How venture capital makes money

How does the business of venture capital work?

How VCs make money

Although not common knowledge, it isn’t too complex.

The celebrity side of venture with its huge windfalls and spectacular failures can be a distraction from reality. Amid all that noise, what about the bread and butter of going to work every day as a VC and actually making a living?

The following is an excerpt from my massive tear down of how venture works, and how to build a company that fits venture investing. Here’s pro tip #22:

The 2/20 Rule

A VC firm usually makes money two ways:

  1. a management fee charged to a fund for managing capital deployed and considered “under management”
  2. and carried interest, which is based on the long-term success of the fund’s portfolio, where the VC will share in the upside of deals that reach a successful exit.

The typical scenario for these two channels is a management fee of 2% on capital under management, plus 20% in carried interest.

Carried interest means that the first 20% of capital returned to the fund goes to the VC as the general partner. The remainder of returns are divided pro-rata between all investors based on how much they invested in the fund.

Here are the entities and relationships of a typical venture management company (firm) and its fund(s).This structure follows a rule of thumb structure, it isn’t a law—funds can and are structured differently at the discretion of those creating them. But it’s a good primer in fund basics.

Additional Reading:
The Meeting That Showed Me the Truth about VC’s and How They Don’t Make Money, by Tomer Dean
So, That’s How Venture Capital Firms Work: VC Demystified, by Sahil Khosla

The content of this article originally appeared as part of 101 Venture Capital Pro Tips. You can read the original as well as 99 additional tips for founders looking to understand the world of new venture financing there.

@chadjardine is the Head of Marketing for @goreact, an edtech startup that makes game film for the classroom. He also teaches courses in venture financing @uutah

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