# 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.

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.

1. JimHirshfield

How many times has an entrepreneur asked you whether your practice is deal-by-deal versus fund level? This seems like something highly unlikely to come up, right?

1. jason wright

yeah, i was wondering what inspired Fred to write this post. it seemed to come out of the blue.

1. JimHirshfield

Out of the black, actually

1. jason wright

actuary?

2. John Revay

I have lost track…perhaps USV is in the early stages of raising a new fund and perhaps is testing the waters – to see if it s/b 20% of net profits …or 20% of profits….

3. PhilipSugar

I am sure it was watching the behavior of a co-investor in a company.Life is the best inspiration for writing.He is probably breaking his ass to try and help the company land somehow not in flames and the other investor really doesn’t give a shit.

2. sigmaalgebra

What are the “management fees”?

1. fredwilson

VCs charge the investors an annual fee to manage their money irrespective of whether they make profits on it

1. sigmaalgebra

Sorry, I mostly knew that. It’s the 2% in the usual remark about “2 and 20” from, say, Buffett. Maybe I didn’t know that the 2% was called a management fee or maybe needed some sleep and was concerned that the “fee” was charged to the funded entrepreneur’s company to pay the VCs for their contributions to the management of the company, e.g., attending the BoD meetings. And, from what little I know about private equity, those investors do charge the company they invest in fees.

2. JimHirshfield

Gimme yer money and I’ll take 2% of it per year no matter what. Thanks.

1. Girish Mehta

And, as such, an incentive to raise as large a fund as possible.This is one reason you continue to see large venture fund raises…(which has a follow-on effect of diminishing returns).

1. jason wright

yeah, % at scale is meaningful.

2. Lawrence Brass

That is while you lay back at the beach while Fred is dealing with misaligned fellows and ladies in planes. 🙂

3. pointsnfigures

True but not true. Most funds have to rebate their fees before they get paid the 20%-and in many cases they recycle fees.

3. Charlie Petty

It’s usually something like 2% of the fund per year. This helps keep the lights on, pay for travel, hire staff etc. in advance of cash flow from carry. Some firms break even on this, some lose money (I.e., GPs need to dig into carry), and some large funds view this as a major profit center (think Blackstone which has billions and billions under management, 2% adds up).

3. fredwilson

Never

1. JimHirshfield

^^ that’a a comment in reply to no one.

1. creative group

Reply to Does AVC recycle their fees. (No)

2. jason wright

discus meltdown

3. Mario Cantin

1. JimHirshfield

It’s showing up all by itself….hmm

1. Mario Cantin

He did it right after your coment which was the first one today. It seems he typed it in the comment box rather than in the reply box by mistake.

2. Richard Leavitt

1. JimHirshfield

What it sounds like when Scooby Doo says “seven”

4. Mario Cantin

Does AVC recycle their fees? I would guess not as you have several associates, etc. on the payroll. Are you willing to share an opinion on that?

1. John Revay

My sense is they put of 1% capital and get 20% of profits..or something link that.They may bonus W-2 comp to individual GPs to fund their 1% in capital contributions….Again – or something link that ….

Interesting game theory angles here for interaction between LP/VC/Founder. So many things at play. External to the raw economics.Accentuating the power law, incenting playing fast and loose, has industry wide ramifications. Feasibily can reshape future of tech innovation and creativity.On the one hand. Inside baseball. On the other, the butterfly effect alive and well in the depths of LP/VC paperwork.

1. Lawrence Brass

I don’t like the play fast incentive, but it is so real. If you miss some steps risks grows but yes, you can catch an opportunity which you will lose otherwise. Doing things right takes time though.

6. creative group

FRED:Post is certified as pure Platinum.

Can you breakdown partner financials within a fund. Is upside aggregated and distributed to all according to pre-agreed percentages.Do partners get a bigger cut of deals they source and manage.In deal by deal funds is there a more collegiate or adversarial relationship between partners.

