The VC Fund Structure
Understanding how VCs get paid, how their funds work, and what drives their behavior gives founders an information advantage
Feld and Mendelson pull back the curtain on how venture capital funds actually work, arguing that understanding VC incentives and constraints is essential for entrepreneurs navigating fundraising and the post-investment relationship.
A typical VC firm has three entities: the management company (the franchise that employs everyone and pays operating costs), the limited partnership vehicle (the actual fund containing investor capital), and the general partnership entity (the legal entity serving as general partner to the fund). This separation matters because these entities can have divergent interests.
VCs make money two ways. First, management fees, typically 1.5 to 2.5 percent of committed capital annually, pay salaries and operating costs regardless of investment performance. Over a typical 10-year fund life, roughly 15 percent of the fund goes to fees. Second, carried interest, typically 20 percent of profits after returning capital to LPs, is where VCs make real money in success cases. A $100 million fund returning $300 million generates $40 million in carry for the GPs.
Funds have a commitment period of about five years during which new investments can be made, and a total investment term of about 10 years with extension options. After the commitment period, a firm can only make follow-on investments in existing portfolio companies. Firms that cannot raise a new fund become the walking dead, still managing old portfolios but unable to invest in new companies.
Reserves are the capital allocated for follow-on investments. Underreserving forces VCs to pick favorites and abandon some companies. Overreserving means underinvesting the fund. Cash flow management, cross-fund investing dynamics, departing partners, and the clawback provision all create pressures that can materially affect how VCs treat portfolio companies.
Corporate VCs and strategic investors operate under different incentive structures entirely, often prioritizing strategic value, technology access, or competitive positioning over pure financial returns.
- VCs have bosses too: their limited partners. The limited partnership agreement makes this clear, and LP pressure affects how VCs behave with portfolio companies.
- Management fees are paid regardless of investment performance. It takes a decade to kill a venture capital firm because fee arrangements are guaranteed for 10 years per fund.
- Carried interest is where VCs make real money. A typical fund gets 20 percent of profits after returning capital to LPs. Individual partners may get no carry if the overall fund performs poorly, even if their personal investments did well.
- The commitment period, typically five years, determines when a firm can make new investments. VCs past their commitment period who have not raised a new fund are the walking dead.
- Reserves determine whether a VC can continue to support your company. Underreserved VCs may resist additional financings, try to limit round sizes, or push you to sell the company prematurely.
- Cross-fund investing creates conflicts because different funds have different LP compositions and different return profiles on exits. This can lead to divergent motivations from the same VC firm.
- When a partner departs a VC firm, it rarely works out well for the portfolio company. The firm often forgets about the company or puts a junior person on the board.
- Research the Fund's Age and StageBefore engaging with any VC, determine when their current fund was raised, how large it is, and how far they are into their commitment period. A fund raised five or more years ago may not be able to make new investments. Ask directly when they made their last new investment. If it was more than a year ago, they may be a zombie firm. Also ask how many new investments they plan to make from their current fund.Pro tipThe closer a fund is to its end of life, the more problematic things become. Investors may pressure for premature liquidity events or distribute your company shares to their LPs, creating dozens of new direct shareholders.WarningSome zombie VCs still take meetings with new companies even though they cannot make new investments. They earn management fees from old funds and want to maintain deal flow appearances. Always verify investment capacity.
- Understand Reserve and Follow-On CapacityAsk how much capital the firm reserves for follow-on investments per company or for your company specifically. If you expect to need multiple rounds of financing, ensure the VC has enough dry powder in reserve so you do not end up in contentious situations where your investor has no more money left and is at odds with you or future investors.Pro tipEntrepreneurs typically underestimate how much capital they will need, while VCs estimate conservatively and high. Understanding each other's assumptions about future capital needs prevents painful surprises.WarningA VC that is underreserved may actively resist additional financings, try to limit round sizes to minimize dilution, or push you to sell the company prematurely, even if that is not the right decision for the business.
- Evaluate VC Compensation and AlignmentUnderstand how the specific VC partner you are working with is compensated. Most firms do not have equal allocation of carry between partners, with senior partners getting disproportionately more. This dynamic can create friction within firms and affect how individual partners support companies. For CVCs, compensation is often salary and bonus with no direct carry, meaning their personal financial incentives differ dramatically from traditional VCs.Pro tipWhen evaluating a CVC, understand whether they invest off the parent company's balance sheet or from a separate fund. Balance sheet investors can have their capital availability shift with changes in the parent company's stock price.WarningNever give a corporate VC or strategic investor a right of first refusal on an acquisition. While higher valuations from strategic investors feel good, this structural term can prevent you from running a competitive acquisition process.
- Plan for Partner Departures and Fund TransitionsConsider what happens if your board member or investment sponsor leaves the VC firm. In most instances, the firm forgets about the company or assigns a junior replacement. Treat the new board member like a new investor and invest in building the relationship from scratch. Also understand the key person clause in the fund agreement that defines what happens if certain partners leave.Pro tipBuild relationships with multiple partners at the firm, not just your primary contact. This provides continuity and advocacy if your sponsor departs.WarningIn some cases, entire portfolios are sold to secondary buyers who have a very different agenda from the original investor, usually much more focused on driving speedy exits even at lower values.
A $100 million fund with a 2 percent management fee generates $2 million annually for operations. Over 10 years, roughly $15 million goes to fees, leaving $85 million for investment unless the firm recycles returns. If the fund returns 3x ($300 million), the first $100 million goes back to LPs, and the remaining $200 million in profit is split 80/20, giving the VC firm $40 million in carried interest. The partners who share this carry may have unequal allocations, creating internal dynamics.
Firms that raised their previous fund in 2000 or 2001 struggled to raise new funds by 2006-2007. These zombie firms continued taking meetings with new companies even though they could not invest, earning management fees from old funds while maintaining the appearance of active investing. Entrepreneurs wasted time in meetings that could never lead to investment.
Feld and Mendelson decided to write this section after a dinner conversation with a very experienced entrepreneur who was in the middle of a late-stage financing. Despite his extensive experience, the entrepreneur did not fully understand the structural dynamics driving his investor's behavior. Their conversation helped him decode what had been confusing him, and he implored them to publish the information.