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Jon Bradshaw & Peter Harris

How do Venture Capitalists get paid? What is "carry"?

What is Carry? (How Do Venture Capitalists Get Paid?)

How do Venture Capitalists get paid? What is “carry”?

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Episode Transcript

Jon: All right. So today we're here with Peter Harris, founder of University Growth Fund. Welcome back, Peter. He's had a busy quarter. They've just closed four deals we've invested in. Can you tell us how much you invested in those four deals combined?
Peter: I could, if I remember.
Jon: What's your what's your guess?
Peter: We probably invested like more than 10% on the last quarter. We've been really busy.
Jon: So that would be what number you're going to go into more. My goal is to get as much info out of Peter as I can. That's the only reason why I'm here. This is.
Peter: A sit. Your questions. Come on.
Jon: All right, so today let's talk about what is carrying venture capital. And also don't think you got off so quickly, but I think a lot of people don't understand how venture capitalists make money. There's these weird terms like carry and management fee. So this would just be a quick session on how do they make money, because I think when you understand how a VC is incentivized to win, you can then understand, you know, if it's a better fit for your business or not and why they may say what you know or not, because I think my guess is saying no is probably the toughest part of your job.
Peter: I don't know if it's the toughest, but it is. It's not an enjoyable part of what I do.
Jon: Have you ever had an entrepreneur cry in front of you then? That's not that tough.
Peter: Exactly. Yeah. So like I said, it's not that someone crying.
Jon: They've lost their house. They put everything on the line.
Peter: That never.
Jon: Happened. You must be sending the you must be just ghosting people then, because that's what the you die angels, an angel investment group. I mean, I'm pretty sure some people might have, like, come close.
Peter: Yeah. I mean, like the the type of investing we do, we're never going to be the largest investor in a deal.
Jon: And never the zero. No, that that funds the funding.
Peter: I mean, yeah, to an extent. But like if they're coming to me and dependent on my dollars like our dollars as a fund. And we're turning them away like they were already in a real tough spot, you know? Okay, so.
Jon: All right, well, let's talk about carrying what it is. So what do you mean when you say, like, when a VC takes carry, carry a C, a RR.
Peter: So did you want to talk about how a VC gets compensated in total with management fee and carriers? Do you want to just talk about Let's.
Jon: Primarily talk about carry, but you could like hint on the other aspects.
Peter: So venture capital is makes money in two ways. The first one is through management fee and the second way is through carry. Now, theoretically, they should only really be making their money on carry.
Jon: Okay?
Peter: And the management fee should just be there to cover operations. So if you have $100 million fund and you're charging 2% management fee over ten years and these are I'm simplifying drastically like every year, you're going to pull 2% of that $100 million of the.
Jon: Total hundred million or the remaining non-deployed cash.
Peter: Well, it depends on how it's structured, and this is where the nuances come. But like generally, like just for simplicity's sake, you have $100 million fine. You're going to drop 2% management fee on that, the total hundred million.
Jon: Okay.
Peter: So over the course of ten years, that's like 20 million bucks, right?
Jon: That's a lot of coin. You're only investing 80 of the.
Peter: That's right.
Jon: You're a huge hit right there.
Peter: But also right off the bat, you're down. You're down 20%. How many? It's not really that high because it you know, it tapers off and there's but yeah, right off the bat you're down quite a bit. Right. Okay. Management fees and those management fees cover salary and overhead and flights and, you know, all the things that just run day to day operations of the fund.
Peter: Okay.
Jon: Okay.
Peter: And so to an extent, like a VC is getting paid based on that management fee. Right? That pays their salary and their their benefits and those kinds of things. But they don't get to participate in what's called carry until all of the management fee has been paid back. Plus all of the money that they've they've invested. Right. And or in other words, if I have $100 million fund and I if I take 20 million of that and the management fee and 80 million of that and I invest it, I'm going to return the entire $100 million before I get compensated with carry on in a way like management fee is almost like a loan from
Peter: investors to say, Hey, here's some money to cover operating expenses. The way we're really going to compensate you, though, is on the carry and so carry.
Jon: Other VCs that don't take a management.
Peter: Fee.
Jon: Like Andresen Horowitz would they just say, hey, we want to.
