If you're looking to fund raise it's critical to understand what the concerns are of VCs, namely who are their bosses. This is likely one of the biggest factors that governs VC decision making.

This Blog will use the following terms.

Terms

Capital Commitment
A capital commitment is the promise of funds from an LP to a GP. Money actually moving from LP to GP is known as a "Drawdown".

Carried Interest (aka "Carry")
Typically 20%-30%, it is how much profit is shared with the VC after the hurdle rate.

Catchup
After clearing the Hurdle rate VCs are typically allows to keep all profit until they create an agreed carried rate (typically 20% of profits for the VC)

Clawback
Kind of the opposite of catchup. If VCs are profitable but then begin to lose money LPs typically have the right to "claw back" any profits the VC kept until profitability is again above the hurdle rate.

Drawdown
When money is transferred from LP to GP. This is typically when the clock starts on IRR.

GP or "General Partner"
this is the VC itself,

IRR or "Internal Rate of Return"
Measurement for profitability, how profitable an investment is. Expressed as a percent.

LP or "Limited Partners"
These are the investors who commit money to a VC.

Management Fee
This is the fee that the GP charges the LP to run the business. You can think of this fee as being a "keeping the lights on" fee. Typically this is around 2%.

Preferred Return or "Pref" also known as "Hurdle Rate"
This is the rate that

Phases of a Venture Capital Fund

Fund Creation

The first step for any VC is to create a fund which investors can pledge money to. To raise funds VCs will often go on a "road show" to shop their fund and its investment strategy to various endowments, pension funds, oil sheiks, cryptobros, and generally anyone else with deep pockets.

The ones that are interested in investing become "limited" partners (or LPs) in the fund while the VC is the sole "general" partner (or GP). The Limited Partners say how much they want to invest and promise to give it to the General Partner when he asks. This is known as a capital commitment.

Investing

The next step in a VCs fund life cycle is to find some investments that have a good chance for return. Once a VC finds such an investment it will have for the money promised by LPs to so that it can make the investment. The act of actually collecting money from LPs (i.e converting commitments into cash) is known as a draw down.

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A large part of how VCs get paid is based on how profitable their investments are. This is known as IRR and is based on two things:

1. How much money is made
2. How quickly that money was made

When the VC takes money from the LP can have a big impact on the IRR which in turn can have a big impact on the amount of profit the VC is allowed to share in. This is why VCs are super pedantic about when they take money from their LPs.

Hurdle

Now that our hypothetical VC, Beacon Capital Partners, has found an investment they can begin their path toward profitability. The first leg of that journey is the "hurdle rate" or "preferred return" or simply "pref". This is the rate of return that LPs can expect to make on their investment before they need to start sharing any profits with the GP. Typically set at 7-8%.

Catchup

The next leg in a VCs journey to get as much profit is "catch up". This is the first step where the GP actually gets to share in the profit of the investment. In this step the GP gets to keep 100% of profits until they hit carry.

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There is also an inverse of Catchup when investments don't go so well. This is known as a "Clawbacks". Clawbacks are a lot like Catchups only in reverse.

When returns drop below the hurdle rate LPs are allowed to Clawback any profit the GP took.

Carry

This is the idea steady VCs hope to reach. This is when their investments are consistently exceeding the hurdle rate and both the LP and GP are able to share in the profits. Carry is typically split 20/80 with 20% going to the VC and 80% going to the LPs.

Case Study: Let's Do Some Math!

Let's put some numbers to this. We'll look at a hypothetical VC with a charismatic portfolio manager. This portfolio manager goes on a roadshow and is able to raise funds from a diverse set of investors.


Fund Details:

  • Fund Size: $100 Million
  • Hurdle Rate: 8% per annum
  • Carried Interest: 20%
  • Catchup - 100% to GPs until they receive their full share of carried interest.


We'll look at the fund over the typical 10 year lifespan

  • Year 1-5: The fund draws down $20 million each year to make investments.
  • Year 6-10: The fund exits investments and returns $40 million to LPs each year.

Fund Steps:

Hurdle Rate
The first step is calculating the hurdle rate. The hurdle rate is determined by a percent (in this case 8%) and the amount borrowed.

Since we are borrowing 20M per year for the first 5 years the hurdle rates over the course of the fund will look like this:

Drawdown Capital Hurdle Rate Interest Hurdle Rate
Year 1 20 20 8% 1.6M 21.6M
Year 2 20 40 8% 3.2M 43.2M
Year 3 20 60 8% 4.8M 64.8M
Year 4 20 80 8% 6.4M 86.4M
Year 5 20 100 8% 8M 108M
Year 6 0 100 8% 8M 116M
Year 7 0 100 8% 8M 124M
Year 8 0 100 8% 8M 132M
Year 9 0 100 8% 8M 140M
Year 10 0 100 8% 8M 148M

Catchup
From the hurdle rate table we can see how much profit the VC needs to generate before catch up will apply. If the VC makes above the hurdle rate then they can apply catch up and take profits up to their carried interest rate of 20%

Let's say in the 7th year the VC had it's first exit and made 150M in profits.

  • First; we would subtract hurdle rate for the LPs
    • 150M - 124M= 26M
      Nice we have 26M in profit to distribute between catch-up and carry.
  • To calculate how much carry a GP can take we look at how much profit the LPs have already taken.
    • The LPs have committed 100M and have received 124M.
    • 124M - 100M = 24M in Profit
  • Because LPs have claimed 24M in profit this is how much the GP is allows to catch up to.
    • GP takes 24M of the 26M of remaining profit.
    • 26M - 24M = 2M of profit to allocate.

After catch up there is still 2M of profit to allocate. Lastly we will apply Carried Interest...


Carried Interest
After catchup any remaining profit to distribute goes to carried interest. In our above example carried interest is distributed 20/80 with 20% going to the VC and 80% going to the LP

We still have 2M after catch up to allocate and so this will be treated as carried interest:

  • VC: 2M * 20% = $400k
  • LPs: 2M * 80% = $1.6M

Conclusion

The VC model can be incredibly profitable for VCs when they are able to generate profits that surpass the hurdle rate. The alternative is also true; an unprofitable VC is likely to quickly go out of business.

As a start up it's important to understand how VCs make money as that can often be the main driver behind the actions of a VC.

A couple parting observations every start up founder should understand.

  • A VC fund that is in the latter half of its life is likely to be much more concerned with profitability than a brand new fund. Startups bundled in older funds will likely feel additional pressure for either profitability or an exit.
  • Time is incredibly important to the calculations for a VC. Time can often be the difference between whether or not a VC can clear its hurdle rate or not.