Venture Capital Limited Partnership Agreements: Understanding Compensation Arrangements

Abstract:     
This paper uses a hand-collected dataset of venture capital partnership agreements to study venture capitalists' compensation. Several new findings emerge. First, VC compensation consists of three elements, not two (management fee and carried interest), as commonly believed. The third element is the value of distribution rules that specify when during the fund's life VCs receive distributions. These rules often generate an interest free loan to VCs from limited partners. A shift from the most popular distribution rule to the second most-popular rule can affect VC compensation as much or more than common variations in management fee (from 2% to 2.5% of committed capital) or carry percentage (from 20% to 25% of fund profit). Second, VC compensation is often more complex and manipulable than it could have been. However, more complex management fee provisions predict lower total compensation, thus complexity is not used to camouflage high pay. Third, common proxies for VC quality predict higher levels of the more transparent forms of VC compensation (carried interest and management fee), but do not predict the levels of opaque compensation (interest-free loan). Fourth, long-term VC performance predicts fund size (which in turn predicts VC pay controlling for fund size), but recent performance does not predict changes in fund size. Finally, VC compensation is less performance-based than commonly believed: for vintage years between 1986 and 1997 (most recent years for fully-liquidated funds), about half of total VC compensation comes from the nonrisky management fee. On average, a 1% increase in fund returns predicts a 0.47% increase in total VC compensation; this pay-performance elasticity is similar to that of public company CEOs during the same years.

Keywords: venture capital, entreprenerial finance, partnership agreement, compensation, management fee, carried interest

JEL Classifications: J30, J31, J33, J40, J41, J44, K00, K12, L14, L84, M13

Working Paper Series