Peter: Maximize carry now? I mean, everybody takes management fee.
Jon: And a lot of VCs, maybe they're out of their money.
Peter: There are some funds where they are the sole LP, and so taking a management fee doesn't make sense because they're just, you know, like I'm the investor going to take my own money and pay myself. So yeah, so that that sometimes happens. But for the most part, yeah, most funds are going to take fee. And you're right, like some funds take a huge amount of compensation and management fee, right.
Peter: If you're managing a billion and you're five guys or five people right. And you're charging 2%, that's a big chunk of dough coming out every single year to pay you.
Jon: But also in your operating agreement, VCs have operating agreements, right? So it's called you could still say, hey, we've the right to take 2%, but maybe you only take 1% as a management fee, which means you could maximize your carry more. Or do VCs not do that?
Peter: It's less about like maximizing your carry and it's more about reducing how much you have to pay back ultimately. Right? Okay. That makes sense because again, it's kind of like a loan.
Jon: Like it's also, I assume, fund credit fund credibility. Does showing that you're taking lower management fees helps you raise another fund? I mean, ultimately your total rely or I mean.
Peter: Kind of about. Right like think about it. If you're an investor in a fund, you want to invest in a fund that's like like being cheap.
Jon: You want to a fund that wins.
Peter: You want to fund the wins, right? So you don't really care if they're being cheap or not. as long as like, they have the resources that they need to be successful. So if a fund says like, we only charge 1% management fee, but then they have a really hard time attracting really great talent and therefore like have a hard time attracting really a great deal flow and then they underperform.
Peter: Like you're like, well, that was a waste because you don't care as an LP about management fee unless the managers suck and they can't return it like all of your money plus a return, right? Yeah. That's the only time management fee really matters. Otherwise, like you're going to get paid back the management fee you've paid. Right? So that brings us to carry.
Jon: Okay.
Peter: So Carrie is like getting paid commissions on your investments. Okay? I make a good investment as a fund manager, and it performs really well and I generate a massive return for my investors. Carrie is like the percentage of that deal, that gets paid to me like a success fee, right? And typically it's 20% of the profits of the fund.
Jon: So two and 22% management fee, 20% of the profits. Yep. Profits are defined as but you're really just, you're not profit, you're just saying, okay.
Peter: So you go back to $100 million fund example, right?
Jon: You only take out if you only take out 5 million and your because your profit would be 95 billion. No you're cost me 5 million.
Peter: So you're so let's assume I'm on those $300 million example. Give me a break. I draw down $20 million in fees. Right now I've got $80 million to invest.
Jon: Okay.
Peter: and what I could do is I could do what's called recycling, which a lot of funds do, but like, I make an investment and it performs well and I get money back and then I take that money I got back both the principal I put in, plus the profits from that investment, and I reinvest it into other deals.
Peter: So a lot of funds are able to get from 100 million minus management fees and they reinvest they recycle capital back up to 100 million. So let's say.
Jon: Maccabees, don't they? Do they are they recycling or are they just, they're returning the funds and then the LPs are saying, let's reinvest.
Peter: Like No, no, no. The fund will actually they won't distribute. Okay. So they'll just take the money comes back to them and they immediately push it back out to another investment. That's like recycling. But okay, so for for simplicity's sake, let's say I have, $100 million fund and I take the $100 million and I three exit. Okay, So now I've turned it into $300 million.
Peter: Okay, well, first thing that happens is right off the bat, the first hundred million is going back to my LPs first, right? I don't get any of that.
Jon: So the if the carry is exactly 90 or the return, the fund is closed and returns exactly 98 million.
Peter: So we're assuming you get 5 million.
Jon: You're going to get 300 million. But in this case it was only 98 million. We get nothing.
Peter: You get nothing.
Jon: In 300 million.
Peter: You would get the first 200 million goes back right. Okay. And then every dollar above that 100 million gets split 8020. Okay. So if I returned, you know, if I, if I made my $100 million fund, $300 million total return to investors, then I'm going to walk home with 20% of the 200 million. So 40 million. And that's ultimately how I should be compensated as an investor.
Jon: Okay. How is that Kerry, divided up in a firm like let's just say there's the carry was 10 million Yeah on the fund that the fund gets.
Peter: Yeah so every firm's a little bit different but Kerry is generally paid to the general partners of the fund.
