At its most basic, the two and twenty is basically the standard fee structure for venture capital firms to charge their investors. The 2% is the annual fee that the fund charges investors to manage the fund. And the 20% is the percentage of the upside that the fund managers take.
What does that mean? We will break it down.
The 2% of the two and twenty
The two, or 2%, of the fee structure, stands for management fees applied against the value of the fund every year.
Particularly, in the first five years of a fund, there is a 2% management fee – this is the active investing period of the fund.
The investors are able to charge their limited partners (the investors in the fund) 2% annually on the value of the fund.
For instance, if you have a $100 million fund, that works out to $2 million in fees every year.
VC firms are able to charge in order to pay all the partners, the support people, the legal costs, and fund administration expenses.
Keep in mind that the 2% management fee is typically over the active investment period, usually the first five years. Then, that fee starts stepping down, typically 25 basis points per year.
So a few years after the investing period, it will decrease to 1.5% and then 1% as the fund ages.
The logic being that as the fund ages there’s not as much work, and not as many people who need to be paid to run the fund.
The 20% of the two and twenty
The twenty, or 20%, of the fee structure applies to the profit sharing. This is better known as “carry” in the industry.
Once the general partners distribute capital back to all the investors, they get 100% of their money back.
Every dollar after that there is a profit-sharing component. The VC general partners can charge the limited partners a standard 20%.
For instance, if you have a $100 million fund and you deliver an additional $100 million of profit, you return $200 million to your investors. And 20% of that extra $100 million is going to go back to the general partners as profit.
That means you’re actually returning $80 million to the investors, and the general partners are able to split $20 million of profits.
VC motivation goes beyond return
If a VC fund is doing well and making good investments, they’re seeing profit participation or carry that is very attractive. It’s why most people are working on a VC fund.
While they could make a lot of money in some other positions in management positions at startups or public companies, the profit share or carry is what gets them out of bed and working very hard every day.
The best VCs are intrinsically motivated people and want to ultimately change the world.
So while money doesn’t motivate them 100% it’s certainly a nice incentive.
The 3% and 30% fee structure
While the two and twenty are the industry standard on VC fees, there are firms with a track record of making great investments and have tons of limited partners that want to invest that are able to charge more.
Those firms charge a 3% management fee and 30% of profits.
At the very, very high end, there are different incentive structures on the carry that can deliver even higher returns to the general partners. Or, for smaller or micro-funds, like pre-seed funds, there could be fee structures that deliver a higher percentage of management fee early on in the funds life to help the managers cover the firm’s expenses on a lower asset base.
Two and twenty is definitely a term that you’ll hear quite a bit if you know a venture capitalist or limited partners.