Welcome to another edition of VC Like ABC. In this article, I break down exactly how VC funds make money.

Before we get into it, here's an overview of what to expect:

How the management fee works, how carry works, and most importantly, what those two things tell us about why VCs behave the way they do and what their incentives are. By the end of this, the next time a VC passes on a great company or seems more obsessed with exit timelines and hypergrowth than revenue, you'll understand why.

In my last post, I broke down how VC funds are legally structured: the management company, the GP entity, the limited partnership, and how they all fit together. If you haven't read it yet, start there. It will help you understand this one better.

VC funds primarily make money in two ways: management fees and carried interest.

First, the management fee. This is money paid by the fund's investors to the management company to cover the cost of running the fund. It's typically 2% of the fund's total committed capital, paid annually, regardless of the fund's performance.

The second is carry, short for carried interest. This is typically 20% of the fund's profits, paid only upon exit.

It's worth noting that 2 and 20 is a guide, not a rule. Some funds negotiate lower carry, some have higher or lower management fees. The exact figures are agreed upon between the GP and the LPs. What we're covering here is the standard structure, but every fund is slightly different.

Before we go further, I’d like you to keep this at the back of your mind.

Throughout this post, you will read two terms: committed capital and called capital. They are not the same thing.

Committed capital is the total amount LPs have promised to invest in the fund. Called capital, sometimes referred to as paid-in capital, is the amount that has actually been requested, sent, and deployed.

LPs don't wire the full amount they commit upfront. Capital is called in tranches over time as the GP identifies investments and incurs expenses. So a fund might have $50M in committed capital but only $20M called at any given point.

Now let's talk about how carry and management fees work in practice.

The management fee is the fundamental fee that VC funds get paid. It's what keeps the lights on and the fund running.

It's typically 2% of the fund's committed capital, paid annually.

Let's consider a hypothetical firm, ABC Ventures, which has raised $50M. That's 2% of $50M, which is $1M per year. That money isn't profit for the partners. It covers the firm's operating expenses: salaries, office space, travel, legal fees, due diligence costs, and everything else it takes to run a fund day-to-day. It is an operating budget.

But here's the nuance that most introductions to VC skip: that fee doesn't always stay at 2% for the full life of the fund.

Most funds operate in two distinct phases.

The investment period, usually the first five years, is when the GP is actively deploying capital: finding companies, writing checks, building the portfolio. This is the most work-intensive period, and the full 2% management fee reflects that.

Then comes the harvest period, roughly years six to ten, where the GP is no longer deploying new capital. They're managing existing positions, supporting portfolio companies, and waiting for exits. Because the workload reduces significantly at this point, most fund agreements include a management fee step-down. During the harvest period, not only does the percentage rate often drop from 2% to 1.5% or even 1%, but many funds also shift the basis for that calculation.

During the investment period, the fee is charged on the total committed capital, i.e the full amount LPs promised to invest. In the harvest period, it often shifts to net invested capital, the amount actually deployed into companies. Since some capital is always held in reserve and some investments will have been written off, net invested capital is typically smaller.

The result is a meaningful reduction in fees that reflects the GP's reduced scope of work.

Here's what the total management fee looks like over the life of ABC Ventures, our example fund that has raised $50M.

And this is paid before the fund makes any profits.

This is something important to understand about management fees: a VC fund can collect fees for a decade even if every single portfolio company fails. The fee runs regardless of performance. The management fee is designed to be just enough to run the fund. It's a salary, not a windfall. The real money is in carry, and carry only comes from exits.

LPs are trying to strike a very specific balance. They want GPs to be well-resourced: able to pay competitive salaries, hire the best people, get an office, and travel to meet founders. A fund that's constantly scrambling to keep the lights on can't focus on finding the next great company. But at the same time, they want to keep GPs hungry. So the structure is designed so that the bulk of a GP's real upside is tied up in carry.

Where this breaks down is at scale. If you're running a very large fund, 2% of committed capital can be an enormous number, enough that the management fee alone becomes genuinely lucrative regardless of how the fund performs. This is where many VC funds start to look more like traditional asset managers. Their real business becomes managing capital rather than being incentivised to find the best companies possible. The same thing can happen if a GP has multiple funds running simultaneously, each generating its own management fee. Suddenly, the incentive to chase carry isn't as strong as it was designed to be. It's one of the structural tensions in the industry that doesn't get talked about enough.