Jon: Only the general partners.
Peter: It doesn't have to be, but but generally.
Jon: So if someone's a an analyst.
Peter: So typically analysts and associates don't receive.
Jon: Kerry Okay, I did not know that.
Peter: Some do, some don't, but it's pretty rare. Usually it's a non carry position. You basically in a venture fund, you have two tiers of people that work at a fund, you have partners and you have non partners. Okay? So non partners are going to be analysts, associates, Secretary CFOs, right. Like those types of Yeah.
Jon: A CFO would not get would not get Kerry.
Peter: Probably not.
Jon: Okay.
Peter: Now granted every firm's a little different so like I can't make a blanket statement there. Okay. But but yeah like you have, for lack of a better term, like support staff, right? And they're getting paid a salary and usually and oftentimes it's they're getting paid very well, right? They don't have access secured. The next here is partner or partner track so that would be like vice president or principal partner or managing partner or managing director.
Peter: Director. Right. All those types of titles, those will typically have.
Jon: Kerry Okay.
Peter: And and when I say partner track, right, it's like if I'm a principal, the idea is I've been brought in, I'm going to get some. KERRY But really the long term goals for me to become a general partner in the fund and share more heavily in the Kerry and there are some firms where it's like only the general partners get the Kerry.
Peter: Okay. In terms of how it gets split up, again, that varies, right? So this is a big debate within venture funds. And one of the issues that that causes venture funds to implode or to struggle is because the senior partners that have been at the fund the longest. Right. They're like, well, I deserve a bigger share of the Kerry, even if they're not necessarily driving the value today.
Peter: Yeah, because they're you know, they're kind of on the beach, they made their money, blah, blah, blah. Right. And so Iraq buyers and then you have the junior guys and they're the white and women and they're the ones that are out there like, you know, pounding the pavement, sourcing the deals, doing the diligence and rolling up their sleeves and they get us mark out of the Kerry.
Peter: And so oftentimes what you see happen is that that junior layer, if they don't feel like they can eventually get up to the top layer, they'll leave and they'll go to either another firm or they'll start their own firm.
Jon: Okay. Yeah.
Peter: And so that's that's very common within the industry. It's very.
Jon: Pretty hard to become a principal that often right, is.
Peter: Pretty hard, yeah.
Jon: Is it harder to get into the NBA or to become a principal?
Peter: That's a good question. What is your guess is there are as many jobs in professional sports as there are in venture capital. Okay. So probably equally as hard.
Jon: Okay. So if you may, well, if.
Peter: You think about it this way, like that's an all venture capital. So if you scrape out, like all the support staff, so analysts and associates and everything else, I mean, that probably makes up, but I don't know, at least a third, maybe two thirds of the industry from a employment number. So, okay, cut your your numbers in half there.
Jon: Okay. What's the hurdle rate and does it affect Kerry?
Peter: So sometimes funds will have a hurdle rate and the way a hurdle rate works is like you don't have to return just 100 million. You also have to hit some sort of hurdle before you start getting Kerry. So maybe it's like 5%. So I got to return $105 million. If it's simple or if it's compounding, then it's, you know, 5% IRR that you've got to hit.
Peter: And so it could end up being like 150 million. You turn before you get Kerry, but then you have you have catch up clauses. So the way those work is, I get let's say I returned 150 million every dollar that gets returned, about 150 million, and then gets paid to the VCs. Catch them up on a Kerry basis until they get 10 million, which would be 20% of the 50.
Peter: Yeah. So you think about it this way. Like the first hundred and 50 goes out to LPs, then the next 10 million after that gets paid out to is exclusively. And then anything above 60 gets paid out 8020.
Jon: Okay What about clawback? Does clawback effect the hurdle rate?
Peter: Yeah. So clawback occurs and one of two well, in two different cases. So there are two different ways that Kerry gets paid, like when Kerry gets paid out. There's the American waterfall and there's the European waterfall. Go under an American waterfall. It's on a deal by deal basis. So every deal like let's say we invest in Spotify and Spotify goes from, you know, $1,000,000 investment to $10 million investment.
