Venture Capital Management Fees: The One Blog Version!

What do VC funds actually charge in management fees, and who cares?

The hypothesis:

The VentureSouth view: Venture capital funds and other similar funds that invest in early-stage companies (like our VentureSouth sidecar funds) charge a management fee that is calculated as follows:

  • 2% of committed capital for the “commitment period” (the period when new investments are being made, say five years), plus

  • 2% of (net) invested capital for the “harvesting period” (the period when old investments are being sold, say the second five years).

We’ll call this the “step-down approach” in this article.

Prompted by some recent discussions on “VC Twitter” we went back to see if the VentureSouth view was correct. We were surprised – and a little disturbed – to find out we were…possibly…wrong…

An alternative view: Venture capital funds traditionally and/or generally charge 2% of committed capital for the whole of the fund’s (typically 10 year) life.

Here are some recent examples of the alternative view:

  • Gyan Kapur telling us on Twitter that the traditional approach is to move down after the 10-12-year mark

  • Samir Kaji explaining (here and here) that 22-25% of capital goes towards management fees and expenses (so at least 2% per year for at least 10 years)

  • AngelList’s rolling funds generally charge “2% per annum over each fund’s 10-year life, payable quarterly over the first four years” (so 20% “total load” with the cash going out faster). (Yikes.) They say this is modeled on traditional VC fund practice.

So which view is right? In this article, we’ll unpack the evidence and share some other thoughts about who cares.

The evidence

Before I dived back into research, I thought the evidence would overwhelmingly support the “VentureSouth view.” My evidence included:

  • Advice from our counsel when we were forming the first VentureSouth sidecar fund in 2014 that the “step down approach” was typical.

  • Examples from nearby industries:

    • like the private equity fund industry, where the ILPA model documents, for example page 5 of the term sheet, definitely describe the step-down approach

    • like SBIC funds, where the SBA model agreement defines “management fee base” using the step-down approach.

  • Public guides on VC funds:

    • like at Seraf: “In most cases, this level of management fee [2% of committed capital] will be in place for a limited time period.  For example it might just apply for the first 5 years of the fund. This is the time period in which new investments are made and most of the follow-on investments occur. After the first 5 years, the 2% fee is usually based on the remaining invested capital (i.e. the amount of capital the fund has invested in active companies in the portfolio.) Over the life of this $50M fund, the fund will pay out in the neighborhood of $7.5M in management fees. That represents 15% of the fund’s original committed capital.”

    • or at Quora where the first answer is the step down approach: “This is usually 2% of the committed investment to the fund but declines after the fund is done investing in new companies – usually year 5 or 6. Starting after the end of the “investment period” the fee will decline annually based on a negotiated formula.”

  • Occasionally perusing offering documents from funds in the Southeast, angel sidecar funds from across the US, and other precedent documents we’ve collected over time.

  • And other analyses, where the assumptions seem (to me) more likely to be a step-down approach than a flat fee. For example, this post on recycling from VC godfather Brad Feld, which uses a standard 15% fee load – which is surely more likely a step-down approach than a flat 1.5% for 10 years, especially given this earlier article explicitly describing the step-down approach.

But as I dug into the evidence, it seems there is actually good support for the alternative view.

  • Views of generally well-informed capital allocators (like Samir), and of VCs that are trying to make the case (that they presumably believe) that their step-down approach (like Tyler) means they are offering VC funds at a 40% lower price than “traditional fees”.

  • Academic literature:

    • Katherine Litvak’s article Venture Capital Limited Partnership Agreements: Understanding Compensation Arrangements (University of Chicago Law Review, 2009), based on 68 fund agreements from 28 VCs, from over time (mean vintage 1997). These had nine different ways to calculate management fees, including the “classic flat fee”, a rising-then-falling fee based on deployed capital, the step-down approach, and variations on all three. The “most popular” of those is the classic flat fee (page 170 and see table 2), and the majority (38 of 69) were variations on that approach.

  • Other public notes:

    • Like the second answer on the Quora thread, which disagrees:  Normal fees are “2 and 20”–2% management fee, paid every year, based on your total commitment (even if they haven’t deployed all your capital).

    • Or this description.

    • Or anything from AngelList and their Rolling Fund managers as they try to prove their default economics are standard.

So who do you think has the better evidence?

Who do we think is right?

After considering this new evidence, I’m willing to concede that VentureSouth’s view was wrong and the step-down approach is very far from universal.

The most recent plausible survey that covers these issues that I’ve found is the “Different” report – source here. Though the sample size and some of the exact management fee bases are unclear, it seems that 66% of funds have a “dramatic decline” in management fee in the middle of the fund, which seems likely to be mostly the step-down approach.