One more thing worth knowing about management fees. GPs sometimes earn additional fees directly from portfolio companies — such as board, monitoring, or transaction fees for helping a company close a deal or raise capital. In many institutional fund agreements, some or all of these fees are offset against the management fee. So if a GP earns $200K in board fees from portfolio companies in a given year, the management fee paid by the fund might be reduced by that amount. This is called a management fee offset, and it's a mechanism LPs use to ensure that the ancillary income the GP earns from the portfolio reduces the fund's cost burden rather than becoming an additional income stream on top of it. The offset percentage varies by fund, but 50%–100% offsets are common in institutional funds. It's one of the line items worth paying attention to when reviewing a Limited Partnership Agreement.

Something to note for aspiring investors: if you invest in a fund of funds rather than directly in a VC fund, you will encounter a layered fee structure. The fund of funds charges its own management fee and carry on top of the fees charged by the underlying funds it invests in. In practice, this means you are paying two sets of fees for access to the same pool of investments. It doesn't make fund of funds a bad investment; there are genuine diversification and access benefits, but it is a cost worth understanding before you commit capital.

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The term "carried interest" is older than venture capital itself. It has a fascinating origin and dates back to the 16th century, when European merchant ships were sailing to Asia and the Americas. The captain of the ship would take a 20% cut of the profits from the goods they carried across the ocean as payment for the risk of getting it there. That's where the name comes from.

Five hundred years later, VCs still use this concept.

Now let's break down how carry works, because simply knowing that it's 20% of profits doesn't tell you very much on its own. The more important question is: 20% of what, paid when, and in what order?

To answer that, we need to examine three concepts:

Let's take them one at a time.

Some VC funds have what is called a preferred return, or hurdle rate. These two terms are used interchangeably and refer to the same thing: a minimum return that LPs must receive before the GP sees a single dollar of carry. The typical rate, where it exists, is 8% per year, compounded annually.

One important point is that most VC funds don't have a hurdle rate. This is different from buyout and growth equity funds, where a preferred return is essentially standard. In venture capital, it's less common, and the reason comes down to time. Early-stage VC investments can take 10 years or longer to reach an exit. Adding a hurdle rate on top of whole-fund carry would mean GPs could wait 15 or even 20 years before seeing any carry at all. Most GPs and LPs agree that's too long, and it makes it very hard to retain talent at VC firms. Where hurdles do exist in VC, they're usually applied at the whole-fund level rather than on a deal-by-deal basis.

The next part gets a little into the weeds, but stick with me because it explains something important about how VCs actually behave with their portfolio companies.

The hurdle rate debate isn't just about timing. It's also about how it shapes GP behaviour. A GP without a hurdle rate is compensated primarily based on value creation. How much did the fund return overall? That's what matters.

A GP with a hurdle rate has to think about both value creation and time, because the clock is running on that 8% annual return from the moment LP capital is called.

This changes how they manage the portfolio. A GP on the clock is more likely to push for earlier exits and make quicker decisions on underperforming companies. Whether that's a good thing depends on who you ask, but it makes a real difference in how VCs approach their portfolios.

This is part of why institutional LPs like endowments and pension funds push for hurdle rates even in VC. They measure fund performance using IRR (internal rate of return), a metric that accounts for both the size of the return and how long it took to get there. Because they think in IRR terms, they want GPs to consider time as well. When they have the negotiating leverage to demand a hurdle rate, they often do.

Here's what a hurdle rate looks like in practice.

Let's go back to ABC Ventures. The fund raised $50M. At an 8% compounded preferred return over 10 years, LPs would need to receive approximately $108M in total distributions, including the return of their original $50M capital, before the GP becomes eligible for any carry at all. The fund needs to more than double its invested capital just to clear the hurdle. That's a high bar, which is part of why many VC GPs push back on it.

If that felt like a lot, don't worry. The key takeaway is simple: where a hurdle rate exists, the GP must meet a meaningful return threshold before earning a penny of carry.

Once LPs have received their capital back plus any preferred return, many fund agreements include what's called the GP catch-up. At this point, the GP receives 100% of any further distributions until the fund's economics are brought back into alignment with the agreed 80/20 split.

