How do you choose the right fee model for your VC fund?

It’s important for LPs to note that management fees are effectively a loan to the VC /investment firm (many family offices don’t appreciate this nuance). ie. Of the total commitment - a total of 20% (usually 2% x 10 year fund life) is paid to the firm so they actually only have 80% of the committed amount to invest. But the firm will only earn carried interest after 100% (or more if there is a hurdle) is returned to their LPs. For *most* firms, carry is what really moves the needle. (This is why a sensible recycling strategy is important for VCs - as you’re trying to return 3-4x (but from a base of 0.8x))

Management fees are a necessary cost that all investors bear when they invest in both public and/or private funds. There are fund managers who do not charge a management fee, but this is extremely rare. Most VC firms' management fee begins to taper down starting in year six by 25 bps (0.25%) per year, until the fee reaches a floor of 1%. This is standard. Management fees can also be used as a negotiating tool to incentivize investors to invest in your fund. For example, some fund managers will charge a lower management fee for investors who come in on a first close. For some public funds, the management fee can vary based on how much an investor invests. There's no set rule for management fees, but they should be in line with standards.

That’s called a fulcrum fee. You PE guys need to talk in terms of IRR not ROI because 3x could be a 10% IRR or a 20% IRR depending on the number of years to exit.

In my view, selecting the right fee model for your venture capital fund is all about harmonizing it with your unique fund strategy while staying attuned to industry benchmarks. I'd recommend considering a base management fee (typically 1-2% of AUM) to ensure your operational costs are covered, coupled with a carried interest (usually around 20% of profits) and a hurdle rate to truly align interests with your investors. Don't forget to build in clawback provisions for that extra layer of investor protection. It's crucial to stay agile and adapt your fee structure as your fund evolves and market conditions shift. Above all, transparency and fairness should remain paramount for long-term success.

Though seemingly a minimal amount (generally 2%), the Management Fee has a significant impact on the NPV for the Limited Partners (LPs). An average fund cycle of 10 years translates into 20% of the total fund size. That is 20% of the capital that doesn't get deployed into money-making deals. In VC, more investments can provide a better chance of hitting super-normal returns (Power Law). Thus, a slight change in the management fee can have a cascading effect on how the entire fund performs. However, this does not mean a fund should reduce or remove the Management Fee to appease the LPs. Charging this amount helps ensure smooth operations, availability of talent and more until the carried interest is realized in the later stage of the fund.

Carried Interest is what the best GPs make the most money on. LPs have no problem with the standard CI level of 20%. Some GPs propose an efficiency model, i.e., higher CI, when they achieve a specific group of return on the fund, i.e., 25% CI on returns above 3x. Nevertheless, you may face a counteroffer when proposing to an LP, who will agree to an efficiency CI and offer a lower CI for weaker returns. It is, therefore a double-edged sword. In addition to what CI you propose in the fund model, how you divide the CI within the team will be crucial. It also matters in the LP's investment decision, so don't propose strange constructs because your investors won't understand them.

I always want to see the total fees over the funds lifetime. Preferably as a percentage of capital committed. Also the waterfall model is of great importance, especially the catch up and how it can prevent possible agent- principal situations on the tail end of the fund.

When choosing the right fee model for your VC fund, consider the carry fees carefully. Carry fees are the share of profits that your fund receives from your portfolio companies, typically after returning the invested capital and a preferred return to your investors. They are meant to reward your fund for generating superior returns and align your interests with your investors. The typical range for carry fees is 15% to 25% of the net profits, depending on the risk, return, and competition of your fund. Some funds may use different carry structures, such as deal-by-deal, waterfall, or catch-up. Carry fees incentivize your fund to maximize returns, exit portfolio companies, and return capital to investors.

Most VC funds operate on a cleaner model which is generally 2% Management Fees and 20% Carry. The management fees structure changes to 1% in post deployment period. However, I have also seen many funds in their 3rd/4th cycle where they have reduced their management fees to 1.5% and increased their carry. Other factors that play a major role in are Re-investing a portion the fees by the management, Waterfall (European/American), Catchup Clause etc.

Going for the "two and twenty" (2% of AUM management fee annually over the course of fund life plus 20% carried interest based on performance and linked to the returns the fund makes to LPs) is the most straightforward model for Limited Partners to understand and follow. With a smaller fund, and especially for emerging fund managers, this may not be the most financially viable solution, but is still considered the right approach and a rite of passage. In many ways, it is similar to when startups are bootstrapping first to get better leverage for negotiations with investors later on.

The first thing to consider when starting a new venture capital fund is defining its investment thesis. What are the objectives you desire to achieve with these investments, what is the return expected, and the size of each capital injection? Also, it is important to decide what kind of activities will be promoted, if it will be more active or passive funds, and what kind of costs those activities will bring. Doing this will give a perspective of what kind of fee will be needed to execute the fund. Once these characteristics are defined, it's ideal to do a financial projection to analyze the viability of this project, that way it will be possible to identify which fees will be feasible.