The mechanics of a VC fund

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As most of you already know, venture capital (VC) is a high-risk, high-reward asset class. It’s well known that many investments will fail to return the money invested, but a few outlier startups can deliver exponential returns. If we want to understand how VCs think about investing, we need to first understand the mechanics of how a VC fund works, and what it takes to return capital to investors. The vast majority of VC funds operate with a similar structure:

Capital committed

VCs raise funds from investors called limited partners (LPs). These LPs are generally pension funds, family offices, institutional investors, and ultra-wealthy individuals (and soon, you, thanks to the work we’re doing at Shuttle). These LPs commit capital upfront, typically over a 10-year period.

When a VC raises a fund, LPs pledge to commit a certain amount of capital to the fund. But instead of handing over the full amount upfront, VCs make capital calls periodically when they need to invest capital into new investments.

Capital calls typically only happen over the first few years of the fund’s life, while the fund is actively investing. For example, a fund might initially call 20% of the capital to start investing in a few startups, then make additional capital calls on a per-investment basis. LPs are generally given a short period to meet the capital call (10–30 days). Legally, LPs are obligated to meet their capital calls, but I've yet to hear of a VC taking an LP to court for missing one. Generally speaking, by year 4 or 5 all the capital will have been deployed and it becomes more about managing the portfolio.

Management fees

Management fees are typically around 2% of the total committed capital, per year, and are paid to the VCs General Partners (GPs) by the LPs. These fees have become a controversial topic, as some funds, particularly larger ones, often accumulate fees far beyond what’s reasonably necessary to cover the operational costs of running the fund. 

Management fees are typically charged annually for the life of the fund, which can last up to 10 years. However, after the initial 4 to 5 year investment period, the fee is often reduced to reflect the shift in focus to managing existing investments rather than actively deploying new capital.

These fees are critical for sustaining the day-to-day operations of the fund, particularly for smaller VCs that have fewer resources and depend on these fees to survive.

Carried interest

Carried interest, more often referred to as “carry,” is a performance-based fee that incentivises VCs to maximise returns for their LPs. The standard is 20% of the profits generated by the fund, but the exact percentage varies depending on the fund’s track record (exceptional historical returns can justify higher carry).

Carry is only earned once the fund has returned the initial capital to LPs. For example, if LPs commit $100 million to a fund, they must first receive back all $100 million of their invested capital before the GPs can claim any carry.

After the capital is returned, profits are then split between the LPs and GPs. The LPs usually receive 80%, while the GPs take 20%.

Here’s a basic example: Let’s say a VC fund deploys $100 million over its lifetime and goes on to generate returns of $350 million. After returning the initial $100 million to its LPs, the remaining $250 million would be split as follows:

• $200 million to the LPs (80% of the profits)

• $50 million to GPs as carry (20% of the profits)

Many funds also have a hurdle rate (also known as a preferred return), which is a minimum rate of return that must be achieved before carry kicks in. For instance, a hurdle rate might be set at 8%, meaning LPs need to receive an 8% annual return before GPs can claim their 20% carry.

Some agreements also have clawback provisions to protect LPs. If a fund initially performs well and GPs receive carry but later investments underperform, the GPs might have to return some of the carry to ensure LPs receive their agreed share of the returns.

Carry is what makes venture capital extremely lucrative for VCs. Importantly though, it aligns the incentives between the LPs and VCs because VCs only earn their reward if the fund performs well.

The dynamics of large VS small funds

Circling back to my point about the management fee controversy, larger funds generate higher management fees, which creates a misalignment between VCs and LPs. VCs become incentivised to raise larger and larger funds so they can harvest management fees from their LPs, even though smaller funds generally perform better. Mathematically speaking it’s far easier to generate 3x returns from a $50M fund compared to a $500M fund due to the enormous amount of capital that needs to be generated by the latter.

In fact, let’s look at a simple example: A $50 million early-stage fund, aiming for a 3x return, needs to generate $150 million in returns for its LPs. Given that early-stage investments tend to focus on higher-risk, higher-reward opportunities, one or two big winners in a portfolio of 30 companies could easily return the entire fund. The maths behind a smaller fund makes it possible to achieve big exits from relatively modest investments, meaning fewer massive successes are needed to return the fund.

In contrast, returning a $500 million growth fund, which needs to deliver $1.5 billion in total returns, requires a much larger scale of exits, in terms of frequency and dollars. Even though the VC makes larger investments in later-stage companies, which tend to have far lower failure rates, they still need several unicorns, or even decacorns ($10B+) in their portfolio to have a shot at returning the fund. A few companies generating 10x returns might move the needle, but the VC needs multiple exits in the $1B+ range or higher to return the fund.

There you have it folks, the core mechanics of a VC fund. We’re only scratching the surface here but these are good fundamentals to understand.

What we’ve been working on at Shuttle

• This week we received the final legal documents for the platform 📃

• Still full steam ahead with our rebrand implementation on platform 🎨

• We joined the awesome Baseline workspace in the city centre 🙌

• Started getting active on our Instagram and X accounts 📢

The Unsophisticated Investor is brought to you by Scott & Rob, the founders of Shuttle. We’re both sick of private markets being a playground exclusive to the ultra-wealthy so we started a company to challenge the status-quo. Shuttle’s singular focus is to unlock private markets for Millennial and Gen Z retail investors and help them build wealth through the highest performing private market opportunities.

Scott & Rob
Shuttle Co-Founders