1. Mario Cantin

I want to know too, but answering all that might possibly enter into over-transparency territory on Fred’s part. You agree?

Not talking about USV specifics. Just general industry frameworks.

2. wynn lare

I don’t think that’s possible …..Over-transparency? If anything it’s over-rated ..to hold cards close to the vest.I don’t have a long history with Fred (yet) but his reputation is established that knowledge is power@mattermark is a great example of dissemination of investment information that is clearly embraced by VC

2. fredwilson

upside is normally aggregated and split in some agreed upon way at the start of a new fund

k. thanks.with fund level carry, are no disbursements made until LP’s are paid back in full first? or are they made on a deal by deal basis.

1. rkt88edmo

Taxable income allocation and cash distribution waterfall aren’t always in step. Most LPAs remedy this with a “Tax Distribution” if the GP has to recognize a large amount of taxable income and their distribution won’t cover the taxes. Each LPA will have it’s own specifics as to when the GP gets their cash. First step in cash returns is usually based on contributed capital to date, but that is the beauty of the limited partnership structure, your lawyers can write the agreement many different ways.

2. fredwilson

it depends. at USV, we pay back our LPs first before taking carry. that massively reduces, but does not eliminate, the risk of over distributing to GPs

1. John Revay

#clawback

Fred, what % returns do you estimate come from cash flow? Is this even a variable under consideration? Or do the structure of next round investments create a disincentive for dividend payments? Would love to see a post/discussion about startups making (or not) dividend payments.

8. Charlie Petty

Does USV have a hurdle rate? @fredwilson:disqus

1. jason wright

what’s a hurdle rate?

1. Charlie Petty

A hurdle rate is a rate of return that some funds must achieve before starting to charge carry. For example, if a fund has an 8% hurdle rate, it has to clear 8% returns before GPs charge carry. This is all determined when funds are being raised as a negotiation between GPs (VCs) and their LPs (investors).

1. pointsnfigures

I have seen this in VC funds, but it’s really popular in PE funds

2. Twain Twain

Minimum acceptable rate of return.

9. Twain Twain

Thanks, totally brilliant post. I had to learn what “carry” was when I was 26 and my UBS manager decided we were going to create a secondaries fund. So he said, “Twain, go and do your Twain thing and tell us what Pantheon and those other guys do.”Up to that point, my only reference point for “carry” was what people do with shopping bags.He ended up building the #1 secondaries team in the world. One of the smartest people!

10. Sebastien Latapie

How frequently do VCs disclose their compensation model with the companies they fund? I would assume this is clearly explained between VC and LP, but less so with the entrepreneurs. Could have a big impact on the fit between VCs and the entrepreneurs.

11. LeeHunold

Are VCs utilizing the “deal by deal” fee structure within a fund of discretionary capital or are they also raising capital on a deal by deal basis?

1. Charlie Petty

Great question. I think this happens a lot less often in VC than PE, where “fundless sponsors” are common. Curious what others have to say.

12. Twain Twain

22% carry with 2.8% mgmt fee is what my VC firm would structure.The issue with parameterizing by distribution curve is it misses out all the “black swans” which are often affected by legislative changes, people dynamics and evolving perceptions. These are qualia rather than traditional historical quant datasets.So … the slightly higher mgmt fee (extra 0.3%) incentivizes fund manager to do extra work in modeling for those.

1. LE

22% carry with 2.8% mgmt feeI like those numbers. I play around a great deal with pricing and note people’s reaction to both certain numbers and also a number that is only slightly higher than typical or what they expected. In the example above 22% is, what, just a tad higher than what is typically charged? That can easily be rationalized by a buyer or sold to them. 2.8% is clearly higher but the .8 works much better in the brain than doing 3% (from my experience). Plus the Chinese (and maybe all asians?) like ‘8’ I actually use that quite often. Plus compared to a number like 20 or 22 it doesn’t seem to be that much. In other words the 22 makes it appear smaller than if you were evaluating the number on it’s own. Repeating numbers (that are even) are also good I have found. \$66 works better than \$65 or \$67. Just my experience no research to cite (although it’s probably out there.)

