The “Incentive Fee” for LPs

I recently heard that many fund managers earn an “incentive fee”, otherwise known as a “performance fee”, which is calculated based on the increase in the funds Net Asset Value – including both realized and unrealized fees. This is different from the typical “carry” at VCs, which is only seen when the asset liquidates.

What this means for VCs is that the fund managers at LPs they have raised from, and are likely fundraising from again (because VCs raise every 3-4 years), see money in their bank accounts when the VCs portfolio companies gets follow-on capital, at a higher valuation.

Simply put, that means is that it’s easier for VCs to raise money for subsequent funds when their portfolio companies are continuing to raise money at larger valuations.

What this also means is that it’s harder for VCs to raise money for subsequent funds when their portfolio companies don’t raise follow-on funding, even if they are growing steadily in both revenue and profit.

What this means for startups is that a VC, in general, will be more likely to invest in you if you tell them you plan on raising again – regardless of whether that’s the right plan. Also that founders can expect VCs to pressure them to raise capital.

Just another example of what seems like misaligned incentives in the value-chain, which can lead to sub-optimal decision making for founders.

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