A glimpse into the VC world

In sales, a good salesperson learns what motivates their customer's behaviour, including how they are personally incented and rewarded in their job. When negotiating any deal, they must understand what is "in it" for the other side, both at a business and personal level. They also learn to speak the customer's language and acronyms. Yet, I often meet entrepreneurs who don't yet understand how a VC's works.

Here is a general description. Different VC's and different funds will vary in percentages and timing, but generally this is the structure. A VC company will raise a fund which will become a Limited Partnership. The investors in this fund (know as Limited Partners or LP's) will be institutional investors (Pension Funds, Insurance Companies, etc) and/or high net worth individuals. The VC Company will be the General Partner (GP) who operates the fund. 

The GP is compensated two ways. First, they are paid a management fund, usually 2% of the total fund value for a fixed period, often 5 years. The fund generally has a fixed life, often 10 years at which time it is liquidated. The proceeds are generally distributed 80% to the LP's, and 20% to the GP's. The 20% split of proceeds is called the "Carry". This 2% and 20% is often referred to as a 2 & 20 rule. In very successful VC firms with strong track records, they have leverage to negotiate better than 20% "carries". Expenses incurred by the VC's over the life of the fund such as partner travel, external advisory fees, etc. must also be paid back to the LP's prior to the 80-20 split. (Ever wondered why VC's are so damn cheap when it comes to traveling to Board meetings or picking up their own legal fees.)

So let's assume a $100M fund is raised. At its end of life, it is liquated for $150M. The LP's receive their investment funds back, less the management fees, The VC then pays back the expenses incurred to manage the fund. The net is then split based on the 80-20 structure of the fund.

Since management fees are generally only paid for the first five years, even if a fund has a 10 years life, VC's generally operate multiple funds which overlap. It is common to see a VC raising their next fund so that the new Limited Partnership with new management fees begin as the management fees of the first fund wanes. As the VC reaches the target they set for this new fund (example would be $100M), the fund is "closed" and the 10 years lifetime begins. The year in which the fund closes is referred to a the "vintage year" for the fund.

If you are looking for a good on-going source of information about start-ups and dealing with the VC industry, try Venture Hacks. Always interesting.