1. Twain Twain

Haha, so after UBS I was a VC for a year. My senior partners chose to go with 25% carried and 3% mgmt fees.Maybe later in my career I’ll cycle back to finance. It’s just that I’ve had these bees in my bonnet about AI for the last few years.At the start of my career, I worked in a hedge fund where we built Neural Network models so it’s been interesting to see those become “hot and mainstream”…And I know all the limitations and weaknesses that make them unsuitable for getting the machines to understand Natural Language.

2. Lawrence Brass

Thinking about pricing for our product-service I thought about charging round numbers and add the motto “we don’t play with your brain” to emphasize our people (not ‘user’) oriented approach which I favor and follow. The problem with this is that I guess any pricing expert will change this on day one arguing revenue loss. Hard to defend.I like your cultural approach in the observation and analysis. Multicultural is the way to go if you target global markets. Thanks for the insight.

1. LE

Best strategy when starting out is simply to observe and reverse engineer what your competitors do. Then alter it as you learn more and as time goes on. There is usually a reason for why people do certain things.

1. Lawrence Brass

Yes, mostly unreasonable reasons. My wife often shows me products she buy that have bundled-with-tape products as a hunt prize, and I can tell she really feels happy about it. And it’s just 4.99 she says – No, it’s 5 and it looks awful!

2. pointsnfigures

Funny, I think most funds are 2-2.5% with 20% carry. In the hedge fund world, mgmt fees are going down to 1-1.5%.

1. Twain Twain

I know but see my comment on Charles Munger quote below. The extra 0.8% is for modeling the emotion metrics.In London, hedge fund mgmt fees are 2%.

13. aminTorres

In this hypothetical scenario, these returns are based on what timeframe?

14. Christopher Ayala

Very strong. Thank you.

15. Girish Mehta

Incentives. Incentives. Incentives.

1. Twain Twain

Thanks for sharing!A contact, rightly, told me to read more Munger because apparently he has these models to counter Kahnemanian System 2 effects which are all to do with trading with emotional and subjective biases.And I said to him that, yes, Munger has become \$ billionaire with this trading strategy.But there are a bunch of other \$ billionaires (and they’re in the startup sector) who’re betting on System 2 metrics rather than any assumptions that the logical, rational data of System 1 will tell us everything we need to know.Munger’s underestimated the emotional factors of incentives.

16. Twain Twain

One day Google Docs team will fix their code so live-updates and user annotations can happen in sheet cells ON BROWSER with touch devices rather than making user download yet another app or wait until they have a mouse that can let them click into cells to see the functions applied in the cell (even simple A1 – A2 type functions).It’s doable with some HTML5, JavaScript and PHP so why Google Docs team hasn’t already coded this is beyond me.Now added Fred’s spreadsheet to my collection alongside JLM’s nuggets.

1. Lawrence Brass

I am not sure about this but I guess the app gives them more control (the ‘do no evil’ type of control) of local and platform specific storage, specially on iOS.

17. Richard

Do you think the carried interest loophole should be phased out?

1. fredwilson

yes and have been saying so publicly for almost a decadehttp://avc.com/2007/06/the-…

1. pointsnfigures

I don’t because of risk. Or, just flat tax everyone at 15% and forget trying to decide what’s fair. If you invest in a C corp that is worth less than \$5M you get tax free profits at up to \$10M. http://pointsandfigures.com

18. ZekeV

I remember a class I took at Stern over a decade ago with Roy Smith. By way of background, I recently read a book on the investment banking industry written in the 90s, and a younger Roy Smith, then a partner at Goldman (when it was still a partnership) was quoted there as well. Anyway, Prof. Smith made an observation about total fund returns in venture finance, that the ability of managers to get something back from their losers is important in predicting returns. Mathematically this is perhaps surprising, because total return is disproportionately comprised of the big winners. But statistically (or at least, anecdotally in the case studies we talked about) there was a strong tendency for the best funds to *also* recoup some of their investment from less good investments. In other words, limited downside is a very important aspect of the venture finance model, just like upside capture. This is a long way of saying, I wonder if deal-specific carry might actually be a demonstrably wrong model for a venture fund. Not that I would know anything about running a venture fund, mind you. My relationship to venture finance is similar to my relationship to spaceflight — I enjoy reading about it.

