One question that I’m often asked is how the expenses and fees break down in a typical VC fund structure. Typically, a VC fund will have three categories of charges (aside from profits or carried interest): organizational expenses, fund expenses and management fees. This post is a rough overview, based on my experience, of how costs are categorized in those groups and paid by a typical fund. These categories also control whether the expenses generally are paid by fund managers (out of fees) or by fund investors (as expenses).
Organizational and Fund Expenses
Each investor (limited partner or member) in a fund typically bears its own pro-rata portion of the costs of forming the fund, including costs of marketing/roadshow, legal and otherwise. In some cases, the maximum amount of organizational expenses will be capped by the fund manager at no more than a fixed amount specified in the fund’s private placement memorandum (PPM) and operating agreement.
Similarly, each investor (limited partner or member) in a fund typically bears its own pro-rata portion of fund costs and expenses relating to the fund’s activities, investments and business. Generally, this encompasses expenses for out-of-pocket expenses associated with the acquisition, holding and disposition of fund investments, which can include extraordinary expenses, if any (such as certain valuation expenses, litigation and indemnification payments), and routine out of pocket expenses such as legal, accounting, audit, investment banking and similar expenses.
In addition to organizational and fund expenses, VC funds typically also pay an annual management fee, calculated based on a percentage (e.g., 2% or 2.5%) of the capital commitments of the fund (as of the final closing), to the fund’s management company. As with expenses, this fee is paid by the fund out of capital contributions of the individual fund investors. Following the termination of the commitment period (when the fund is making new investments – often 5 years from the initial closing), the management fee rate is usually phased down and may be based on net invested capital as opposed to capital commitments. Management fees are used to fund overhead of the management company of the fund, including salaries, benefits and other compensation and expenses of members, employees, consultants and agents of the manager as well as rent and overhead charges, office expenses and expenses for clerical, travel expenses incurred by the principals in the course of investigating investment opportunities for the Company.
Many funds provide general partners the right to waiver a portion of their management fee in exchange for a special allocation of profits from the sale of portfolio securities. An analysis of this structure isn’t part of this post, aside from noting that care must be taken to ensure proper tax treatment for and administration of such a structure.
Management fees are often reduced by all or a portion of similar fees that the management company may receive from portfolio companies as consideration for services rendered to such companies, including, in some instances, director fees.