Let's make it concrete. ABC Ventures returns $150M total. That's $100M in profit on the original $50M invested. Here's how the money moves:

The catch-up exists so the GP doesn't get permanently shortchanged by the hurdle. Without it, the GP would receive nothing until the hurdle is cleared, then immediately flip to an 80/20 split, leaving them with less than 20% of total profits. The catch-up corrects for that.

One small but important point: when you hear "20% of profits," the exact definition of profits is always governed by the limited partnership agreement. Management fees, fund expenses, recycling provisions, and other fund-specific terms can all affect what counts as distributable profit. The headline number is the starting point, not the full picture.

One of the fund-specific terms that can meaningfully affect what counts as profit is the recycling provision. Recycling is when a fund takes proceeds from an early exit and reinvests them into new companies rather than distributing them to LPs immediately. It allows the fund to deploy more than its original committed capital over its lifetime. For example, if ABC Ventures invests $10M in Company 1 and sells it for $20M in year two, a recycling provision might allow the GP to reinvest some or all of that $20M into new deals rather than returning it to LPs. The practical effect is that the fund can make more investments than its committed capital would otherwise allow. For founders, this matters because it affects how much dry powder a fund can actually deploy. Not all funds recycle. When a fund does, it is usually capped at a certain percentage of committed capital and governed by specific rules in the LPA.

While 20% is the standard carry rate, some of the most successful VC funds charge more. Certain top-tier funds charge 25% or even 30%, usually kicking in only after the fund has hit a return threshold, such as 3x invested capital. Some funds also offer LPs a lower management fee in exchange for higher carry. The exact structure is always a negotiation. What we're covering here is the standard and how it works in practice, not the ceiling.

A key part of understanding how carry works is understanding the waterfall. Understanding the exact order in which that money flows is what makes the whole picture click.

The waterfall is the sequence in which money is distributed when investments are realised. It doesn't happen randomly. There's a strict order, laid out in the limited partnership agreement, that governs who gets paid what and when. Think of it as a series of buckets. Each bucket has to be full before the next one gets anything.

There are two main waterfall models you'll encounter in VC. The first is whole-fund carry, also known as the European model. The second is deal-by-deal carry, also known as the American model. The difference between them matters more than most people realise, and not just if you're an investor. If you're a founder, which model your investor operates under affects how motivated they are to push for your exit at different points in the fund's life.

This is the more LP-friendly model and the standard for most institutional VC funds. Under whole-fund carry, the GP receives carry only after the fund's capital has been returned to LPs. Every investment in the portfolio is looked at together, not individually. Winners and losers are netted against each other. The fund lives or dies as a whole.

Let's run this through ABC Ventures. The fund invested $50M across three companies.

Total invested: $50M. Total returned: $100M. Total profit: $50M.

In the example above, ABC Ventures does not have a preferred return, so the waterfall moves directly from return of capital to the 80/20 profit split. In funds that do have a hurdle rate, two additional steps sit between those two: first, LPs receive their preferred return on top of their capital, and then the GP catch-up kicks in before the 80/20 split begins. The sequence is always the same: return of capital, preferred return if applicable, GP catch-up if applicable, then the final split. What changes is which steps are present.

Here is how the money actually moves. The GP sees no carry until year 9, when Company 3 exits and the full $50M of LP capital has finally been returned. The $20M loss on Company 2 is absorbed by the fund as a whole, offset by the gains on Companies 1 and 3. Only once every LP dollar is back does the 80/20 split kick in. The GP's $10M in carry represents 20% of the $50M total profit.

This model is clean, straightforward, and fair. Which is exactly why LPs prefer it.

This is the more GP-friendly model. Instead of waiting for the whole fund to be returned, the GP receives carry as each individual investment exits. Every deal is evaluated on its own.

Using the same example, let's see how it plays out under deal-by-deal carry.

Company 1 exits in year 3 for a $30M profit. The GP takes 20% carry immediately: $6M in year 3. Company 2 goes bankrupt in year 5. No profit, no carry. Company 3 exits in year 9 for a $40M profit. The GP takes 20% carry: $8M in year 9.

Total carry paid to the GP across the fund's life: $14M.

