Much like equity at a startup, venture capital firms utilize carry (or “carried interest”) to compensate and incentivize their general partners. Whether you’re a founder or thinking of becoming an investor, it’s good to know how carry works at a VC firm.
How does a GP get compensated?
At a venture capital firm, compensation for general partners is two-fold. The first component is the base pay, otherwise known as a management fee. This is a fee paid by the limited partners to the GPs and is a set amount used to pay all of the overhead expenses for operating a VC firm, such as salaries, travel, and rent.
The second component is carried interest, otherwise known as carry. This is the share of profits from an investment that is paid out to general partners at a VC firm. In short, it serves as the main performance motivator for GPs as it has high potential for a substantial payout, especially in funds with low management fees.
There are two scenarios in which carry is issued:
European style waterfall
This is when carry is applied to the whole fund. Say your limited partners contribute 10 million dollars to your fund to invest. In all, your portfolio is worth 15 million dollars. It doesn’t matter which investments did well and which incurred losses. Instead, the focus is on overall portfolio-level returns.
With this type of carry, there’s often no hurdle rate, also known as preferred return (meaning the required rate of return a fund is expected to make). All of the investors’ capital must be returned first before carry can be collected. In this scenario, if there is a hurdle rate, then all capital must be returned with some percentage before carry is collected.
American style waterfall
This is when carry is applied on a deal-by-deal basis. Say a venture capital firm makes 10 investments of five million dollars each. Of those 10 investments, five see a gain of two million dollars each, and four incur losses of one million dollars each. Because the carry is deal-by-deal, the general partners will collect carry on each of the successful investments’ gains and not have to consider the losses. Thus, the general partners will collect a total carry of two million dollars, assuming the carry is at a rate of 20 percent.
American style has a lower risk of everything going to zero, which may make it friendlier to GPs.
How carry works
Before GPs can make money from carry, the limited partners must make back their amount of invested capital from a fund and sometimes a hurdle rate must be met. After that, the carry comes out of any profit that is made.
How much profit is made from investments determines the amount of money that can be collected in carry. If an investment generates more profit, the carry will naturally be higher. Alternatively, if an investment generates a smaller amount of profit, the carry will be lower.
Limited partners that finance a fund determine the percentage of profit that will go toward the carry for GPs during fundraising. The ability to command higher or lower carry is based on how much LP demand there is for this specific fund (which is often based on background and prior fund performance). This percentage can range anywhere from 15 to 30 percent of the profits but generally hover around 20 percent. Keep in mind that the percentage is market-driven and can vary.
Things to consider
There are a couple of things to consider with carry. First is the tax treatment. Currently, carry is treated as long-term capital gains and taxed at a rate of 0 percent, 15 percent, or 20 percent—based on the GP’s income bracket.
It’s also important to be aware of the clawback, a contractual provision that may be triggered when there’s either a clerical error or otherwise that results in collecting too much carry. In case of a clawback, the GP is required to pay back the difference to the LPs.
Sometimes, at larger VC firms, carry can be subject to vesting for employees at the firm, similar to stock options for employees. For example, an employee might get 10% carry allocation that vests over a five year period. If they leave before the five years, they would only earn the amount that has vested over that time.
Ultimately, we highly recommend relying on trusted advisors such as fund administrators or attorneys for guidance on how to deal with and manage carry.
Why carry matters
Carry is a form of performance-based compensation that aligns with investor interest so that GPs find outperforming deals. Though there are numerous other ways that GPs can also get compensated, often a large percentage comes from carry.
DISCLOSURE: This communication is being sent on behalf of Carta Investor Services, Inc. (“Carta”), an affiliate of eShares, Inc. dba Carta, Inc. This communication is not to be construed as legal, financial or tax advice and is for informational purposes only. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.