How does a venture capital firm work?

The basic model is “2-and-20”, or 2% in committed capital paid in fees annually, and 20% of the profits going to the partners. 

So take Storm V, a $180m fund.  The LPs (the Limited Partners, the folks that give VCs the money to invest) pay 2% of the committed capital each year for “fees”. 

So in a $180m fund, the LPs “pay” the firm $3.6m a year to run it.  That’s not chump change, but it’s not as much as you think including rent, travel, expenses.  It’s not all salaries.

And the partners also have to invest a roughly similar amount back into the firm as LPs themselves — several percent of the “committed capital.”

Then, the General Partners keep 20% of the profits — after repaying all the money invested, plus all these expenses.

Then, once the firm has returned $180,000,000 in cash back from its investments — the size of the fund — if the firm returns more than $180m, then and only then the partners get to keep 20% of whatever the profits are beyond that.  That’s returns from IPOs and acquisitions.  So this can take 10-12+ years … if you even get past 1x, the so-called “hurdle” before any profits.

So if you do amazing investments it can be pretty lucrative.

If you do mediocre investments it isn’t.

If you do poor investments, in 5-10 years, you’re out of a job.

I’m making a lot of simplifications here, but it explains roughly how it all works.

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Published on August 10, 2015

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