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

Venture capital (VC) fund managers often profit significantly by managing other people's money, regardless of the fund's performance, through a standard fee structure known as the 2/20 model

The 2/20 model allows fund managers to earn a 2% annual management fee and a 20% carried interest on profits exceeding a certain return threshold, known as the hurdle rate

Even if a fund underperforms, managers still earn the management fee, which critics argue incentivizes poor outcomes as managers are not financially penalized for underperformance

The venture capital industry has a high-risk, high-reward nature, with most startup investments failing and returns skewed towards a few successful outliers

Despite the variability in fund performance, all VC fund managers typically earn the same management fee, leading to significant earnings even for underperforming funds

Critics suggest that fund managers should have more "skin in the game" by using their own capital and reducing or eliminating management fees, especially for underperforming funds

Some investors are advocating for alternative fee structures, such as zero management fees, clawback provisions, and tiered carry models, to align fund managers' interests with those of investors

The current 2/20 model rewards management over performance and may not accurately reflect the risk dynamics of modern investing

As VC funds grow in influence and startup investing becomes mainstream, there is a pressing need to reform fund management economics to ensure managers profit only when their investors do

The article is inspired by insights from Pushkar Singh, Co-founder of Tremis Capital, highlighting the need for change in the VC industry's incentive structures