But here's the problem. The fund's total profit was $50M. The GP's actual entitlement is 20% of $50M, which is $10M. The GP has been overpaid by $4M.

This is where the clawback provision comes in. The clawback requires the GP to return any excess carry to LPs at the fund's final liquidation, the terminal event that closes everything down. In theory, this makes deal-by-deal carry fair over the long run. In practice, it creates a genuinely messy situation.

By the time the clawback is triggered, years may have passed since the GP received that early carry. They may have already paid taxes on it, distributed it among partners, or spent it. When a clawback occurs, GPs are typically only required to return the carry net of taxes already paid. That means LPs rarely get the full amount of the overpayment back.

This is why many funds establish what's called a clawback escrow. A portion of the carry, often between 10% and 20%, is held in a separate account for the life of the fund rather than distributed to the GP immediately. It acts as a reserve, a pot of money that can be used to settle any clawback obligation without requiring the GP to reach into their own pocket years later. It's a practical solution to a structural problem, and it's one of the details that signals whether a fund has been set up thoughtfully.

It's one of the less-talked-about but genuinely important risks of deal-by-deal structures, and a significant reason most institutional LPs push hard for whole-fund carry.

One more thing worth knowing. Most VC funds have a fixed term of ten years, but extensions are common. When a fund runs past its original term, the GP and LPs sometimes renegotiate the terms of the arrangement, including management fees and, in some cases, carry. A fund that has been running for twelve or thirteen years with unexited positions creates a different set of incentives than one in year six. The waterfall mechanics stay the same, but the conversations around them can get complicated. If you're an LP or a founder with a long-standing investor relationship, it's worth understanding that fund extensions aren't just administrative. They often come with renegotiation.

Which model will you encounter? Whole-fund carry is the standard for most institutional VC funds globally, and increasingly the expectation of sophisticated LPs. Deal-by-deal carry is more common in SPVs, syndicates, and emerging-manager structures, though it is still used by some established US venture and growth equity funds, particularly those with longer track records and sufficient leverage with their LPs to maintain GP-friendly terms. If you are unsure which model applies, it is always worth asking before you take the money.

As a founder, the practical implication is this. In a whole-fund model, the GP's personal upside is tied to the survival and growth of every single remaining asset in the portfolio until the very end. They need everything to perform before they see carry. That means they are incentivised to support every company in the portfolio, not just the ones that have already exited. In a deal-by-deal model, the GP has already de-risked their own personal economics once a few winners exit. Their urgency around your exit specifically may look different. Knowing which model your investor operates under is a good question to ask before you sign the term sheet.

There is one more concept worth covering before we get to the big picture: the GP commit.

When a GP raises a fund, they are not just managing other people's money. They are expected to put some of their own money in, too. This is called the GP commitment, and it typically represents 1% to 3% of the total fund size. In ABC Ventures, a 1% GP commitment on a $50M fund means the GP is contributing $500K of their own capital alongside the LPs.

Why does this exist? There are two major reasons.

The first is alignment. A GP investing their own money thinks differently about risk than one who is purely playing with other people's capital. When the fund loses money, they lose money too.

The second is signalling. A GP who is unwilling or unable to commit meaningful personal capital is a yellow flag for sophisticated LPs. It raises a simple question: if you don't believe in this fund enough to put your own money in, why should we?

In practice, the GP commit can be genuinely hard for emerging managers and first-time fund managers. Coming up with $500K to $1M of personal capital at the point of launching a fund, before any management fees have been collected, is a real constraint. And honestly, it increases the barrier to entry for diverse and emerging managers. It's part of why many new funds simply don't exist. The people who would build them can't afford the commitment. It's often the first conversation that gets complicated in LP negotiations, and it's one of the reasons why first-time fund managers frequently raise smaller funds than they originally planned.

Some GPs fund their commitments using a loan secured by expected future carry, a structure sometimes called a capital call facility or a GP commit loan. It's worth knowing this option exists, though it adds complexity and not all LPs are comfortable with it. I've also seen situations where an emerging manager was impressive enough that LPs were willing to waive the GP commit requirement entirely. So, like most things in fund formation, it comes down to negotiation and the strength of the relationship.

