The Mechanics of VC Fund Payouts

Earning profits by investing in young companies through venture capital funds requires undergoing a lengthy process.

Investors who put their money into VC funds seek returns higher than typical investments.

However, to achieve this, they must relinquish control to the fund managers and wait until the fund’s end of life (typically 7 to 10 years) to hope for the eagerly awaited capital gain.

Compensation within a VC fund is more complex than it appears.

When a fund closes, the fund managers (GPs) have a predefined period to implement the investment strategy sold to investors.

As part of this strategy, they are compensated with a fixed portion of the fund (usually 1 to 2% per year), known as management fees. In a fund lasting nearly 10 years, GPs will receive about 15% of the initial fund amount.

When the fund concludes years later, the harvest will finally take place.

It typically divides into four parts:

1. The cash-out initially serves to reimburse the LPs for their initial investment.
2. Generally, LPs require GPs to achieve a minimum profit rate before hoping to receive a share of the fund (different from the fixed portion). This rate is called the preference rate (pref) or hurdle. For example, if it is set at 8%, LPs will receive the first 8% of profits earned throughout the fund’s duration.
3. Next is the catch-up, a portion of the realized profits extending from the pref to reach the carried interest. This goes to the GPs.
4. The carried interest is the primary mechanism of compensation for a fund. When the fund’s profits reach a set threshold, the remaining amount is distributed between LPs and GPs, known as the carried interest. The standard model is an 80–20 split: 80% for investors and 20% for the management team.

*Some fund models allow LPs to be compensated at each exit without waiting for the end of the fund.