Carried Interest

Carried interest is the performance-based compensation VC general partners earn on fund profits above a return threshold, typically 20% of profits. Often shortened to "carry," sometimes called "performance fee" or "incentive allocation," it is paid after LPs receive return of their contributed capital plus a defined preferred return (the "hurdle rate," typically 8% annualized), and is the primary economic driver of the VC compensation model. It is also the subject of ongoing tax-treatment debate because carry has historically been taxed as capital gains (typically 20% federal) rather than as ordinary income (up to 37% federal), saving GPs significant amounts in taxes.

The standard "2 and 20" structure: GPs earn 2% annual management fees on committed capital (covering operating costs of the firm) plus 20% carried interest on fund profits above the hurdle rate (the major personal compensation). For a $200M fund returning 3x ($600M back to LPs and GPs), the profit is $400M, the carry on that profit is 20% = $80M, distributed to the GP partners according to the firm's internal carry-sharing arrangements. The hurdle rate mechanic: LPs typically must receive their capital plus an 8% annualized preferred return before any carry distributions to the GP. The "catch-up" provision then often allows the GP to receive 100% of subsequent profits until the GP's overall split reaches 20%, after which profits are split 80/20 LP/GP. The tax debate: carried interest has historically been taxed as long-term capital gains (max federal rate ~20% plus 3.8% NIIT) rather than ordinary income (max federal rate 37%), because it's structured as the GP's share of investment gains rather than salary. Critics argue this is a loophole; defenders argue it correctly reflects the at-risk nature of GP economics. The 2017 Tax Cuts and Jobs Act extended the required holding period for long-term carry treatment from 1 year to 3 years, the only meaningful federal reform since the issue became politically prominent. Various proposals to tax carry as ordinary income have been introduced but not passed as of 2025.

What founders get wrong: Not understanding that VC partners are fundamentally compensated on big outcomes from their portfolio winners. The management fees pay their salaries; the carry is what creates wealth. This shapes everything: which companies they aggressively support, which they let drift, when they push for exits, when they push for growth. Knowing the math explains a lot of VC behavior.

Related: General Partner · Management Fee · Venture Capital Fund · Limited Partner

FAQ

What is carried interest?
The performance-based compensation that VC general partners earn on fund profits above a return threshold, typically 20% of profits after LPs receive their capital back plus a defined preferred return (8% annualized typical). The primary economic driver of the VC compensation model. Often shortened to "carry."

How does the 2 and 20 structure work?
GPs earn 2% annual management fees on committed capital (covering firm operating costs) plus 20% carried interest on fund profits above the hurdle rate. For a $200M fund returning 3x ($600M total), the $400M profit generates $80M in carry to the GP partners, distributed per the firm's internal carry-sharing arrangements.

Why is carried interest controversial?
Because it's historically taxed as long-term capital gains (max federal rate ~20% plus 3.8% NIIT) rather than ordinary income (max 37%), which critics argue is a loophole and defenders argue reflects at-risk economics. The 2017 Tax Cuts and Jobs Act extended the holding period to 3 years; further reforms have been proposed but not passed as of 2025.