1. pointsnfigures

Interesting. When we traded on the floor, a sure sign of a successful trader was how they handled their losers. Did they manage to limit losses? Could they get creative and turn it into a scratch? Could they get creative and turn it into a win? of course, this also had to be done within normal risk parameters.

19. JLM

.\$50MM of invested capital for 8 years with an annual management fee of 2% would yield \$8MM of management fees over the life of the fund — gross oversimplification to be sure.Even at a 50% AOFB (average outstanding fund balance), it is still \$4MM.Management fees are not insignificant.A big fund — \$1,000,000,000 — making bigger individual investments is a cash cow during the period of time it is under management.Do the math.VC is a very good business and it can be spectacular. Why not?JLMwww.themusingsofthebigredca…

1. LE

I kind of wonder what the story is with quoting the same fees to everyone (I am assuming but don’t know if this is the case).Seems that a VC fund could actually do better by charging different amounts to different investors…legitimately. Is that done? If not why not? Maybe even have the fee vary by years of management until payoff. [1]The 2% (or even more) is reasonable. You are paying the VC for the time they spend learning and doing what you don’t obviously have the time to do. In Fred’s case 20 or 30 years of knowledge. That is worth much more than 2% (even if it’s 2% per year).[1] By the way “it’s not done that way” is not a reason to not try or do something. When I started my first business I had no idea how others priced. So I used common sense and made it all up. Only years later did I find out that I was way over what others were charging for certain variables. The market was fine with the pricing though.

1. Matt Zagaja

I was thinking the other direction, investors might do better if they could buy cheaper VCs.

1. LE

Not the way I look at it actually. This is not Walmart or Amazon where shaving pennies count. Fred has spent his whole life (as have other VC’s obviously) in this business makes actually little sense that the charges for all vc’s are so similar by convention.

1. Matt Kruza

The two percent may seem sort of standard, but the HUGE upside is in the carry. Your top funds of each vintage year (maybe 2-5%) are probably 5-10 x capital. So the ones who differtiate in venture do it on the carry. Many / most top tier are 25-30% https://www.quora.com/Which… Just to make math simple: \$100 million fund at 2% management is \$20 million (probably less because its sort of a weighted average capital balance, negotiablle of course.) so lets say \$15-20 million. Say you are a mega success (facebook, twitter, ebay, cisco etc.) and you are just even 5x fund.\$500 milion profit. at 20% that is \$100 million and at \$30% that is \$150 million.That additional \$50million is 2-3x the total management fees. I guess simple point being is while I don’t like the role VCs get to play today, the overall focus on higher deal carry does make sense for both parties. If anything I would DECREASE management fee to 1% and trade a little of carry if I were the LPs

2. pointsnfigures

that assumes a VC partner is a commodity, which they aren’t.

1. Matt Zagaja

I’d like to think not, and surely Fred and many others do quite well at it, but overall Kauffman says 64/100 of the ones they surveyed underperformed S&P 500 after fees.[1] Unless you are skilled at picking VCs (which if you are then you should just become one and use that skill to pick investments)[2], then I think it’s probably best to pick the ones where the qualities you can measure limit your downside. I do like Dave’s suggestion of zero management fee funds.[1]http://www.kauffman.org/~/m…[2]The meta-expert picking problem plagues a lot of people. But as the saying goes nobody gets fired for buying IBM or hiring people from MIT or Google.

20. Matt Zagaja

Now wondering why I didn’t become a VC.

