How VCs actually make money: the mechanics of 2-and-20
Management fees, carried interest, hurdle-free economics, and the power law that makes one company pay for the whole fund. The business model of venture capital, explained.
Venture capitalists invest other people’s money. The people — pension funds, endowments, family offices, funds of funds — are limited partners, and the economics between them and the fund’s managers explain nearly everything about how VCs behave.
#Fees keep the lights on
The standard structure is "2 and 20": roughly 2% of committed capital per year in management fees, and 20% of the profits — the carried interest — once LPs get their capital back. On a $100M fund, fees run about $2M a year, paying salaries and rent regardless of performance.
#Carry is the prize
Carried interest is where fund managers actually get rich. If that $100M fund returns $300M, the $200M profit splits $160M to LPs and $40M to the general partners. No profit, no carry — which is why a fund that merely returns its capital is, for its partners, a decade of work for salary alone.
#The power law does the heavy lifting
Venture returns are not normally distributed. In most funds, one or two companies generate the majority of returns, a handful return their cost, and the rest go to zero. This is why VCs chase outliers rather than safe bets: a portfolio of ten "pretty good" outcomes loses to one great one.
A venture fund is a search engine for outliers, financed by fees and paid in carry.
Understanding these mechanics explains investor behavior that otherwise looks irrational: why funds reserve capital for follow-ons, why they push portfolio companies to grow rather than to profit early, and why "too small an outcome" is a real rejection reason for a perfectly good business.
