Draper Talks Venture #1: How do Venture Capitalists Make Money?
It’s important to understand as an entrepreneur how venture capital works as an entrepreneur.
Venture Capitalists are money managers. We raise money and manage it for other people, these people are called Limited Partners. The normal VC firm will raise on “2 and 20” terms. The “2” is in reference to the management fee, which means every year, 2% of the funds raised will go toward operations of the firm. So if a VC raised a $10,000,000 fund, the fund would have an annual operating budget of $200,000 for the life of the fund (generally 10 years). The “20” is in reference to Carried interest.
When VCs make a ton of money, they make money off of carried interest, not management fee.
“Carried Interest in finance is a share of the profits of an investment paid to the investment manager in excess of the amount that the manager contributes to the partnership, specifically in alternative investments i.e., private equity and hedge funds.” — Wikipedia
This basically just means that the venture firm gets 20% of the upside after they have returned the money being managed. Which is why Venture Capital is built on moon shots and not safe bets. Safe bets might give you 3–5x return over 7 years, but something like Google, could give you 10,000x.
These are the normal numbers, every venture firm is different, but these are the two defining numbers in any fund.
I think it’s important for any startup to understand the incentive structure of those who they are trying to fundraise from in order to get the big picture of how the world works. This will help stack the odds in your favor as you build your startup.
