly don’t have a perfect system, and only time will tell if ours works. But, we like how our compensation helps us focus as a team on the entrepreneur. It also makes for a very collegial firm culture.

Last, if you’re an entrepreneur or a VC who would like to engage further on this off-line, just give me a shout. Always happy to try and help.

33 thoughts on “How are VCs paid?

  1. This is a hugely important post, thank you for writing it.

    For years I’ve advised entrepreneurs who are seeking Venture Financing to only bother doing so if they are dealing with the guy or guys who really run the firm or forget it, all partners are not equal

    1. Hi David, I think you are right, but I think there can be exceptions to the rule of going to the senior partners. I think that’s because those partners may not have the time needed to work with entrepreneurs: 1. They’re already on a ton of boards, 2. Senior partners normally handle the fundraising and communication with their investors (which is a *huge* amount of time), and 3. Those partners’ roles may have changed–they may have gone from being investors to a general manager of other investors. By #3, if a firm is very large, the senior partner is really managing a lot and keeping tabs on his other partners’ decisions. Moreover, if that firm has separate funds in other geographies, the US partners don’t really “manage” their non-US partners, but the Chief Partner does. That gets very hard, given possible cultural differences, and, in particular, interacting with a new investment team on the other side of the globe. So, it is a lot to handle, particularly for an early stage firm where there are “less data” and “more gut” is required for decisions.

      So, not sure what advice I have other than entrepreneurs just need to be aware of what situations they may encounter. Your thoughts?

  2. Hi Joe,

    Great post. As an aspiring entrepreneur, it is great to see the curtain pulled back on how most VC firms monetize. In your opinion, why do you believe that VC firms have not taken your approach to investment and structure: treating the entrepreneur as the true customer? It seems to me that it would only benefit companies in developing and attracting qualified startup leads.

    I am sure you are busy, but I would love to engage further in a discussion. I included my email when I posted this comment. I wish you and your firm the best of luck, and keep up the great enthusiasm for your craft!


    1. Hi Nick, I don’t know what other venture firms are thinking. Also, the data show certainly that “tough” firms often have great results (and sometimes, are among the best). I think part of it is preferred style?

    2. Also, I just emailed you with my mobile #. Happy to chat though today is insanely busy day

  3. Thanks Jo. I am crafting an email to you about my questions, it may be better than having you trying to fit in a conversation while you are busy today. Feel free to respond whenever it is convenient for you. I really appreciate it.

  4. I echo David’s comments. This information is very helpful for all of us in the ecosystem and the post is incredibly well-written too. Thank you!

    1. Hope all is well, Steve? Would love to hear how LL is going–give a shout if you get a chance. Thanks for reading the blog.

  5. Hi Jo, Thank you and good one.

    Some thought from my shores..

    [1] Many of the VC’s/PE’s who raised pre 2007 and Invested, will have to wait longer for an exit than they had planned during their investment (atleast in India).

    [2] One of the major PE firm in India has experienced its share of what you have stated. Not to mention few VC firms macro reading prior to 2008 and the subsequent investment thesis have all gone wrong.

    [3] Its becoming critical for VC/PE firms to invest according to the “Time Cycles”. To do this understanding causation’s of Time cycles is the key – economics /market demand for the investee’s service or product and its offtake. Some of the drivers are geo-politics and the levers used for the same (Oil, Currency, maneuvering(I am not stating very obviously the direct method of geopolitics maneuvering of the mighty) through central bank actions directly linked to cycles, US dollar window to all countries including Europe)==> my thought is there is going to be shorter cycles and larger swings of US dollar, countries switch away currency of choice.

    [4] For Entrepreneur it becomes critical to understand when the VC firm last raised its funds, investments done from that fund, (internal dynamics you have brought out fantastically well, including the Partner’s alignment –> KUDOS) more importantly operationally experienced quality team that can add value in Go-to-market/guide the investee companies.