There is also an indirect connection between the GP commitment and the clawback. In some fund structures, the GP's committed capital serves as a partial clawback reserve. If a clawback is triggered at the end of the fund's life, the GP's capital in the fund can be used to offset the obligation before the GP must reach into personal funds outside the partnership. It's another reason why the GP commitment is not just symbolic. It has real structural consequences.

The GP commit is not just a formality. It's one of the clearest signals of conviction a fund manager can send.

Now that you understand how VC funds make money, a lot of things that might have seemed confusing or frustrating about investor behaviour start to make sense. This section explains why.

Carry is calculated on profits. The more of a company a VC owns, the more of the upside they capture when it exits. That's why VCs push back on high valuations at early stages. It's not irrational. It's math. If a VC invests at a high valuation, they get a smaller ownership stake for the same check size, which means less carry on exit. When a VC negotiates hard on price, they are protecting their economics, not just being difficult. And it plays into their larger portfolio construction model.

This one surprises founders the most. A company can be genuinely good and still get a no.

Fund size and portfolio construction matter enormously. A $50M fund writing $500K checks needs enough companies to build a diversified portfolio, but not so many that no single winner can move the needle on fund returns. Remember the power law. A company might be a great business, but not venture-scale. Or it might be venture-scale but not the right fit for where the fund is in its lifecycle. A GP in year four of a ten-year fund is still actively deploying. A GP in year six is not. The timing of when you pitch matters as much as what you're pitching. Always ask investors where they are in their fund cycle: are they raising a new fund? How long have they been deploying? Are they actively writing checks? These questions matter more than most founders realise.

Carry only triggers on realised gains. Paper valuations don't count. A company doing $50M in annual revenue with no clear path to an exit is not generating carry for its investors, no matter how well the business performs. This is one of the genuine tensions in the founder-investor relationship. Investors are incentivised to exit their investments, and that only happens when you sell the company, go public, or sell their stake to other investors via secondaries. Founders, on the other hand, are building businesses. Investors are building portfolios designed to return capital to LPs within a fixed timeframe. Those two things are usually aligned, but not always. When a VC starts asking about exit timelines earlier than you expected, it's usually not because they don't believe in the business. It's because the fund clock is running and they need to return capital. If you plan to take venture capital, that is something you should have at the back of your mind from day one.

A GP in year eight of a ten-year fund is in harvest mode. They are managing existing positions, trying to realise their profits, and winding down. Their attention, bandwidth, and incentive to meet with a new founder are structurally lower than in year two, unless they are simultaneously raising or have just launched a new fund. If you are pitching an investor and you know they are late in their fund cycle, understand that you are not just competing with other deals. You are competing with the fact that they are looking to wind down and return capital to their LPs.

I touched on this in the waterfall section, but I want to re-emphasise here. In a whole-fund model, the GP's personal upside is tied to every single company in the portfolio performing until the very end. They are incentivised to support you even when things get hard, because their own carry depends on the entire fund working. In a deal-by-deal model, the GP has already secured their own economics once a few early winners have exited. Their urgency around your specific exit may look and feel different. This is not a reason to avoid investors using deal-by-deal carry. It's just important to understand which model you are dealing with before you take the money.

Everything above is written from the founder's perspective, but if you are trying to break into VC or build a career as an investor, these economics matter just as much to you. When evaluating a fund to join or a GP to back, the fee structure reveals a lot about the firm's culture and incentives. A fund with a very high management fee relative to its size may be optimised for fee income rather than returns. A fund with no hurdle rate may be less motivated by time-sensitive performance than one that has made that commitment to its LPs. A GP who has not made a meaningful personal commitment is signalling something about their conviction. These are not disqualifying factors on their own, but they are questions worth asking. Understanding fund economics is not just academic. It is due diligence.

If you want to save this for reference, here is everything we covered in one place.

VC funds make money in two ways: a management fee that keeps the lights on regardless of performance, and carry that only materialises when companies exit. The management fee is a salary. Carry is the prize. But as we've seen, the mechanics behind that carry, the waterfall, the hurdle rate, the catch-up, the clawback, the GP commit, tell you almost everything you need to know about why investors behave the way they do. The economics explain the behaviour. Every time.

In the next post, we are going to zoom out and look at the full map of startup investors: who they are, what they want, and how to figure out which type of capital is actually right for your business or your portfolio.

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