How are Venture Capitalists Rewarded? The Economics of Venture Capital Partnerships

We develop a model showing how investors, venture capitalists (VCs), and entrepreneurs integrate
into a venture capital fund (VCF). Investors’ demand for VC services will depend on their beliefs
about the accuracy of VC screening and their expected revenue without a VC. The quality of
screening will depend on VCs’ information, incentives, and expected profits. The model characterizes
equilibrium prices that VCs charge for their services and the individual payoff schedules of
VCs and investors as function of project cash flows. We calibrate the model using data from existing
empirical studies and find results that match the management fees charged by real-world VCs
and the industry returns. Our analysis provides new insights into the formation of VC-investor
partnerships and suggests that the services provided by VCs improve capital market efficiency.