We wanted to see if that was true of funds we know too. Excluding the VentureSouth funds (more on those later), 46% of southeastern early stage funds for which we have investment documents used the definitive step-down approach; about 20% were unclear (we only had high level marketing materials, not the legal documents needed to be certain); and the rest used something else – either a flat fee or some kind of hybrid declining basis.

Based on that best data we have, I think it’s probably fair to conclude that a majority, but perhaps only a small majority, of funds use the step-down approach.

That’s pretty staggering.

More nuanced answers

Perhaps there are also more nuances to add here? Maybe:

  • It varies by time. The flat percentage of committed capital approach might be an early or legacy structure? Seems possible given the somewhat dated academic literature showing the flat 2% model and the way this is called the “traditional” structure.

  • It varies by investment stage: maybe larger funds use the “step-down approach” and first time, smaller, or emerging manager funds use the traditional approach. This is certainly the view of this description, which thinks only larger funds might use the step-down approach. This could be plausible. There is a certain amount of “fixed cost” to managing a fund, and that might be too high to be covered from a percentage of capital deployed if the capital deployed was small. And perhaps larger and later stage VCs have investors comparing them to PE and SBICs, so cannot get away with the flat version that emerging managers can use with their (less sophisticated?) LPs?

  • It varies by geography: maybe some markets use the step-down approach but others stick with the “classic” version? Maybe institutional investors have more leverage over Silicon Valley funds, and so can force more step-downs, while smaller Southeastern LPs are at the mercy of fund managers on terms? Seems hard to come up with viable theses there, but perhaps there is at least some regional variation?

  • There are versions that are hybrids – “a bit of both” that complicate descriptions? For example, this post from Greenspring describes a management fee structure of 2.5% of committed capital in years 1-4, 1.875% in years 5 and 6, 1.25% in years 7-10%. We have other examples of this in our southeastern dataset too. Is that a step-down approach? Sort of, but not really.

It remains surprising that these issues are so opaque, the terminology so confused, and the data so lacking that these suggestions are so hard to evaluate.

Why does the “management fee base” issue even matter?

In the grand scheme of Life, the Universe and Everything, it doesn’t really matter how a management fee is calculated: great (and lucky) investors create great net returns; bad (and unlucky) ones do not. A variation in management fee base is clearly less important than the quality of the fund manager.

But on the margin things are not that simple.

First: Disturbingly often, investors pay these fees – and I mean pay them and don’t get them back again.

The theory is that an investor sees management fees repaid out of proceeds from investments, before carried interest (the share of the profits on a fund, and supposedly the main source of compensation for fund managers) gets paid.

The reality is that in a disturbing proportion of cases – because median returns to VCs are not that high – funds do not, or only just, return their invested capital. In that situation, the paid management fees remain with the poorly-performing fund manager.

In the Litvak article cited previously, “an average VC received about half of [its] compensation from the management fee, which…is either completely or largely unaffected by fund performance.” So as you look at a “downside return” case, you should care because this likely is money you won’t see again. The higher the fees, the bigger the deficit.

Second: every dollar from a fund that pays, or reserves to pay future, fees means one less dollar invested. If 20-25% of a fund doesn’t get invested, it’s a lot harder to generate a 3x net ROI to investors. You need to resort to other techniques (e.g. recycling proceeds) to make up the gap; techniques that (worst case) add even more risk to an already-risky proposition or (best case) delay your cash distributions.

Thirdly: less numerically, but still importantly, you need to understand your fund manager’s mindset. A 2% step-down fee covers the costs of running most funds, except arguably at the very smallest (<$5M) sizes. If the fund manager is paid more generously, why are they entitled to the more generous sum? Can you really believe someone with the 2% “traditional” flat fee – paid regardless of performance or how the fund goes – is going to hustle, work hard, and operate in your best interest?

How big a difference does the “management fee base” make?

Obviously the best analysis of this question would look at results: do funds with a step-down fee base approach outperform other management fee bases, on a net (DPI) cash basis? Maybe great managers can provide better net returns despite flat fees just because their investing skills are so much better? I don’t think there’s data to tell us.

So instead let’s look briefly at the math from the “front end” of a fund:

  • 2% fee on committed capital for a fund for 10 years = 20% “total load” (2% * 10 years). On a $10M fund, that’s $2 million.

Total load jpeg.jpg
  • 2% fee on a step-down approach is harder to calculate, because it depends on the length of the investment period and the time to reach exits for the portfolio. Let’s take a hypothetical example of a 3-year deployment and linear decline in assets of a $10M fund. The fee there is $1.23 million, equivalent to a 12.3% “total load” – and $750,000 lower than the flat fee way.

  • Note that even if it takes longer to deploy and / or more capital stays outstanding longer, the very most the step-down approach could cost is 20% full load – same as the committed fee approach.