1. LE

Geez there are many things that I would have become if I knew what I know now about the world. Back when I was growing up a persons exposure to careers was determined by a small neighborhood of friends and family and/or the bias of your parents and/or who they associated with. Doctor, lawyer, businessman. Anything that didn’t earn “good money” wasn’t even a consideration. Passion and love meant nothing at all (and for good reason as our parents grew up w/o a safety net). Careers in entertainment or arts were laughing stock careers not something that anyone would take seriously.The problem today is that there is a brain drain because many of the smartest kids are just shooting for the moon with a startup or a career in software where they will work for a startup doing something that is close to bullshit. (Those that remain in school that is).Money is more important today than it ever was. Part of the reason is it’s so much easier than it was “back then” to see what the Jones are doing. So some kid that might work for US Geological survey or for Nasa now won’t see that as providing enough money to have the life that he sees others having. Big shift in attitudes.

2. pointsnfigures

Because it’s almost impossible to raise money! For example, do the fund economics on a \$10M fund. Remember, at \$10M, the odds of you finding a big winner are smaller. Almost not worth it to do unless you get to \$20M or above

21. Kent Karlsen

How is the funds’ lifetime calculated? When is the fund legally closed and money taxed? Let’s say the fund operate “over time”, then management fees should increase 🙂 I am not saying it’s wrong, just wonder how it works.

22. Pranay Srinivasan

On follow on / side car funds where the funds are much larger to chase into winners, inside the same Firm, how is that carry split, esp since there are usually no management fees in those? Also by virtue of following into winners inside the same firm with a larger fund, are those affecting the seed / Ser A bets as well?

23. Ryan Feit

Thanks for raising this important topic. Most people who are investing through platforms and sidecars clearly do not understand the significant difference in economics.Are we not defeating the original intention of carried interest by building entire portfolios with deal-by-deal carry? The entire point of carried interest in private equity and venture is for a portfolio manager to get compensated for generating a return for an investor (ie. I will only make money if I achieve a certain return on your entire investment). However, this is not at all the case with deal-by-deal carried interest and typical portfolio carry and deal-by-deal economics to the LP diverge significantly. Let me use a simple yet striking example:I invest \$10 million of your money into 10 deals. 1 deal is a home run (10x) and the other 9 of them are total failures (0x). Assuming no management fees, I generated you no return on your investment. See the dramatic difference under both scenarios below:Assumptions:- Investments = 10- Investment/deal = \$1 million- Winners = 1 at 10x- Losers = 9 at 0xPortfolio carry:- General Partners: \$0- Limited Partners: \$10 million–> LP return = 0%Deal-by-deal carry:- General Partners: \$1.8 million- Limited Partners: \$8.2 million–> LP return = -18%So let me get this straight- I gave you \$10 million to invest, you made me \$0 and you still keep \$1.8 million? Instead of at least getting my money back I only get 8.2 million back? That’s right, in a deal-by-deal carry model, there is no “clawback” and a GP is incredibly incentivized to “shoot-for-the-moon” on every deal because losers really don’t matter anyways (as Fred pointed out).Deal-by-deal sidecars on a one-off basis, once in a while are understandable. But that is not what is happening online. People are building portfolios of 10+ investments via deal-by carry instead of entrusting a manager to generate returns across a portfolio. Like most things, people will not realize how bad the economics are until these investments season and we go through a full economic cycle.

1. Twain Twain

There can be a clawback clause on deal-by-deal carry. Every contract’s negotiable and, if you’re an LP, you have the choice to be a passive or an active investor just as much as the GP.An active LP would negotiate clawbacks.For founders, knowing these types of metrics are important because they’re a tell-sign about how much the GP will also work to increase the value of your startup and if they’re “smart money”.

1. Ryan Feit

Interesting, have you seen any “clawback” clauses on any platforms that charge deal-by-deal carry?

1. Twain Twain

SecondMarket, Sharepost and others have to abide by compensation clawback requirements of Section 954 of the Dodd- Frank Act.

