Venture capital funds are the heartbeat of startup dreams, and understanding how they tick can be a game-changer. Whether you’re eyeing VC investment, aiming for a job in the industry, or just curious about the financial magic behind startups, this guide breaks it all down in an easy-to-digest way. Let’s dive into the basics of VC fund economics, from how they work to who gets paid and why, covering the key aspects without overwhelming details.

What Is a Venture Capital Fund?

A venture capital fund is a pool of capital collected from multiple investors, known as Limited Partners (LPs), and managed by a professional team, called the General Partner (GP). The GP’s role is to invest this capital in high-potential startups, aiming for significant growth and returns.

LPs: They provide the capital but don’t get involved in the decision-making. Think of them as passengers on the investment train.

GPs: They manage the fund, make the investments, and guide the startups toward success. They’re the drivers of the train. 

Disclaimer: For the purpose of this article, we assume the GP also acts as the managing company of the fund, though in practice, this may not always be the case.

Capital Commitments vs. Capital Contributions (No, They Don’t Take All Your Money at Once)

Imagine we’ve secured some top-notch LPs and raised a $100 million fund. Exciting, right? But does that mean we have $100 million sitting in the fund’s bank account from day one? No, most likely it’s close to zero. When an LP commits to a VC fund, they make a capital commitment—a promise to invest a specific amount, say $10 million per LP, over the life of the fund (typically around 10 years). However, they don’t provide the full amount upfront. Instead, they contribute in smaller installments whenever the GP requests it through capital calls, which can be as simple as an email outlining a sum of the potential deal the fund intends to invest in. This process unfolds as investment opportunities arise, and the fund deploys capital as needed.

Example:‍

You’ve promised to invest $10 million, but the GP only needs 10% of that to start. So, you’ll transfer $1 million when it calls for it. As more investments are made, it will call for more of your committed capital.

This staggered system helps LPs manage their cash flow while giving the fund flexibility to invest when opportunities arise.

Management Fees or How the GP Pays Its Bills

VC fund managers (the GPs) don’t work for free—after all, someone has to keep the lights on and ensure there’s an endless supply of caffeine for those long hours spent searching for the next unicorn. To cover operational costs, GPs charge management fees, typically around 2-3% of the total committed capital. This fee goes toward paying salaries, keeping the office running, and maybe funding the occasional team karaoke night (with some questionable song choices, no doubt).

Of course, there are different ways to structure these fees, but let’s look at a typical example.

Example:‍

If the fund size is $100 million and the management fee is 2%*, the GP will collect $2 million per year, which adds up to $20 million over the fund’s 10-year life. That means only $80 million is left for direct investments, while the remaining $20 million covers the GP’s operational needs.

‍*The 2% is an average over the life of the fund. Typically, GPs charge a bit more in the early years when they’re actively investing and less later when things slow down. But on the whole, it balances out to around 2%.

Carried Interest: The GP’s Real Payoff

Now, let’s talk about carried interest — this is where the GP makes the real money. Carried interest is a share of the profits that the GP gets when the investments are successful. It’s usually around 20% of the profits after the LPs have been paid back their original investment.

Example:‍

Let’s say the fund invested $100 million and, a few years later, those investments are worth $500 million. After returning the $100 million to the LPs, there’s $400 million in profit. The GP takes 20% of that, which means $80 million in carried interest for the GP.

This is the GP’s big reward for picking the right startups and guiding them to success.

The Origin of the Term “Carried Interest”

The term “carried interest” comes from the good old days of sailing, when things were a bit more dangerous (think storms, pirates, and scurvy). Back then, ship captains and their crews would get a cut of the profits from the cargo they literally carried once it was sold. It was a risky business—far more dangerous than navigating today’s startup ecosystem (though some might argue it’s a close call). Nowadays, instead of dodging pirates, GPs navigate spreadsheets. But the idea is still the same: they get a share of the treasure once the journey (or investment) succeeds. Hence, “carried interest.” Fewer sword fights, more pitch decks.

Waterfall Distribution: Who Gets Paid First?

When it comes to splitting profits, the order is known as the waterfall structure. There are two main types:

1. European Waterfall: LPs get their full investment back before the GP sees any carried interest. It’s like LPs getting the first slice of cake, and only after they’re full does the GP get its piece of the remaining cake. Back to our example, if the fund makes $500 million, the first $100 million goes to the LPs. Only then does the GP take its 20% cut from the remaining $400 million.
2. American Waterfall: The GP can start earning carried interest on individual successful investments even if the entire amount invested by LPs hasn’t been returned yet. Think of it like Americans being the eternal optimists—grabbing a slice of cake as soon as it’s ready, even if the whole cake hasn’t been served yet. For instance, if one investment returns $50 million in profit, the GP might take its 20% carry on that $50 million right away, even if the LPs haven’t yet received their full $100 million. This allows GPs to start earning sooner, but it can be riskier for LPs who might not get their full investment back before the GP starts benefiting.

Clawback: A Safety Net for LPs

To keep things fair, most funds include a clawback provision. If the GP takes too much carried interest early on (because some early investments did well) but later investments don’t perform, the GP might need to return some profits to the LPs.

Hurdle Rates: Setting a Minimum Performance Bar

In some funds with American Waterfall, there’s a hurdle rate or preferred return that the GP has to meet before it can start earning carried interest. This means the LPs get a minimum return (usually 8%) before the GP takes its cut.

Wrapping It All Up

In a nutshell, venture capital funds balance risk and reward: LPs invest and get repaid first, while GPs manage the fund and earn from big wins. GPs collect management fees to cover their costs, but their big payout comes from carried interest—when the fund hits it big, they share in the profits. It’s like LPs supply the cash, and GPs cook up success. Understanding how capital flows, fees work, and profits are split helps you see why GPs are motivated to find the next big winner. It’s the high-stakes game of startup finance, where everyone hopes to land on a winning square.