Understanding the Typical Carry Structure for General Partners in Small Venture Capital Funds

When it comes to the structure of fee arrangements in venture capital (VC) funds, particularly for small venture capital (VC) firms, the typical carry size for general partners (GP) is a topic of significant interest among industry practitioners. In this article, we will explore the standard formula for carry and additional considerations such as the hurdle rate.

The 2 and 20 Formula: A Comprehensive Overview

One of the most widely recognized carry structures in the VC industry is the '2 and 20' formula. This structure distributes earnings from the fund among the general partners (GP), limited partners (LP), and the management fees taken out by the GP.

The 2 and 20 formula can be broken down as follows:

2% annual management fee: This is the management fee charged on the total capital under management. It is a fixed percentage and is typically charged every year to cover the GP’s operational costs and salaries of the investment team. 20% of profits: This is the carry or performance fee that the GP earn after a certain threshold is met, often referred to as the hurdle rate. It is a pool of profits that is distributed between the GP and LPs, with the GP taking a performance fee of 20%.

While the 2 and 20 formula is a standard, it is worth noting that different firms may have variations. Some VC firms might choose to implement a '1 and 20' or even a '3 and 20' structure, depending on their willingness to take risks or the level of competition in the market.

The Role of the Hurdle Rate

Many general partners (GPs) in the venture capital industry adopt the practice of setting a hurdle rate before they initiate the carry split. The hurdle rate serves as a baseline for the minimum internal rate of return (IRR) that a fund must achieve before the GP can share in any of the profits. This rate is typically set as a percentage of the capital invested by the LPs.E

For instance, a 20% hurdle rate would mean that the fund must generate a return of at least 20% before the GP can start taking their 20% carry from the profits. This mechanism incentivizes GPs to make investment decisions that are more profitable in the long run rather than focusing solely on short-term gains.

Impact of the Carry Formula on Venture Capital Investing

The carry formula plays a significant role in shaping the strategies and investment decisions of VCs. The two components of the formula—management fee and carry—impact the financial structure and operational dynamics of venture capital firms in the following ways:

Profit Maximization: The 2 and 20 formula incentivizes GPs to maximize profits, as the carry is a percentage of the profits after the hurdle rate is satisfied. This encourages long-term thinking and seeks to ensure that the returns from investment are more substantial. Risk Management: The hurdle rate acts as a risk management tool, ensuring that GPs and LPs are sharing in the risk and rewards equally. This helps in maintaining harmonious relationships between the two parties and promotes a cooperative environment for successful investments.

Furthermore, the carry structure affects the fundraising process. Venture capital firms with a reputation for a more favorable carry structure may find it easier to attract limited partners (LPs), as they are more likely to see a higher return on their investment. However, it is crucial to strike a balance, as too high a carry percentage may deter LPs from investing, while too low a carry may not be sufficient to attract and retain top talent.

Conclusion

In conclusion, the typical carry structure of 2% management fee and 20% performance fee serves as the standard benchmark for small venture capital funds. The introduction of the hurdle rate adds an additional layer of complexity, ensuring that GPs and LPs share in the risks and rewards in a fair and transparent manner.

Understanding the intricacies of carry structures, including the 2 and 20 formula and the role of the hurdle rate, is essential for any entrepreneur or investor looking to engage in venture capital. It not only provides a clear picture of the financial arrangements between the GP and LP but also helps in making informed investment decisions that can lead to successful outcomes.