Venture capital has a standard operating model. Funds raise capital from investors, draw it down over time, charge fees, and share in the upside through carry.
The structure doesn’t vary much, but it matters.
It determines when your money is tied up, what gets paid out first, and how profits are split.
For anyone allocating to VC, understanding how the fund works behind the scenes is essential to making sense of the return profile.
How venture funds actually work
The partnership structure
Venture capital funds operate as limited partnerships. Limited Partners (LPs) provide the capital and have limited liability. General Partners (GPs) make all investment decisions and bear unlimited liability for fund operations.
This structure typically runs for 10 years, matching the time startups need to mature from early-stage companies to exit-ready businesses.
The capital call system
Unlike most investments where you pay upfront, venture investing works on commitments. You might commit $250,000 but typically only pay 5-10% upfront when the fund "closes" (i.e. begins investing), with the remainder called as needed over 3-4 years.
The initial call covers fund setup and early investments. Subsequent calls occur as the fund identifies new opportunities and when existing portfolio companies require follow-on funding.
This system reduces return drag – your money isn't sitting idle while fund managers search for deals. It also provides funds flexibility to adjust deployment based on market conditions.
The fee structure
Management fees: paying for the work
Venture funds charge an annual management fee, typically 2% of committed capital. This covers substantial overhead: fund managers conduct due diligence on thousands of potential investments each year, while providing ongoing strategic support to portfolio companies.
These fees often include step-down provisions. Many Australian funds reduce management fees to 1.5% after the initial investment period ends, reflecting reduced workload as deployment completes.
Performance fees: alignment of interests
Beyond management fees, venture funds earn "carried interest"—typically 20% of profits above a hurdle rate (explained below). This aligns GP interests with LP returns by ensuring fund managers only earn significant fees when LPs achieve strong returns.
The profit distribution (called a "waterfall") works as follows:
- Return of all LP capital
- LP hurdle return (typically 8% annually)
- Remaining profits split 80% to LPs, 20% to GPs.
Example profits from a seed fund investment
Let's say you invest $250,000 in a seed-stage VC fund.
The fund raises $45 million in capital from LPs, and $5 million from GPs ($50 million total fund size). The fund invests in 50 Australian startups in various innovative high-growth industries.
Eight years later, the VC fund's portfolio looks like this:
- 25 of the startups have failed
- 10 of the startups have "exited" and broke even
- 10 of the startups have "exited" and achieved a modest return (average 5x)
- 5 of the startups, which were seeded with an average of $1,000,000, have "exited" with returns of 50-100x.
Considering both investment losses and returns of the startups in the initial portfolio, the fund ends with a balance of $275 million.
The fund charges the standard 2% management fees (annually) and 20% performance fees above an 8% hurdle rate (i.e. the fund must generate LPs at least 8% annually before GPs can take a performance fee).
Based on the above scenario, returns look like this:
Returns calculation
1. Management Fees
The management fee is 2% per year over 8 years:
Management fee = 2% × $50 million × 8 years = $8 million
2. Total balance after management fees
$275 million − $8 million = $267 million
3. Hurdle rate calculation
This is a benchmark return that must be reached before a fund's GPs can claim carried interest or "performance fees", ensuring LPs get a certain return on their investment as a priority.
