Management fees are a critical aspect of venture capital (VC) firms, ensuring a regular income for the firm, separate from the investment’s performance. These fees are typically a percentage of the fund’s total capital and provide a steady revenue stream. In this article, we will explore how new VC managers earn through these management fees, using a hypothetical scenario where a new manager oversees three successive funds: Fund I of $5 million, Fund II of $20 million, and Fund III of $50 million.
Venture capital management traditionally begins with smaller funds, which are simpler to raise and deploy. For many new venture capital managers, starting with a smaller fund serves as a proving ground, enabling them to demonstrate their investment acumen and operational capabilities without the pressure of a substantial fund. As these managers gain experience and a track record of successful investments, they can then quickly scale up, managing larger funds. Larger funds not only increase the capital available for investments but also boost the potential management fee income. It’s a strategic progression, enabling the managers to build their reputation, refine their investment strategy, and gradually attract more substantial investment capital. In our model, we see the fund manager moving from a $5 million fund to a $20 million fund and finally to a $50 million fund, demonstrating this typical growth trajectory.
The Power of the Management Fee Model
Most new venture capital managers work with a standard 2% management fee, but the actual structure can be tailored to meet their needs and those of the investors as outlined in the Limited Partnership Agreement (LPA). In our scenario, we will examine a management fee structure that starts with a 4% fee for the first four years, and then declines over the next six years, averaging out to 2% per annum over a decade. This model, known as the management fee waterfall, assures a reliable revenue stream, independent of the success or failure of the investments.
Our 10-year management fee waterfall looks like this:
- Years 1-4: 4%
- Years 5-6: 1%
- Years 7-10: 0.5%
Fund I: $5 MM
In the first year, the manager of Fund I charges a 4% management fee on the $5 million fund, earning $200,000. Over the next three years, the manager continues to levy a 4% fee, generating an overall income of $800,000.
From the fifth year onwards, the management fee starts to decline. Let’s assume that it decreases evenly over the next six years to maintain an average of 2% per year over the full decade. Thus, by the end of the tenth year, the total management fee from Fund I would equate to $1 million (20% of the total fund).
Fund II: $20 MM
After two years of managing Fund I, our manager initiates Fund II of $20 million. Now, they have two simultaneous sources of management fees. The management fee from Fund II, following the same declining fee structure as Fund I, would amount to $4 million over the ten-year period.
Fund III: $50 MM
Four years into managing funds I and II, our manager now launches Fund III of $50 million. The total management fee from Fund III, again maintaining the same declining fee structure, would be $10 million over a decade.
The Three Fund Trajectory
With this fee model, our new manager could generate the following income from each fund:
Year 1:
- Fund I: 4% of $5 MM = $200,000
- Yearly Total: $200,000
Year 2:
- Fund I: 4% of $5 MM = $200,000
- Yearly Total: $200,000
Year 3:
- Fund I: 4% of $5 MM = $200,000
- Fund II: 4% of $20 MM = $800,000
- Yearly Total: $1 MM
Year 4:
- Fund I: 4% of $5 MM = $200,000
- Fund II: 4% of $20 MM = $800,000
- Yearly Total: $1 MM
Year 5:
- Fund I: 1% of $5 MM = $50,000 (beginning of declining rate)
- Fund II: 4% of $20 MM = $800,000
- Fund III: 4% of $50 MM = $2 MM
- Yearly Total: $2.85 MM
Year 6:
- Fund I: 1% of $5 MM = $50,000
- Fund II: 4% of $20 MM = $800,000
- Fund III: 4% of $50 MM = $2 MM
- Yearly Total: $2.85 MM
Year 7:
- Fund I: 0.5% of $5 MM = $25,000
- Fund II: 1% of $20 MM = $200,000 (beginning of declining rate)
- Fund III: 4% of $50 MM = $2 MM
- Yearly Total: $2.225 MM
Year 8:
- Fund I: 0.5% of $5 MM = $25,000
- Fund II: 1% of $20 MM = $200,000
- Fund III: 4% of $50 MM = $2 MM
- Yearly Total: $2.225 MM
With these totals, it’s clear to see how the management fee structure can provide a consistent revenue stream to the venture capital firm, even starting with a small fund with rates declining after the fourth year. Starting new funds every two years helps to compound the earnings and offset the declining rates of older funds.
The Compounded Gain
This system’s elegance lies in the compounding management fees as each new fund is initiated. As each new fund begins, the manager is simultaneously collecting management fees from multiple funds. By the fifth year, with the introduction of Fund III, they are collecting fees from all three funds.
Over ten years, the total management fees earned would be approximately $15 million ($1 million from Fund I, $4 million from Fund II, and $10 million from Fund III). This compounding fee structure provides a significant and relatively stable source of income for the fund manager, separate from the potential profits from successful exits of the invested startups.
Conclusion
Venture capital can be a risky endeavor, with substantial returns often balanced by the potential for significant losses. New venture capital managers can mitigate some of this risk through the careful structuring of management fees. By using a declining waterfall fee structure and initiating new funds every two years, new managers can create a compounding effect. This approach ensures a steady income stream that can help support the firm’s operations and contribute to its financial stability.
This model is especially critical for new managers entering the venture capital space. While they navigate the complexities of selecting profitable investments, the management fee model can provide a financial cushion and contribute to the overall health and longevity of the firm. The resulting financial stability can enhance the manager’s reputation, attracting more investors and leading to larger future funds.
Remember, the venture capital world is about more than just picking winners. Financial management, including the judicious use of management fees, plays an integral role in a firm’s success. As new managers gain experience and increase the size of their funds, their fee-based income will grow, providing a firm foundation on which they can build a prosperous venture capital career.