So, you’ve decided to launch a new venture capital fund. You’ve got an investment strategy, a management team, advisers, deal flow, and some first close investors lined up who love your ideas and your team. Now you just need to convert these prospective investors into actual investors.
This is no easy feat, as not only do you need to convince them that you will invest their money wisely, but you also need to convince them that the limited partnership agreement (“LPA”), which is the legally binding agreement between you, as the general partner of the fund, and them, as limited partners of the fund, is fair for both parties and standard for a venture capital fund.
This video gives an overview of how limited partnerships work in venture capital as part of Carta’s free VC 101 curriculum.
We collaborated with Michael Wu, Partner at Winston & Strawn LLP, to outline the key aspects of the LPA that will set up your partnership for long-term success and alignment with your limited partners.
How do you do this? The first step is to make sure the LPA’s terms are generally accepted as being the best among the available alternatives because they achieve results that are better, more efficient, or fairer than the alternatives. Fairness to your limited partners is key.
The second step is to make sure the LPA’s terms are market, or within a range considered to be market, for venture capital funds. There are some terms we’ll discuss below that are common to LPAs, but there isn’t necessarily a “market”—co-invest and side letters, for example.
The LPA for a new venture capital fund should not deviate much, if at all, from established best practices and market norms for venture capital funds. However, some terms may vary based on the venture capital fund’s investment strategy, industry/sector focus, deal flow, size, and management team, among other things, so there is normally some variation between LPAs.
We’ve summarized the key terms of a venture capital fund LPA and what we view as best practices and market norms for such terms. Remember, the terms of your fund can vary from the terms described below, so long as they are reasonable and within market norms.
Consider the duration of your partnership
The term of a fund, or the period commencing the day it begins operations and ending when it is dissolved, is generally between 8-10 years. Smaller or newer funds may have a shorter term, as they have less capital to deploy. Most funds permit the term to be extended by two additional one-year periods to maximize value of the remaining investments at the end of the term.
This is the period during which the general partner can admit investors as limited partners to the fund. The fundraising period typically starts with the fund’s initial closing and ends with its final closing. A fund may have several closings in between. In most cases, the final closing occurs within 12 months of the initial closing.
Investors at each subsequent closing will generally contribute capital—and be treated—as though they came in at the initial closing and participate in all of the fund’s investments that haven’t been previously disposed of. Accordingly, the existing investors’ proportionate share of the fund is diluted each time new investors are admitted to the fund.
In order to make this more fair for the fund’s existing investors, the subsequent close investors typically pay a subsequent closing fee to the existing investors, which is calculated like interest (e.g., at 5-7% per annum) on the subsequent close investors’ capital contributions from the date of the initial closing to the date of the applicable subsequent closing.
A fund can typically only call capital to make new investments during its investment period. The investment period normally starts at the initial closing and ends on the 3rd-5th anniversary of the initial closing or the date on which 70-75% of the fund’s capital is deployed—whichever occurs first. After the investment period is over, generally only follow-on investments or investments actively considered before the end of the investment period can be made.
Determine how your firm will create alignment
Investors want to see that the principals of the general partner (“Principals”) have “skin in the game” and have invested a significant portion of their liquid net worth into the fund. Typically, Principals will commit in the aggregate an amount equal to 1-2% of total commitments. Some Principals will use a management fee waiver or offset (i.e., a cashless contribution) or contribute “warehoused” investments to the fund to satisfy a portion of their commitments.
If there’s an exit of a portfolio company (e.g., an IPO or acquisition) during the investment period, rather than distributing the capital to investors, the general partner can recycle or reinvest some or all of the proceeds. Typically, only an amount equal to the cost basis of the investment is recycled. Limited partners like recycling because during the investment period, the management fees are based on committed capital, so they are getting a discount on the management fee with investments made with recycled capital. It’s also good for general partners, as they can earn extra carried interest on the additional investments made with recycled capital.
The general partner may call capital from limited partners up to their commitments with at least 10 days’ notice, though the first capital call after the initial closing may be on less than 10 days’ notice. Many general partners arrange for a capital call line to help smooth out the capital call process. Basically, the fund draws from the line to make an investment or pay a fund expense and then calls capital from investors to replenish the line. The LPA should contain language that banks need to see in order to provide a capital call line to the fund.
The LPA should have mechanisms in place to discourage limited partners from defaulting on their capital contribution obligation. The default provisions can seem a bit draconian (e.g., a forfeiture of a portion of the capital account balance, forfeiture of future profits, forcing a sale of the LP’s interest, etc.), but harsh penalties can help limit defaults (which typically adversely impact the fund).
The fund usually pays the investment manager, which is the entity that provides the fund with investment advice, a quarterly management feed. Typically, the management fee is paid in advance and amounts to 2% of the aggregate commitments during the investment period. The fee is often reduced, or stepped down, after the investment period (e.g., reduced each quarter or calculated based on the amount invested). The management fee is generally offset by any other fees received by the Principals, the investment manager, the general partner, or their affiliates from the portfolio companies.
The fund pays for all of its expenses, which are generally categorized as “organizational expenses” and “operating expenses.”
Organizational expenses include fees, costs, and expenses related to forming the fund, preparing the offering documents, and raising capital. Operating expenses include all other fund expenses.
Generally, limited partners like to see a cap on organizational expenses so that they know the general partner isn’t spending too much of the fund’s assets on setting up the fund and bringing in investors. If the cap is exceeded, the general partner or its affiliates are responsible for the excess fees, costs, and expenses. There really isn’t a rule of thumb regarding what the cap should be, but the lower the cap the better.
