We are often asked about the “market” rate for management fees in actively managed venture capital funds. This primer discusses mainstream venture capital funds, so to speak. If your fund is in the venture space but has special attributes (such as being a secondaries fund, a very small micro-fund, a top-up fund, etc.), different market conditions apply. Some of these special situations are discussed elsewhere in this blog.
With that in mind, at a high level, there are three things to consider generally when structuring management fees: first, what is the amount of those fees; second, when in time do those fees start and end; and third, will the amount of fees reduce (i.e., “step down”) at some point in time reflective of perhaps a lesser level of work later in a fund’s lifecycle.
As to amount, management fees are typically based on an agreed percentage rate applied to an agreed capital base, and are usually described annually in the legal agreements (though in terms of cash payment they are most often divided up and paid quarterly or semi-annually). In actively managed venture capital funds, the market rate is 2.5% of aggregate committed capital in the first part of a fund’s life. This is contrary to say the buyout side of private equity where you often hear “2/20”, i.e. where the fee rate is often 2% instead of 2.5%. Rates in venture capital funds are quite regularly 2.5% reflective of the fact that whereas a buyout fund may have a very large committed capital base and do 5-10 investments over its lifespan, a venture capital fund usually has a smaller capital base, often much smaller, and over time can make a quantity of investments on the magnitude of 2-3x that of a private equity fund. In short, there is a lot to do, and where the capital base is more modest, management fees are not typically a source of a high degree of residual profitability over fixed expenses, if any. With that said, in some very large venture capital funds (say $750 million and north), fees can sometimes drop to 2.25% or 2%, though depending on the size and nature of the organization, even these larger funds may often have a fee rate of 2.5%. The preceding is widely applicable in the United States and Asia venture capital markets (as to USD-denominated funds); in Europe there may be more tendency for fees in venture capital funds to be in the 2% range, possibly reflective of a much smaller overall industry and an accordingly less degree of market term separation from private equity.
As to the start time for the payment of fees, they are often assessed from the initial closing (including retroactively for later admitted investors) though sometimes they are assessed beginning later, such as from the time of first capital draw or first investment. This is somewhat dependent on the strategy in raising the fund and the expected time at which the team will start looking to place opportunities therein. If the predecessor fund is out of dry powder and therefore necessarily the fund being raised will be the place where the next new opportunity is taken down, then there is significant justification for fees from the initial closing. The team is after all “working” for the new fund already, in the sense they are out there sourcing deals for it; as such, the justification for payment of fees is clear. In other situations, an existing fund may have remaining available capital for a couple of new deals, and there is an intent to put identified opportunities into the existing fund accordingly. In this situation, the new fund is being effectively raised but put on the shelf, so as to be ready when capital is needed without any chance for a period of time without capital for new deals. Where this is the case, a later inception of fees in the new fund may be warranted.
One also needs to consider when fees end. This is a point that has been undergoing some change in the last 5-10 years, and may be subject to some negotiation. There are three ending times that are most common: at the end of the natural term (say, 10 years in); at the end of any extensions to the term (say, 12 years in); or at the final liquidation of the fund (say, 13 years in). In the last couple of years, we have seen increasing instances in which fees are paid all the way to final liquidation, albeit often at much lower rates than initially (see below, regarding fee step downs). The theory here is that there is work to be done, someone needs to do it; and that is not free to provide, nor should it go unpaid for. We see a number of venture capital funds with whom we work collecting fee to final liquidation on this basis, more in number than was the case some years ago.
Finally, there is the issue of the potential for fees to reduce (i.e., “step down”) at some point in time. This is usually at the time that investments in new portfolio companies ceases, and the venture fund enters a period where it is doing solely follow-on investing and harvesting. The theory in reducing the amount of management fee at that time is primarily that there is less work to be done, and secondarily, as a corollary thereto, that there is likely to be a successor fund providing a “full” fee base and therefore it is not necessary to collect high fees in the fund that has reached this level of maturity. One way or another, most venture capital funds do have some “step down” concept.
A connected issue is, where fees reduce, how is that done exactly? There are three ways the reduction in fees can be accomplished: the percentage rate can be reduced and the capital base can be left unchanged (a “rate step down”); the percentage rate can be left unchanged and the capital base can reduce (a “base step down”), or both the percentage rate and capital base can be reduced (a “double step down”). In the years immediately following the reduction, say years 5-10 or 5-12, double reductions are quite uncommon and usually reflect quite a bit of lack of negotiating leverage on the part of the fund manager. This is versus reductions during liquidation, where a double reduction is more common.
So, again focusing on what happens at or around year 5, in almost all cases it will be one or the other of a rate step down or a base step down. Most venture capital managers will prefer a rate step down. The reason is that this leads to a situation where one can state with specificity (at least from the time of final closing when the capital base amount is known) the exact amount, in dollars, of management fees in later years. Since management fees are meant to be used for fixed expenses (think rent, equipment, hiring staff) and are usually consumed fully in furtherance of those expense requirements as opposed to leading to retained earnings, not knowing the dollar amount fees you will get in say year 6 (as would be the case where those fees are some percentage of a capital base not known until that time) is an extremely hard position for a manager.
With that said, while savvy investors understand this and will work to support the needs of the managers they invest in, they often prefer a base step down. Their point of view is that no matter how low a percentage rate drops, it may be inappropriate to apply any rate to the full committed capital base later in the lifecycle when there are few remaining investments. With that said, especially in smaller venture capital funds (say, $500 million and south), usually the method of rate step down prevails. Sometimes, a compromise may be agreeing to a double reduction in the liquidation period to address the foregoing concern very late in the fund’s life.
It is important to get these concepts right. We have found that getting them wrong can amount to “penny wise, pound foolish”, in extreme cases, hampering a manager’s chance of success. What we mean by that is, investors put fund managers in business. They pay a lot in fees to do that, no matter how negotiations on the above issues work out. Fees are needed to compete for talent in the marketplace. It is a shame to see negotiations to reduce fees result in a situation where the fund manager can’t hire and retain the “A” team from a compensatory standpoint. Careful attention to market norms can assure the manager avoiding a competitive disadvantage, yet doing so in a way that is respectful of the investors’ perspectives on these matters.
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