1. Ryan Feit

Right but solely relevant if listing on a national stock exchange (NASDAQ, NYSE, etc.). Not if listing a deal on an unregulated platform as an exempt investment advisor.

2. Twain Twain

I’m guessing you’re an exempt investment advisor?Maybe there’s a startup to be founded here … :*)

2. rkt88edmo

Deal by deal used to be more common pre-2004, marketplace forces and LP awareness plays a role in how new fund mgrs set up. As certain managers or the entire market gets over subscribed power shift back to the fund manager. As Twain Twain pointed out, there is often a clawback so that at the end of the day the economics of the deal for the LPs will be the very similar no matter which method is used, but it does change the timing on the cashflow and taxable income recognition which can be significant.Haven’t seen a large clawback actually executed though, seems like it would be a painful process.There is also a third method in theory and that is carry based on cumulative “exits” to date.

1. Ryan Feit

Good points. Clawback actually occurs all the time in private equity (I’m not sure about venture) and can be very painful for the GPs who have to pay back carry to LPs down the line with post-tax dollars. Agreed that if deal-by-deal carry includes a clawback provision than this is a different story but haven’t seen it.

2. creative group

Ryan Feit:Post Certified Platinum!copyright enforced…. 🙂

3. pointsnfigures

At the same time, if you are going to invest your own money and be successful you need to treat it like a full time job. You have to find and evaluate deal flow (hard) and you have to be able to help build the company (sometimes harder). Paying the VC 2/20 to do it is often a better alternative.

1. Ryan Feit

Sounds like we are in agreement Jeff

1. pointsnfigures

Yes, except I really think if you want to be successful you need to be in touch physically for most of your deal flow. Hence, angel investors that work geographically are probably better off than ones who spray and pray.

4. PhilipSugar

Agree with your post completely from the investor point of view.There is another point of view which I always take: the Entrepreneurs point of view.The worst behavior you see as an Entrepreneur from VC’s is when things don’t work out. It’s natural and I’m not saying anybody should be happy.But there is a VC saying something like “feed your winners, starve your losers.”If you are a struggling Entrepreneur in a fund that doesn’t have to care about its “losers” the technical term for your situation is that: “you are fucked”Edit:You know I really have to think about that. You are not getting any support, that is for sure. But on the flip side you aren’t getting any flailing either. Why bother with something that doesn’t matter?? Why sit there and try and cram down a bridge loan and replace a CEO, its just not worth it, it means nothing.So it really depends.

1. awaldstein

If you have ever been in a situation where you simply can’t raise funds.Where you get nos from friends and supporters.It has happened to many of us at one time or another.That’s when you realize this is as it should be–people investing or lending you money and with some exceptions, that currency is more than the relationships.Such is life.

1. PhilipSugar

Yes we’ve discussed this before, we agree.My main point was thinking about what happens when things don’t go well. Not when they flame out. That happens as Fred points out at least 1/3rd of the time.That is when I have seen a ton of value lost. You get the flailing that destroys the company instead of cutting back working hard, surviving, building, and having opportunities present themselves.

1. awaldstein

There’s not a good answer.When things are not rocking they are tough on all sides.I find that working with seed investors or small funds is sometime more challenging in ways as they by definition are smaller, and have it seems less flexibility.Could be wrong but that’s my impression.

2. PhilipSugar

It’s that they care more about losing money. When you are a big successful fund and something doesn’t go well you either gracefully shut it, merge it, and tell the entrepreneur to try again. (which they usually can do because you sell the IP for next to nothing and the slate is clean)When you are smaller, you don’t want to lose that money and you flail.

3. awaldstein

yup that’s close to my experience.

2. Donald E. Foss

Let’s not raise our hands on how often that happens. Normally I’d say something about having been there, done that, got a t-shirt, but in this case, you can’t afford the t-shirt.Arnold, moments like you describe probably create the most introspective, learning moments ever, regardless of whether you recover from it or not.

1. awaldstein

Hey there my friend!Nicely said. Poignant these circumstances certainly are.Sounds like we should chat.