The proceeds of an exit of a portfolio company are typically distributed to the limited partners and the general partner pursuant to a “waterfall” distribution mechanism. There are two types of waterfalls: the American waterfall, which applies on a deal-by-deal basis, and the European waterfall, which applies on an integrated or fund-level basis.
In almost every waterfall, 100% of the proceeds available for distribution are first distributed to the limited partners as a return of capital. After the limited partners receive a return of capital, there is some variation around how the next tranche(s) of proceeds are distributed.
In many cases, especially with newer or smaller funds, the remaining proceeds are divided between the limited partners (typically 80% of the proceeds) and the general partner (typically 20% of the proceeds). However, it is also very common, particularly with larger funds, for the remaining proceeds to be distributed 100% to the limited partners until they receive a preferred return (typically at an annual rate of 7-8%) on their investment, then 100% to the general partner as a “catch up” and finally, between the limited partners (typically 80% of the proceeds) and the general partner (typically 20% of the proceeds). The general partner’s portion of the proceeds is commonly referred to as its “carried interest.”
With the American waterfall, the proceeds available for distribution are calculated for each portfolio investment (i.e., the return of capital to the limited partners is based on the capital contributions for such portfolio investment), which makes it likely that the general partner will receive carried interest sooner than under a European waterfall, which calculates the proceeds available for distribution at the fund level (i.e., the return of capital to the limited partners is based on the aggregate capital contributions to the fund). Limited partners generally prefer the European waterfall to the American waterfall because it does a better job of ensuring that the limited partners get their return of capital back before the general partner receives any carried interest.
Aim for the upside, but prepare for the downside
If, upon liquidation of the fund, the general partner has received more carried interest than it is entitled to (e.g., in the case of a few big wins initially followed by a number of investments that resulted in losses), the general partner must contribute the excess (less any taxes paid) back to the fund for distribution to the limited partners. To ensure that the general partner is able to satisfy this clawback obligation, the Principals will either enter into personal guarantees to fulfill their respective obligations or the general partner will set up an escrow account and deposit an amount typically equal to at least 25% of any carried interest distributions into the account. Limited partners tend to prefer having an escrow over a personal guarantee.
A key person provision is almost always in the LPA and is usually triggered when one or more key persons, usually the Principals, sells his/her equity in the general partner or fails to devote substantially all of his/her time to the general partner for 180 consecutive days. If a key person event occurs during the investment period, normally no new investments may be made by the fund until the key person is replaced. The LPAC, as defined below, is typically involved in approving the new key person or resolving the key person event.
If the Principals, the general partner, the investment manager, or their agents and affiliates (“Covered Persons”) are sued as a result of something they did or didn’t do for the fund, the LPA will typically indemnify the Covered Persons for any and all liabilities, costs, and expenses unless the Covered Persons’ liability arose from the Covered Persons’ gross negligence, bad faith, willful misconduct, or material breach of the LPA or applicable law.
Many LPAs have an “LP clawback” provision, which requires the limited partners to return a portion of the distributions they received from the fund if needed to satisfy the fund’s indemnification obligations to the Covered Persons. Typically, the LPA will have limits on the LP clawback (e.g., it does not apply after 2-3 years from the fund’s dissolution and no more than 25% of distributions may be clawed back).
Most LPAs allow the limited partners to remove the general partner for “cause” (e.g., if the Principals or general partner engage in embezzlement, fraud, bad faith, etc.). Usually, removing the general partner for cause requires the vote of at least 66.6% in interest of the limited partners.
While it’s less common for an LPA to permit the limited partners to remove the general partner without cause, some institutional limited partners require or expect to see this in the LPA. Normally, removing the general partner without cause requires the vote of at least 75% in interest of the limited partners.
Demonstrate how you want to involve your limited partners
Many funds offer co-investment rights to limited partners and third parties. For example, if the general partner has arranged to acquire more shares of a portfolio company than the fund needs, the general partner can allocate some or all of the additional shares to limited partners that invest over a certain amount in the fund to incentivize limited partners to invest more into the fund. The investment manager should have an investment allocation policy to determine how investments are allocated among the fund, other funds with investment strategies that overlap with the fund’s, and investors with co-investment rights.
Each fund should have a “limited partner advisory committee” (“LPAC”), which is formed to address conflicts of interest, approve valuation methods, extend time periods, approve investments that would otherwise be restricted, and review key person events. The LPAC is for fund governance and does not get involved in fund investments. Members of the LPAC are selected by the general partner and the LPAC typically consists of 3-5 limited partners (or their representatives).
The terms of the LPA may be modified by side letters or agreements with certain limited partners. Typically, side letters are only entered into with the fund’s larger investors or early investors and will have a “most favored nation” (“MFN”) provision that allows limited partners to see and, subject to certain limitations, elect into the provisions of other side letters. We recommend considering a “dollar-weighted” MFN so an investor can only see and elect into the side letters of other investors who have committed at least as much as the investor.
Conflicts of interest
There are likely going to be several potential or actual conflicts of interest (e.g., the investment manager providing advice to multiple funds, the principals having interests in portfolio companies, etc.). In most cases, disclosing the conflicts of interest and/or having the LPAC approve of transactions involving a conflict of interest addresses any potential issues caused by the conflict of interest.
Although the list above doesn’t cover every concept or term of an LPA, it does cover some of the most common terms for a venture capital fund and the best practices and market norms for these terms.