Peter: Right. Well, our check on a Kerry perspective on that under American waterfall would be 20% of that $9,000,000.8 million. And then we get like when that happens, we get paid that back and then like our next deal would exit and we you know, and so on and so forth. If you have a successful fund, it doesn't really matter if you do a European or American like you're going to get paid back.
Peter: You're going to make the same Medicare. At the end of the day, American tends to be European. On the other hand, you have to return all that. The whole 100 million that you invested, that all has to be returned first before you get a single dollars. ABC So ultimately, like on our example, if you have a fund that's 100 million turns into 300 million, you're still going to get the same 40 million of Kerry under both models.
Peter: But under American, you're going to get paid sooner. Okay? Under European Union, you pay later. Under American is more risky because what if Spotify does really well and then every other company we invest in fails? Well, I just cashed out $1.8 million in Kerry and then I lost all the rest of my my investors money. Right. So now they're ticked, right?
Peter: They're like, well, you should have been compensated for that because you lost all of our money on all of your other deals. So what they'll do is they'll have clawback provisions which basically say, hey, you know, that 1.8 million that we gave you. Yeah, well, you lost all the rest of our money. So we want that 1.8 back.
Jon: Okay.
Peter: So that's a clawback.
Jon: So in the Spotify example, when that checks paid out, as a VC, you do not actually spend the money then because that would be like. Or does that go into like a special fund?
Peter: You could spend it, but then you're still going to be on the hook if your other investments don't pan out.
Jon: So, okay, so what do you what would you most VCs let's not ask about? What would you would do, but what? Well, we.
Peter: Don't most VCs don't operate under an American waterfall system.
Jon: Okay.
Peter: That's mostly private equity funds do that. The reason they don't is because it's kind of risky, right? Private equity tends to be less risky than venture. Yeah, but, yeah, I mean, I think somebody sees they invest it, spend it. Some VCs hold it. I mean, I don't I honestly don't know, because that's not a problem that I've had to deal with.
Peter: Okay. So the other clawback provision that exists is in a European waterfall, you do get paid out. Oftentimes you're going to get paid out a little bit early. And that's because as a VC you have different tax obligations because your fund is performing really well, hopefully. Right. But it's all paper gains. And so but you, because of the way you get compensated, right?
Peter: Like there's this like almost like phantom carry that's out there. And so you have to pay taxes on it. And oftentimes what VCs will do with their owl piece is negotiate, Hey, let's get compensated, like give us enough to just cover our tax burden. Right? And then once the returns actually come in, like, then we'll settle up at that point.
Peter: And so if but if the returns don't end up coming in, then there could be a clawback to pull back that money that they paid you for taxes. But it's really rare.
Jon: So what's going to happen if the Federal Reserve gets their way and you can be taxed on unrealized capital gains? That would suck. Would that affect.
Peter: VCs? Yeah. Could cause DC is at a minimum, VCs are investors in their own funds.
Jon: And then you'd be subject to the capital gains rules. Yeah.
Peter: And so and then if you make it worse and you say that carried interest, well, carried interest is currently taxed at capital gains rates.
Jon: Okay.
Peter: Be taxed on that as well.
Jon: So if they're trying to target people like specific like Jeff Bezos and Elon Musk, a lot of these funds inherently are going to get caught up in that.
Peter: Potentially a lot of entrepreneurs, a lot of you see, I don't think it's a good move.
Jon: I don't think it's good move, but it's a win. I had a big like mind moment. I'm like, whoa, That would that would stifle innovation in America.
Peter: yeah, 100%. Yeah. All right. I mean, not to go off on a tangent here, but how do you pay taxes on something that you've you haven't actually received?
Jon: And why would you then buy stock that would be subject to unrealized gains? Just just move. Jeff Bezos. We'll move.
Peter: Everybody move. Okay. Well, what they'll do is they'll just vote their politicians out of the office and put in new ones and it'll get reversed.
Jon: Okay.
Peter: I mean, here's the thing. At the end of the day, if you haven't figured this out yet, the rich are never going to pay taxes because they'll figure out ways to not pay taxes. But the rest of us schlubs that are have to figure it out on their own.
Jon: A moment of silence. All right. Thanks, guys. Make sure you ask questions below if you got questions for Peter. Myself again, that's Peter Harris with the University Growth Fund, John Bradshaw and likens the scribe And we'll see you. See you again soon. Thanks.