5. Mark Chin

Hedge funds have a similar 2% fee + 20% carry. Can you imagine how ridiculous the deal-by-deal structure would be for hedge funds? Heads I win, tails you lose. God bless the LPs who agree to this structure.

24. Dave McClure

fred you ignored management fees but I think in funds that perform @ <2X the mgmt fees end up being a substantial form of the GP compensation.in the example that you give, a normal 2% Mgmt fee would result in compensation of \$1M per year (2% of \$50M), or \$10M over the life of a normal 10 year fund. that would actually *exceed* the carry payout.certainly for funds that do less than 1X it might be all the GP cares about, and even for 2X funds it might color behavior quite dramatically.would be interesting to look at a structure that does deal-by-deal carry but *ZERO* mgmt fees as an alternative to typical fund structure, which might incentivize better behavior even in the case or substantial losses… or perhaps with a fixed budget instead of % fees which encourage larger fund size.

1. fredwilson

yes. i agree. but i was hoping to focus this post on deal by deal vs fund level carry and so purposely didn’t want to get into fees

They’re too intertwined, as well as other fees, to separate them. As Dave said, other fees are a substantial portion of GP comp.

Can you even operate as a fund without management fees? Mind blown. Without ongoing income, you’d be incentive to exit ASAP, and I imagine GP carry hurdles would be substantially lower. Also, you’d have a major risk of funds going out of business before realizing investments b/c of the cost of operations. Regulatory and compliance costs are massive.

1. Dave McClure

(there are other ways for VC funds to generate cash than just mgmt fees, however it’s true for most *traditional* funds that is the primary and largest source of operating expenses. for 500, that isn’t the case but we are rather unusual in that mgmt fees are <50% of our operational cost)

Do VCs tend to outsource the administrative functions as it relates to investor reporting & fund admin and compliance/regulation? Instead of management fees, do you call extra capital to cover operating expenses in lieu of management fees?

2. Jack Smith

@adam_sher:disqus I’ve seen some small funds that started charging \$0 management fees. Usually if you’re starting a fund, you have already made some money elsewhere, so aren’t necessarily reliant on the management fees for a salary.

3. Clayton

I think the management fee is sometimes treated as invested capital to be returned in the waterfall, assuming profitability. There also are variations on charges for committed vs invested capital, as well as step-downs in the amount of the fee over time to disincentivize zombie behavior. There are a variety of lower management fee coupled with higher carry structures out there-if you don’t have to worry about living expenses and have confidence in your ability to select investments, you would much rather have a 0:30 deal as a VC!

25. Lawrence Brass

Oh, came for a beer but I would rather have a double expresso and take notes.. and re-read.Thanks.

26. Jud Waite

What excites me most about the further adoption of D2D carry is the evolution of early stage, private company analysis. There is an obvious incentive to discover the fund’s breadwinners as early as possible and the savviest investors will find new, creative ways to do so (using a combination of statistics and their own secret sauce).

27. TK

When GPs have deal-by-deal carry they do not get more money than GPs with the whole fund carry structure. They just get it faster. At the end of the fund life, there is a clawback provision that takes care of this. All gains and losses are aggregated at the fund level and a GP is only entitled to carry on aggregate gains. Also, even in a deal-by deal structure, it is typical for a GP to return invested capital in deals that have been permanently written off before they can take carry on the rest of the portfolio.

28. Guy Friedman

I totally get doing the breakdown of losers, breakeven and exits the way you did to illustrate your core point, but what’s the actual breakdown in your last few funds (if you can share)? Did it follow the basic same trend: 1/3 were zeros, 1/3 breakeven, 1/3 exits > 5X?

1. pointsnfigures

Angel math is even more severe. Assume 20 investments 10=0%, 5-7=break even 2=10x 1=30x. One pays for your whole portfolio-which is the power law of returns.

