Fund Level Vs Deal By Deal Carry

In a venture fund, the general partners will make something like twenty or twenty five investments. There are outliers for sure. A few venture funds will make less investments than that. And there are seed funds that will make significantly more investments than that. But that’s not the point of this post.

The thing I want to talk about is how losses (and gains) are treated in a venture fund. A traditional venture fund will take its losses on a given portfolio of twenty to twenty five investments and earn them back with their gains before calculating their carried interest. The carried interest is the primary way a venture capital firm makes money. At USV we take a 20% carry. There are firms in the VC business that take a larger carry (25% and 30% being the other common numbers). But we are happy with 20% and do not feel the need to charge more.

Let’s do some math to make this clear. Let’s say a VC firm makes twenty investments of $2.5mm each. That’s $50mm of invested capital. We will ignore management fees for this exercise to make it simple. Let’s say seven are complete losers and seven get their money back and six are winners returning 5x on each. So the seven losers produce $17.5mm of losses. And the six winners produce $60mm of gains ($75mm in proceeds less $15mm of cost). So the fund’s total gains are $42.5mm ($60mm of gains minus $17.5mm of losses) and a 20% carry on that will produce $8.5mm of profits for the VCs on that fund. The limited partners will get back $84mm on their $50mm investment, a gain of $34mm which produces a 1.68x multiple on their investment. This is not a great venture fund. But it is way more typical than people think.

Here is the spreadsheet I used to do all of this math.

There are investors who get what is called a “deal by deal carry.” In that model they do not have to account for their losses in the calculation of carry. So they take 20% on their successful deals and don’t have to net out their losses. In the example above, those investors would make $12mm in carry on the same portfolio and the limited partners would get back ~$80mm or 1.6x.

But leaving aside the math between the limited and general partners, the other thing about deal by deal carry is how it changes the incentives. If investors don’t have to worry about the 2/3 of the portfolio that produces disappointing outcomes, they will pay all of their attention on the winners and work to make those investments as successful as possible. That might be good. The VC economics already trend toward incenting that behavior because all of the gains come from a small portion of the portfolio. Deal by deal carry just amplifies that.

Deal by deal carry has not been common in the VC business. It is more common in private equity where the distribution of outcomes looks very differently. But with the rise of syndicates being raised on venture capital marketplaces, we are seeing an increasing number of angel and early stage investors who have deal by deal carry.

As I said, there are pros and cons to both compensation models. I don’t want to say that one is better than the other. But they do produce different kinds of behavior and entrepreneurs should understand how their investors are being compensated. It will explain their approach and behavior.