How big a difference is this? Again, it depends on the performance of the fund, but, for median / marginal performers, $770,000 in a $10M fund makes a material difference to net investor ROI.

This stuff matters.

Problems with the step-down approach.

The step-down approach is, in our opinion, the most appropriate management fee base.

  • It provides appropriate resources to pay for deploying the capital well, based on the amount that has to be deployed at the beginning.

  • The resources reduce once investments are deployed and work moves to monitoring, which still takes time and effort (adding value isn’t easy, you know), but arguably not as much as diligence and deal structing.

  • And the resources fall further still as the portfolio reduces in size and time requirements.

However, it’s not perfect. If you are thinking in detail, you might have identified a couple more areas where it creates bad incentives.

  1. An obvious danger is that an unscrupulous fund manager wants to keep the investment period open as long as possible, to milk maximum management fee by keeping the base on committed capital.

  2. A second bad incentive is to raise capital that can’t be deployed quickly. Although there are definitely merits to including “temporal diversity” (i.e. investing in vintages over time, as well as in geography, industry, fund managers, etc.), you can’t invest by leaving cash in the bank earning 0.01% interest (and -2% management fee). Fund managers might raise more money than they can actually deploy to maximize the fees.

  3. A third bad incentive inherent in the step-down approach is to delay writing off invested capital. The 2% applies to net invested capital; the “net” means the base is reduced by the cash invested in companies that have been written off. A fund manager might delay write-offs to keep collecting the fees.

  4. Lastly, fee gouging. A Limited Partnership Agreement for a venture capital fund might include something like this: The Fund shall also bear legal, audit and accounting, banking, and financial fees and expenses of the Fund; expenses relating to the Fund’s portfolio (i.e., interest on borrowed money, brokerage, registration of securities); and any extraordinary expenses of the Fund. You might (justifiably) wonder why these fees aren’t part of the management fee. This applies to all bases, of course, but you might think managers using a step-down approach are more likely to layer these fees on top because they have fewer resources. Could be true.

What can an investor do about these things?

Perhaps not much in many cases, beyond doing your diligence and trying to work only with reasonable fund managers!

However, remember that all this bad behavior would pale in comparison to taking the much higher flat fee! Even if a manager did as much as possible to maximize management fees on 1-3 above, they still couldn’t get above the 20% total load from the traditional approach! So perhaps sticking to managers that use step-down approaches would be sensible?

How do I use this information?

New people invest in venture capital and angel funds all the time, and it’s hard to know what’s standard vs. reasonable vs. unusual vs. egregious if you are a new investor.

Heck, we started this series of posts in the first place because what we thought was “standard” turned out to be investor-friendly.

Hopefully the series can help you evaluate fund managers. Naming no names, except where people make public claims, everything in this article is from real examples of management fee base claims and shenanigans.

Is a fund manager adequately incentivized in a step-down approach, or being greedy on a committed capital approach? (Yes, and yes, in our opinion.)

Is the fund manager whose term sheet says “The Manager will receive a management fee calculated at an annual rate equal to two percent (2%) of the committed capital of the Fund less the cost basis of all the Fund’s securities previously distributed in kind to the Partners, and the minimum annual management fee will be $150,000 [compared to a $10-25M target fund?]” doing something manager friendly (Yes on the committed capital), weirdly non-standard (Yes on netting just cost of distributions in kind. What about everything else?), and potentially egregious (Yes – $150k / year to administer a 1-2 company portfolio in year 9? Come on.)?

Is a 2.5% fee OK because the fund is small? (Maybe. But does $15M count as small?) Would it be OK on a committed capital basis? (Not in our opinion.)

Is the AngelList Rolling Fund approach (2% of committed capital for 10 years, paid out in the first 4 years) reasonable (No.), comparable to a “traditional VC” using the step-down approach (No – more expensive than the (slight) majority of VC funds), or sensible (No. What happens in years 5-10‽)?

Is the fund manager claiming their 12.5% total fee load is offering a 40%-off bargain – here, for example – making a legitimate marketing point? If you believe our earlier evidence, you might conclude “meh, not really”.

So as arcane as the “management fee base” topic is, we think a well-informed LP should be getting very precise answers from a potential fund manager about how they calculate the management fee – and reading as much into that as they need to.

To wrap up

So to wrap up this article in a few bullets.

  • We thought our step-down approach for VC management fees was universal market practice; it is not.

  • It turns out that many VCs are greedy (who would have thought that?!)

  • If you are considering investing in any early stage investment vehicle, you should pay close attention to the details. A “2% management fee” might be standard – but the devil is in the details.

Good luck making money, having fun, and doing good – and reducing your total load – when investing in early stage companies.