1. Guy Friedman

That’s the common assumption you see in articles and blogs – my question is it actually true in practice or is just repeated enough we all assume that’s the norm for a typical fund? is there a study/survey with this breakdown (return per investment vs overall return)

In our funds (closed-end commercial real estate) we structured the carry on a fund-level. The biggest factor in this decision was to avoid the bigger conflict of taking early exits on in-the-money investments and pushing out worse investments. I can’t think of a peer that uses deal-by-deal carry in the closed-end fund format. Our very first deal in our first fund produced a gross 8x. We would have loved to take our 20% on that since it is unlikely we’ll have a similarly performing asset (in any fund).Now, there are other ways in which we make money such as management fees, acquisition/disposition fees, asset management fees, leasing commissions, construction management, financing (assuming no brokers involved). Having a fund-wide carry most likely causes us to take more advantage of these fees. Our ability to charge these fees is dictated by our PPM and LPA, and our LPs are aware of this “load” before signing up.Where we vastly defer from VCs is what happens to a property v. a company if something doesn’t go well. In our properties, there is a foreclosure process and the employees at the property level are minimally affected (you always need property management, janitorial staff, and leasing brokers). While we may make a bad investment, there are other actors (mostly lenders) who are vested keeping a property open, which keeps property level employees employed. In your investments, a bad investment may result in shutting down a company and laying off 100% of the staff.I would guess that deal-level carry would cut down on incremental fees taking by the VC/PE investor but may result in situations where the LPs want Clawbacks.

30. Nurzhas M

Fred, great post. I think both can exist and from LPs perspective the decision comes down to whether LPs believe that their portfolio investing approach fits them better than VC/GPs portfolio investing approach. To clarify, this might be true if (1) LPs believe they are better startup investment pickers (or enjoy it more), in which case the role of VC/GPs comes down to institutionalized deal access; (2) LPs have overall portfolio that is structured in a way that makes sense not to invest in all of VC/GPs fund deals (i.e. investor is LP in other funds, or is building its 1-2% risky investment allocation from their overall portfolio at a different capital deployment pace/style/stage), (3) if LPs prefers different (smaller or larger, if later stage) and varying amount per startup investment than [(fund’s minimum LP contribution) / 20-25 deals]. Dave also raises very good point on management fee incentives for VC/GPs in fund approach (haven’t seen deal by deals with management fees that last)…

31. leapy

These are the posts I love. Thank you.

32. Jim Calderon

Do LPs ever have terms like a liquidation preference that guarantees a certain rate of return without worrying about how the investments have performed?

33. David Stark

As a partner at a firm charging deal by deal carry, I think you raise important points and LPs need to understand the impact of these different structures.Two important things to consider: 1) As Naval and others have discussed, deal by deal carry comes hand in hand with investor choice. There is a big difference between a managed fund charging deal by deal carry and a marketplace syndicate doing it. If marketplaces provide investors the added value of being able to pick which investments they make, it follows that the compensation structure should reflect this key difference. As OurCrowd, AngelList (I believe) and others roll out fund products that don’t involve investors choosing deals, these products are being done with fund level economics in contrast to the legacy deal by deal economics on these platforms.2) The issue of incentives must be viewed as though this is a multi-stage game for most VCs involved. No VC is incentivized to underperform if they have any hopes of raising capital in the future. At the end of the day, all investors are held accountable for their returns. While it is logical to assume that deal by deal carry incentivizes focusing only on the “winners” to maximize carry, in reality it is not clear that this is the profit maximizing strategy in the long run and therefore incentives are not as misaligned as you suggest. Since deal by deal carry usually coincides with having different investors in each deal, having a deal go bust likely means losing those investors for future deals. And since bad news typically precedes good news in VC, if the deal by deal VCs aren’t focusing on all of their investments, they won’t be in business for long if all of their investors churn. In contrast, VCs with fund level economics have the luxury of making up for lost investments with other winners in the fund, so they don’t have as immediate of a negative feedback loop and can actually afford to focus only on the winners more than the deal by deal managers can.