How a VC Fund Works

What a "VC fund" actually is

A VC fund is a legal entity, usually a Delaware Limited Partnership, with two parties:

• Limited Partners (LPs) — the investors who put money into the fund. They have limited liability, hence "limited." They put up most of the capital.
• General Partners (GPs) — the people running the fund. They invest the LPs' money, take fees, and earn a share of the profits. The firm you've heard of (Sequoia, a16z, Benchmark) is a GP entity.

A specific fund is usually called something like "Sequoia Capital XV" — the 15th fund this firm has raised. Each fund is a separate legal entity. A firm like Sequoia might have several funds running in parallel: a current early-stage fund, a current growth fund, a previous early-stage fund still holding companies, etc.

The relationship is governed by a long document called the Limited Partnership Agreement (LPA). It sets out who can invest in what, how fees work, how profits are split, what happens in conflicts. Most LPAs run 80-150 pages.

Who the LPs are

LPs are the people whose money the fund actually invests. The big categories:

• Pension funds (CalPERS, teacher retirement systems). Largest source of capital in the industry by far.
• University endowments (Yale, Harvard, Stanford). Sophisticated allocators with long horizons.
• Foundations (Hewlett, Ford, Gates).
• Insurance companies.
• Sovereign wealth funds (GIC, Abu Dhabi Investment Authority).
• Family offices — wealthy families.
• Funds-of-funds — funds that invest into other funds for diversification.
• High-net-worth individuals — usually a small slice of any given fund.

What unites them: long time horizons, tolerance for illiquidity, and a desire to allocate a small percentage (2-15%) of their portfolio to venture in hopes of outsized returns. That allocation gets distributed across several VC funds, often across multiple vintage years.

Who the GPs are

The GPs are the partners at the firm — the named people who get to write checks. At a small firm there might be 2-3 GPs total. At a large firm, 20+. Below the GPs are principals, vice presidents, associates, and analysts. Only GPs are technically partners in the LPA sense.

GPs usually contribute their own capital to the fund — typically 1-3% of the fund's total. This is called the "GP commit" and it aligns their incentives with the LPs. If the fund loses money, GPs lose their own money too.

How GPs get paid: the 2-and-20 model

The classic VC compensation structure has two parts.

Management fee — typically 2%

The fund charges 2% per year of the committed capital as a management fee. On a $100M fund, that's $2M/year. This pays for:

• Salaries of GPs and staff
• Office, software, travel, legal
• Diligence costs (lawyers, accountants)
• Conferences and LP meetings

Management fees are often "stepped down" — full 2% during the investment period (years 1-4 or 1-5), then reduced afterward (e.g., to 1.5%, or based on remaining unrealized investments). This roughly aligns the fee level with how much active work is happening.

Over a 10-year fund life, total management fees on a $100M fund are usually $15-20M. That comes out of the fund's pool, meaning LPs only see ~$80-85M actually invested into companies.

Carried interest — typically 20%

Carry is the GPs' share of the profits. The standard rate is 20%. The mechanics:

1. The fund returns capital to LPs first (typically until they get back 100% of what they invested).
2. After that, profits are split 80/20 — LPs get 80%, GPs get 20%.

Some funds add a hurdle rate (sometimes called a "preferred return") — LPs get back their capital plus, say, an 8% annual return before GPs start earning carry. Hurdles are more common in PE than VC; many top VC funds don't have one.

▸Worked example — a $100M fund returning 3x

Setup: $100M fund, 2% management fee for 10 years (constant for simplicity), 20% carry, no hurdle.

Item	Amount
Committed capital	$100M
Management fees over 10 years	$20M
Capital actually invested	$80M
Gross proceeds from exits	$300M
Returned to LPs first (their $100M back)	$100M
Profits remaining	$200M
GP carry (20%)	$40M
LP profit share (80%)	$160M
LP total received	$260M
GP total received	$40M carry + $20M fees = $60M

LPs put in $100M, got back $260M — a 2.6x net multiple after fees and carry. The GPs took home roughly $60M across the fund's life.

The carry is what creates the upside for GPs. A successful fund pays partners millions or tens of millions per partner. An unsuccessful fund pays only the management fee — enough to keep the lights on, but not life-changing.

Fund life and investment period

A typical VC fund has a 10-year life with two phases:

• Investment period (usually years 1-4 or 1-5) — the fund deploys capital into new companies. New investments stop after the investment period ends.
• Harvest period (years 5-10) — the fund follows on into existing portfolio companies, holds, and tries to exit. No new investments.

The 10-year clock can be extended by 1-2 years with LP approval — increasingly common as companies stay private longer.

A fund's vintage is the year the fund started deploying. "2017 vintage" means the fund was raised and started investing around 2017. Vintage matters because returns vary enormously by what was happening in the market when capital was deployed. The 2009 vintage (post-GFC) was extraordinary. The 2021 vintage (peak ZIRP-era valuations) is going to be brutal for many funds.

Why GPs raise new funds every 2-4 years

A firm doesn't deploy a fund for the full 10 years — they invest aggressively in the first 3-5 years, then start raising the next fund. This is why a firm often has multiple funds running in parallel: Fund I in harvest mode, Fund II actively investing, Fund III being raised.

This pace creates a treadmill. Every 2-4 years the partners are out raising again, which is its own grind. It also means LPs need to commit to multiple fund vintages with the same firm to maintain exposure — they can't just cherry-pick one year.

Common LP misalignments

A few structural quirks worth knowing:

• Cross-fund investing. A firm with multiple funds can invest its different funds into the same company at different rounds. This sometimes raises conflict-of-interest concerns. LPAs handle it with consent procedures.
• Recycling. Some funds allow recycling — capital returned from early exits can be redeployed into new deals, effectively investing more than 100% of committed capital. LPs usually like this when it's capped.
• Subscription line debt. Some funds use credit lines to delay calling capital from LPs, which boosts IRR (LPs' money is in the market for less time). Performance reporting can get noisy as a result.

What this means for an analyst

You're operating inside this structure even if no one explains it to you. A few practical implications:

1. Your firm's deployment pace matters. A firm that's deploying its 8th-out-of-10 year of capital is more aggressive than a firm 2 years into a new fund. The cadence affects how willing the firm is to write new checks.
2. Markups matter to LP fundraising. When your portfolio companies raise new rounds at higher prices, the fund's paper returns go up. This makes LPs want to write checks into the next fund. Markups aren't real money until exit, but they drive the fundraising cycle.
3. Reserves matter. A fund holds back capital to follow on into its winners. The math of follow-ons is its own discipline; module 5.2 covers it.
4. Fund size shapes strategy. A $100M seed fund and a $1B multi-stage fund are playing different games even when they invest in the same companies. Always look up the fund size before judging an investor's behavior.

This structure shapes everything else in the industry. Read it once, internalize it, then move on to the power law in module 1.3.