The hurdle rate return is 8% annually on the $45 million contributed by LPs for 8 years:
Hurdle rate return = 8% × $45 million × 8 years = $28.8 million
4. Return of capital and hurdle rate to LPs
Total return to LPs before performance fee = $45 million + $28.8 million = $73.8 million
5. Remaining profit after return of capital and hurdle rate
Remaining profit = $267 million − $73.8 million = $193.2 million
6. Performance fee to GP
Performance fee = 20% × $193.2 million = $38.64 million
7. Remaining profit after performance fee
Remaining profit after performance fee = $193.2 million − $38.64 million = $154.56 million
8. Split of remaining profit
- LPs' share of remaining profit = 80% × $154.56 million = $123.648 million
- GPs' share of remaining profit = 20% × $154.56 million = $30.912 million
Total Distributions
$197.448M
Total distributions to LPs
(22.07% IRR)
$77.552M
Total distributions to GPs
(33.26% IRR)
Individual LP Return
Now we've calculated the total fund returns, we need to calculate how much your (individual LP) $250,000 investment would have made:
1. Proportion of the fund
Proportion of the fund = $250,000 / $45,000,000 = 1/180
2. Individual LP's share of total LP distributions
Individual LP's share = $197.448 million / 180 = $1.097 million
3. Profit on initial $250,000 investment
Profit = $1.097 million − $250,000 = $847,000
Australian tax advantages and savings
Because this was an ESVCLP fund, you would pay no capital gains tax on these profits, plus receive a 10% non-refundable tax offset on your initial $250,000 investment ($25,000). This represents a total tax saving of approximately $198,550 compared to equivalent gains from listed equities (factoring in the 50% capital gains discount on assets held for 12+ months).
ESVCLP (Early Stage Venture Capital Limited Partnership) structures provide substantial benefits that significantly improve your after-tax returns compared to other investment classes.
Why fund performance varies dramatically
The experience factor
The relationship between fund manager experience and performance isn't straightforward. While experienced teams have established networks for deal flow and operational expertise, research suggests that first-time fund managers often outperform, potentially due to higher motivation and fewer legacy constraints.
Vintage year timing matters enormously. Funds launched during market downturns often generate superior returns as valuations reset. Post-2008 and post-2022 vintage funds historically outperform those launched during market peaks.
Portfolio construction approaches also drive variance. Some funds make 100+ investments seeking volume, while others concentrate on 20-30 focused investments. Look for funds that balance diversification with meaningful position sizes—this is typically based on fund size (e.g. a $50 million fund might invest in 50 companies). These considerations become crucial when you're ready to choose a venture fund.
The investment timeline
1. Initial investment period
Fund managers typically deploy 60-70% of capital during the first 3-4 years. This active phase requires intensive due diligence, with quality funds evaluating 1,000+ opportunities annually to make 10-15 investments.
Successful funds reserve 30-40% of capital for follow-on investments. This follow-on strategy distinguishes professional venture funds from angel investors.
2. Portfolio support and follow-on investing
After initial deployment, fund managers shift focus to supporting existing portfolio companies. This includes strategic guidance, network introductions, recruitment assistance, and coordinating follow-on capital as companies prove traction and require additional funding.
Quality funds double down on winners, maintaining ownership through subsequent rounds. This portfolio support often determines whether companies achieve modest returns or become the 10x+ winners that drive venture returns.
3. The harvest period
Portfolio companies typically mature during years five through eight, reaching acquisition or IPO readiness. This timeline reflects the startup development cycle: 2-3 years for product-market fit, another 2-3 years for scale, then exit preparation.
Distributions occur as companies reach liquidity events. Unlike private equity's predictable exit timelines, venture outcomes cluster around years 5-8 but can extend through year 10 or beyond.
Extension provisions address delayed exits. Most Australian funds include 2-3 year extension options if market conditions prevent optimal exit timing.
Access considerations
Minimum investment realities
Fund economics necessitate meaningful minimum investments. Administrative costs for managing hundreds of LPs become prohibitive relative to fund size. Most Australian funds require $250,000+ commitments. However, programs like Skalata's Smart Stakes enable qualified investors to access funds with lower minimums.
Sophisticated investor requirements restrict access to individuals with over $2.5 million in assets or $250,000 in annual income – a threshold that continues to spark debate across the industry.
Due diligence considerations
Reference checking with existing LPs provides insight into manager quality, communication standards, and portfolio support effectiveness. Quality funds will encourage LP conversations.
Portfolio analysis reveals investment quality beyond headline returns. Examine company trajectories, follow-on funding success, and exit timelines for realistic performance assessment.
Understanding the mechanics, conducting real diligence, and asking the right questions makes the difference between being a passive participant and a confident partner in the decade-long journey of a venture fund.