    [5] Typical Wall Street kind of IB /VC/PE team needs to look out for more of “Operating teams/ Partners” or better still if its a “Operating Partners formed VC/PE firm with good understanding of Macros, Investment evaluations, Sourcing and VC/PE Finance.

    Shri Krishna Prakash

  6. Hi Mr. Tango,

    I wanted to get in touch with you and talk about working as a member of your investment team. I have attached a link to my LinkedIn account. If you have a chance, please take the opportunity to look at my experiences and get in touch with me by email. I look forward to hearing from you.

    Michael Joseph

    1. Hi Michael, thanks for the note. Unfortunately, we only hire at the partner level and look for people with previous VC experience. That may change in the future, but that’s our approach for now. Please keep in touch, though, and enjoy your last year at Dartmouth.

  7. Joe – nice job here – what I love most about this post is that it gives a perspective into Venture Capital that most entrepreneurs don’t understand. Two quick questions on payment if you would be able to shed light:

    1. On exit how are funds typically dispersed to partners?

    2. What is your estimate of an average salary of a VC in a medium size firm in Boston?

    Thanks Joe!

    1. Hi Chuck, returns are disbursed based on previously agreed to splits among the partners. Regarding compensation, I’ve found that it is all over the map and there really is no average.

  8. Tremendously valuable post for the entrepreneurial community, Jo. Thanks for taking the time to share it.

  9. Great post.

    I have zero interest in working in environments where you cannot feel like your partners are truly your partners.

    The crew at Benchmark Capital set the standard in taking a HUGELY SUCCESSFUL brand and keeping it small and flat. An inspiration because it must have been so tempting to keep growing.

    1. Fred, you raise an important point. If one or two people benefit from the fees, then they have an incentive to hire a lot of people and grow assets under management. It is a very high margin business to give employees a partner title but not share the economics with them of a bigger fund.

      If a firm is equal like Kepha, our incentive isn’t to grow as the incremental fees are shared with a new partner. Our incentive is to find the right fit.

      It isn’t a partnership if some have tenure and others are employees-at-will. Unequal management company votes leads to asymmetrical power relationships where the Chief Partner cannot be held accountable except in a coup d’état.

      We intend to always keep small the Kepha partnership. We don’t think early stage VC scales.

      Last, good point about Benchmark. They are certainly an inspiration. We have some common founding LPs and know that we are very lucky. I was told by them that the Kepha approach sounded very familiar to them. I hope Kepha has a fraction of Benchmark’s success!

  10. Jo,

    Great post. Hope you are well. I’m at a ScaleBase, a Cedar Fund company now in the hot NewSQL space. Maybe we should connect as our funding needs evolve. Ram Metser (Gaurdium-to-IBM) is our Exec Chair.



  11. Looks like your blog software is changing the published date on every update. Screenshot -

    It would be better if it shows the date when the post was first published. One would look at the date posted, to know how up to date the information is, and it would be confusing to see the last updated time there.

    An excellent post!

  12. This is excellent and well-needed transparency. It took me 6 years, 5 books, and some reverse engineering to learn this!

    It is very well written too.

    Thank You Jo!

  13. Great post! Its critical for everyone (ie. future founders, current founders, employees at startups, etc) to have a solid understanding of the investment levers that drive the industry. Seems like too many people rush in assuming one thing and getting blindsided or being unprepared.

    Thanks for writing this. For your other readers I’d recommend Brad Feld’s Venture Deals which is a quick read and has some good explanations as well.

  14. Jo good post.

    I speak to entrepreneurs daily. Here’s the one piece of feedback. They hate that they have to learn so much about VC’s, their payment structure, their LP’s, their payouts, etc. Most feel they are spending more time learning about the VC industry than focusing on their company and its funding.

    Your post is very good, and it may be aimed at other VC’s but to the average entrepreneur, “Two questions you need to ask the VC firm you are looking to take money from” as a PS would suffice.

Leave a Reply