How Venture Funds Actually Make Money
Management fees and carried interest pull in different directions, and the fund's structure explains behavior founders often find baffling.
Founders regularly misread investor behavior because they assume a fund's incentives match their own. Understanding the economics explains a great deal that otherwise looks irrational.
Two revenue lines
A fund charges its investors an annual management fee, calculated on committed capital, which pays salaries and running costs. It also takes carried interest — a share of the profits, typically after the original capital has been returned.
The fee keeps the lights on. The carry is where partners actually make money, and it only arrives if the fund returns more than it took in.
The fund is a closed-end vehicle
A fund raises a fixed amount, invests it over a defined period, and must eventually return capital to its own investors. It cannot hold a position indefinitely, however well the company is doing.
This is why an investor may push for a sale in a company that is growing steadily. It is not necessarily a judgement about your business; it may be the arithmetic of a fund approaching the end of its life.
Why they need very large outcomes
Most investments in an early-stage portfolio return little or nothing. The fund's return depends on a small number of positions becoming very large.
This has a direct consequence for founders: a business that will reliably become a solid, profitable, mid-sized company can be a poor fit for venture capital, not because it is a bad business but because it cannot move a fund's returns. That mismatch is the source of a great deal of founder unhappiness, and it is visible before anyone signs.
Reserves
Funds hold back capital to support existing companies in later rounds. Whether a fund has reserves left for your company is a real and answerable question, and the answer changes what a signal from that investor means.
The question to ask
Ask what stage of its life the fund is in, whether it holds reserves for follow-on, and what a good outcome for this investment looks like in their model. Investors answer these questions readily, and the answers tell you whether your ambitions and theirs are the same.