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Compensation models in Venture Capital Partnerships

©2002 Masterarbeit 40 Seiten


Private Equity and Venture Capital have become an important factor in corporate finance and has returned high profits to investors and fund managers. This papers gives an overview of the structure of venture capital partnerships and their sources of income - specifically management fees and carried interest. A venture capital fund model explains the financial in- and outflows over the lifetime of a venture capital fund and the distribution to general and limited partners and the management.

Inhaltsverzeichnis:Table of Contents:
2.Overview of worldwide venture capital markets4
2.1Long term development5
2.2Key drivers for the Development6
3.Performance of Venture Capital Funds8
3.1Dependence on vintage year9
3.2Latest developments and outlook10
4.Venture Capital Partnerships13
4.1The Structure of Venture Capital Backed Investments14
4.2Sources of income for VC-management companies15
4.3Why Is Carried Interest So Important in Private Equity?16
5.Income model for the management company18
6.Discussion of the impact of different compensation principles21
6.1Management Fees21
6.2Carried Interest23
6.3Total compensation of general partners25
7.How the management does participate27
8.Conclusions and new trends30



ID 5933
Christian Schön
Compensation models in
Venture Capital Partnerships
MBA-Arbeit / Master of Business Administration
an der Donau-Universität Krems, 7
4 Monate Bearbeitungsdauer

ID 5933
Schön, Christian: Compensation models in Venture Capital Partnerships
Hamburg: Diplomica GmbH, 2002
Zugl.: Krems, Universität, MBA-Arbeit / Master of Business Administration
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Christian Schön - Compensation Models in Venture Capital Partnerships
- 1 -
1 Introduction
2 Overview of worldwide venture capital markets
2.1 Long term development
2.2 Key drivers for the Development
3 Performance of Venture Capital Funds
3.1 Dependence on vintage year
3.2 Latest developments and outlook
4 Venture Capital Partnerships
4.1 The Structure of Venture Capital Backed Investments
4.2 Sources of income for VC-management companies
4.3 Why Is Carried Interest So Important in Private Equity?
5 Income model for the management company
6 Discussion of the impact of different compensation principles
6.1 Management Fees
6.2 Carried Interest
6.3 Total compensation of general partners
7 How the management does participate
8 Conclusions and new trends
9 References
10 Glossary

Christian Schön - Compensation Models in Venture Capital Partnerships
- 2 -
1 Introduction
Over the past decade, venture capital is credited with fuelling economic growth, cultural change,
and financial exuberance. Technological advances have dramatically reduced the cost of
information, with a tremendous economic impact. In the financial sphere, venture capital is
regarded as the frontier of innovation, liberated from the regulation and precedents of traditional
Over the past 25 years, the venture capital industry has experienced dramatic growth. Annual
inflow into venture funds has expanded in the United States from virtually zero in the mid 70'ies to
$ 157 billion in 2000. Disbursements of these funds into portfolio companies have been almost as
great a growth. Many of the most visible new companies like Apple Computer, Intel, Genentech
and Microsoft ­ have been backed by venture capital. This growth has led to increasing attention of
the venture capital industry by the, executives of major corporations and policymakers worldwide.
A similar development started, although delayed, in Western Europe. Starting in the United
Kingdom the venture capital boom flooded the continent, first the Scandinavian countries, then
France and lately the German-speaking region. Broadvision, Qiagen and Singulus, to name some,
became the European stars of companies backed by venture capital.
The venture capital industry has developed its own terms and definitions. Private equity is the term
to describe the universe of all venture, buyout and mezzanine investing. Fund of fund investing is
also included in this broadest term. Angel investors or business angels, real estate investments or
other investing scenarios outside the public market are usually not included. Indeed the term
Private Equity is also used to summarize buyout and later stage financing. In contrast the idiom
venture capital is applied to start-up and early-stage financing.
Venture capital can be viewed as a cycle that starts with the raising of a venture fund, proceeds
through the investing in, monitoring of, and adding value to firms, continues as the venture
capitalist exits successful deals and returns capital to their investors; and renews itself with the
venture capitalist raising additional funds. A significant difference between the two cycles may be
the limited term of the venture capitalist partnership that compels the distribution to investors, who
then choose whether to reinvest with the same general partner in a new fund.

Christian Schön - Compensation Models in Venture Capital Partnerships
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The explicit compensation for the venture capitalist is a combination of a fixed management fee
(usually, a percentage of the fund's capital or assets) and a variable performance-based return (a
percentage of the profits). The function of the variable component is considered as incentive to
promote effort or to signal the qualities of the venture capitalist.
This paper tries to supply insight into the construction of partnerships, compensation principles, of
the ideas and intentions behind, the distribution to the management and the impacts to funds. It
tries to find and discuss the most important parameters to compensation and the implications to
the funds management.
The author of the paper had great difficulty to find relevant and reliable data available on the topic,
especially at a detailed level. Even in countries like the United States, which has a longstanding
history in venture capital and where pecuniary information is played more open than in Europe,
relevant data is scarce. Only a few consultants and some associations have access and insight into
partnership contracts and data of fund returns. This study therefore relies on already compiled
information publish by various venture capital organisation, like Venture Economics, European
Venture Capital Association and some researchers like Paul Gompers and Josh Lerner from MIT.

