How Venture Capital Works: Inside Fees, Carry, and Fat Paychecks

In the world of venture capital, there’s a well-worn mantra: “High risk, high reward.” But for many venture capital (VC) fund managers, the real magic lies in turning other people’s money into personal profit—regardless of whether the fund actually delivers returns for investors.

At the heart of this system is a fee structure that has remained largely untouched for decades, one that critics argue is fundamentally flawed and incentivizes poor outcomes for investors. So how exactly do VC fund managers make money, and why are more investors questioning the fairness of the current model?

How Do VC Fund Managers Make Money? Breaking Down the 2/20 Model

Most venture capital funds operate under a 2/20 compensation structure. This means fund managers charge:

• 2% annual management fee over the life of the fund.

• 20% carried interest (or “carry”) on profits—only if they exceed a certain hurdle rate.

Let’s break that down with a real-world example:

Assume a $100 million VC fund with a 10-year lifespan. This is a common structure, as most VC funds are expected to invest in startups and return profits to investors within a decade.

Management Fee – The Guaranteed Payout

A 2% management fee annually for 10 years translates into $20 million guaranteed to the fund managers, irrespective of fund performance. This fee is meant to cover operational costs—salaries, rent, travel, due diligence, and more—but in effect, it also ensures fund managers are compensated even if their investments go south.

The result? Only $80 million of the original $100 million fund is available for investing in startups, with $20 million already earmarked for management.

Carry – The Incentive Bonus

Now comes the “carry,” or carried interest—a 20% share of profits that fund managers earn only if the fund exceeds a minimum return threshold, known as the hurdle rate (commonly 8% annual IRR).

Let’s say the $80 million invested grows to $300 million in returns over 10 years. After subtracting the initial $100 million invested, the net profit is $200 million.

From this, the fund managers receive $40 million (20% of profits) as carry.

In total, they’ve now earned $60 million—$20 million in management fees and $40 million in carry—on a $100 million fund.

Heads I Win, Tails I Still Win

The real controversy lies in what happens when a fund underperforms. Suppose the VC fund only returns $90 million after 10 years—investors have lost $10 million.

Do fund managers lose money too? Not at all.

They still collect their $20 million management fee, because that is independent of fund performance. Investors lose capital, but fund managers walk away with 20% of the fund in fees.

This is where critics argue that the VC industry’s incentive model is broken. Fund managers are rewarded for simply managing capital, not for generating returns.

Venture Capital: A Winner-Takes-All Industry

Venture capital is inherently risky. Most startup investments fail, and returns are highly skewed towards a few outliers. This makes the distribution of fund performance extremely uneven.

• Since 1990, the average return of the US VC industry has been 16.1%, significantly higher than public equities at 10.6%.
• However, median VC fund returns are only 9–10%, lower than public equity returns.
• The top 10% of VC funds achieve 25%+ IRR, while the bottom 20% lose money.

Despite this variability, almost all VC fund managers receive the same 2% annual fee. Even those in the bottom quartile of performance earn tens of millions in management fees, while their investors suffer losses.

Broken Incentives: The Case for “Skin in the Game”

The current model allows fund managers to take no financial risk, while investors shoulder all the downside. Critics argue that fund managers should have more “skin in the game”, meaning:

• Lower or zero management fees, especially for underperforming funds.
• Greater use of fund managers’ own capital to run operational costs.
• Carry should be earned only if investors receive returns above the hurdle rate.

Such reforms would align the interests of fund managers with their investors, ensuring that managers profit only when their investors do.

Time for Change?

Some progressive investors are now demanding alternative fee structures, such as:

• Zero management fees, with fund managers paid solely through carry.
• Clawback provisions, where managers return part of their fees if the fund underperforms.
• Tiered carry models, with higher carry only for outsized returns.

These approaches aim to reward long-term performance, not just asset accumulation.

Profit Without Performance?

In its current form, venture capital is a business where fund managers often make millions even if their investors lose money. The 2/20 model is built to reward management over performance, and it may no longer reflect the risk dynamics of modern investing.

As VC funds grow in size and influence, and as startup investing becomes mainstream, there is a pressing need to rethink the economics of fund management.

If venture capital truly aims to build the future, it must first fix its present incentive flaws.

Credit: This article is inspired by a LinkedIn post by Pushkar Singh, Co-founder – Tremis Capital, and a mentor to founders building outstanding businesses.