Appendix B: Returns, Management Fees, and Carried Interest

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How Venture Capitalists Measure Returns

Depending on whether a company has exited, venture capitalists use two different metrics to measure returns: cash-on-cash return and IRR.

​Definition​ A cash on cash return (or CoC) is the amount of money an investor receives after an exit takes place divided by the initial investment amount. Some refer to a CoC return as a realized return, emphasizing that the return is actual cash in a bank account.

Steve Anderson, investor at Baseline Ventures, invested $250K into Instagram. Assuming he did not make any follow-on investments into the company, his cash-on-cash return when Facebook bought Instagram would be $120M divided by $250K or a whopping 48,000%.* Cash on cash returns are also commonly expressed as a multiple, as in, “Anderson made 480X on investment,” where $250K multiplied by 480 is $120M.

Returns can also be expressed as a multiple of the fund the investment came from. For a $100M venture fund that has returned $300M, the multiple for the fund would be expressed as “a 3X return cash on cash.”

By nature of how a CoC return is calculated, a company must have exited—this is the simplest way to measure returns. But LPs want to measure the performance of a fund over time. If a company is still private (on average it takes a startup ten years to exit) and its stock is illiquid, investors have to use another method to estimate the value of their investment over time, called IRR.

​Definition​ Internal rate of return (IRR) is the industry standard metric used by venture capitalists and LPs to measure the performance of the illiquid individual investments in a venture fund and the performance of a fund overall. IRR is a single metric that communicates how much money a fund returns across its lifetime by computing the annual return rates for each year of the fund.

There’s really no explaining IRR in a single paragraph definition. We recommend reading the following two pieces by Scott Hirleman and Jason D. Rowley to get your head around the concept:

• “Why IRR is the Most Important VC Performance Metric (That’s Also Nearly Impossible to Use)”

• “Everything You’ve Ever Wanted to Know About VC Returns (But Were Afraid to Ask)”

In theory, IRR allows LPs and VCs to benchmark their performance against peer group funds.

In practice, the math of IRR is messy, with multiple methods of calculation. We recommend reading this breakdown of three methods of calculating IRR from the Corporate Finance Institute. If you want to dig deep into the math of IRR, check out this video. If you want to dig even deeper into why IRR can be messy and is calculated differently by different groups, this is the post for you.

Each year, Cambridge Associates publishes private investment benchmarks, including IRR benchmarks for the venture capital asset class. You’ll have to give them your name and contact information, but that’s how you’ll get the most up-to-date reports. As of Q2 2018, they report returns classified by stage ranging from ~12% all the way up to ~25%.

Carried Interest and Management Fees

While the power law of returns generates revenue for venture capital firms, individual venture capitalists at a venture firm make money in two ways: carried interest on realized returns and annual management.

​Definition​ Carried interest (carry) is a performance fee, in the form of a portion of future profits from an investment, paid to general partners or fund managers in a venture capital firm. Carry is calculated as a percentage—typically between 20% and 30%*—of the return on investment after limited partners have been paid out 1X their investment. Carry is split (though not always equally) between partners. A common expression for carried interest payout is “2 and 20,” which means a fund charges a 2% management fee and a 20% carried interest fee.

​controversy​ Carried interest is controversial. In tax law, carry is not considered part of an individual’s take-home pay and so is not affected by income tax. Instead, it’s taxed at a much lower rate as a long-term capital gain. Including carry, the average venture partner took home $634K in 2017.

Management fees are an amount, typically calculated as a percentage of the funds committed to the firm, that limited partners owe annually to the venture fund in which they are invested. Management fees frequently cover fund operating expenses, or overhead, which include rent, office supplies, and salaries and benefits.*

​technical​ Venture funds typically charge 2–2.5%* in management fees. You’ll often hear VCs refer to management fees as a charge for the cost of handling all “assets under management.”

Given this, if a $100M fund charges even a 2% fee in the first year of their fund, then the management fee would be $2M.

​confusion​ The management fee percentage may not be static over the life of the fund; it often tapers off. For example, in the “deployment” years (the first four years of a fund), the fee might be 2%; it may then cascade to reflect the workload transition from capital deployment or sourcing to portfolio management and harvesting. In the final year of a fund, the management fee might be down to 0.5%.

​Definition​ Recycling is a practice in which a venture capital firm reinvests some or all of the capital it receives from an exit, rather than distributing the return to its partners. If a firm takes management fees and does not recycle capital, it will not invest the full value of the fund, which means its investments must be more profitable to generate the same return to limited partners and general partners or fund managers. Depending on its agreement with its partners, a firm may recycle some or all of its management fees by reinvesting up to the amount of these fees, making the fund 100% invested, or it may recycle an even greater amount, making the fund more than 100% invested.*

For example, a $100M fund may have a fairly standard goal of returning four times the capital invested by LPs. But if fees amount to $15M, only $85M would be available to invest in startups. To hit a 4X return on the $100M fund, the fund actually has to hit 4.7X on the $85M invested, which is even harder to do than 4X. So instead, the fund can recycle up to $15M of exits and reinvest that capital without fees. That means the fund will be investing the full $100M instead of $85M, and it will need its investments to return 4X instead of 4.7X to hit $400M in value.

​confusion​ It is not clear how most first-time fund managers handle management fees. Some VCs report that many first-time fund managers charge under the 2% fee and some waive the fee completely, while others report the opposite by front-loading fees to cover operating expenses (so instead of 2% per year for four years, then 1% for six years, they might do 3% for four years and then 0.5% for six years).

For firms that are raising Fund I or II, LPs that commit early may receive a discount on fees. It is not uncommon to see anchor LPs get charged a lower fee than LPs that commit later.

Figure: Typical Fund Management Fees over Time

Source: Holloway*