Christian Schön - Compensation Models in Venture Capital Partnerships
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2 Overview of worldwide venture capital markets
At least $ 177 billion of private equity and venture capital was invested globally in 2000 setting a
new record ­ an increase of 30% over the 1999 figure of $ 136 billion. This is equivalent to 0,62%
of the world's gross domestic product (up from 0,5% in 1999). Some $225 billion of funds were
raised globally in 2000 ­ up from $136 billion in 1999.
North America invested and raised most of the private equity and venture capital in 2000, with
$126 billion invested (71% of global investment) and $157 billion raised (70% of global funds
raised). This was a slightly smaller proportion than in 1999, yet once again almost four times the
investment level of Western Europe.
As in 1999, the USA led the way in 2000 with more than $122 billion invested. The UK was again
the country second in line but more than 10 times smaller than the U.S. with $12 billion invested.
France overtook Germany for third place and a number of European Countries slid down the
rankings. Those that moved up were mainly in Asia Pacific, although Israel moved from tenth to
sixth position and Argentina and India entered the rankings for the first time.
Figure 1: World VC-markets by Investment (Source: PWC Global Private Equity 2001)

Christian Schön - Compensation Models in Venture Capital Partnerships
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2.1 Long term development
Over the past two decades, the private equity market has experienced a tremendous boom. The
capital committed to U.S. private equity funds-- partnerships specializing in venture capital,
leveraged buyouts, mezzanine investments, build-ups and distressed debt--has grown from $534
million in 1979 to over $95.5 billion in 1999.
Fundraising in 2000 continued to proceed at a record rate, with $157 billion raised in the year 2000.
Private equity's growth rate has out-stripped that of almost every class of financial product. Much
of the press coverage about the private equity industry concentrates on dealmaker activity and
recent acquisitions or sales. Although the remaining sensitive day-to-day market activity is
important, investors should not lose sight of the broader trends driving change in private equity
Most investment has historically been in U.S. buy-outs but recently interest in Europe and venture
capital has soared. The European private equity markets quadrupled in the last five years from a
stagnating level of $ 7 to $9 billion to more than $35 billion in 2001. Other markets like the Asian
and Latin American markets fell back in terms of dynamic growth (see figure 2).
Figure 2: Historical development of Private Equity (Source: Salomon Smith Barney)

Christian Schön - Compensation Models in Venture Capital Partnerships
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2.2 Key drivers for the Development
Over the past 20 years, the venture capital industry has become a source of innovation and creating
wealth in the economy. U.S.-based venture capital firms created over $2 trillion in value since 1980.
Investments in communications, software, the Internet and biotechnology present value-creating
opportunities for ventures over the next 20 years. The rate of transformation in both old and new
industries has generated an ever-increasing number of venture capital opportunities. On a
fundamental level, at least three factors determine the long-run steady-state level of demand for
private equity in the economy. These include
(1) the rate of fundamental technological innovation in the economy;
(2) the presence of liquid and competitive markets for private equity investors to sell their
investments (whether through stock offerings, mergers or acquisitions); and
(3) the willingness of highly skilled managers and engineers to work in entrepreneurial
These decisive factors have significantly improved in recent years, creating greater opportunity for
private equity investors. First to consider is the rate of technological innovation. Perhaps the
clearest indication of the rate of technological innovation can be seen in the number of patents
filed. Patent applications by U.S. inventors, after floating between 40,000 and 80,000 annually
between 1900 and 1985, have grown over the past decade to over 120,000 per year. The greater rate
of intellectual innovation provides fertile ground for future venture capital investments.
Another example of the more favourable conditions for private equity has been the development of
public markets for new stock issues. In the U.S, the market is an increasingly efficient one. Europe
has seen the creation of a substantial number of exchanges geared to emerging growth stocks like
Neuer Markt, EASDAQ or Nouveau Marche. Unlike earlier efforts to create such exchanges, a
number of these have been able to attract high-quality listings and to generate a substantial trading
An illustration to the third factor is the management talent produced by today's business schools
and universities. At Harvard Business School, nearly 25% of the graduating class in 1999 went into
high-technology start-ups. Another 10% entered the private equity industry. A similar situation has


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Donau-Universität Krems - Universität für Weiterbildung – unbekannt
2002 (Oktober)
management fees private equity compensation carried interest

Titel: Compensation models in Venture Capital Partnerships
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40 Seiten