Besides developing an investment thesis, building out your founding team, and winning and dining potential investors, what else goes into setting up a venture capital fund? Many first-time fund managers assume that configuring a fund is the same as incorporating a startup, but the legal and regulatory requirements are often far more complicated. Before a fund has even made its first investment, chances are, lawyer fees have already racked up to tens of thousands of dollars (if not more). Here, I’ll go over the fundamentals of fund formation.
Fund Structure
Most venture capital funds have a three-entity structure: the limited partnership, the general partnership entity, and the fund management company.
- The parent entity of the three entities is the limited partnership, which establishes the relationship between investors, or limited partners (LPs), and fund managers, or general partners (GPs). The limited partnership agreement delineates the rights of the LPs and GPs, the compensation to the GPs, how investor profits will be diluted as more LPs are onboarded, and other terms relevant to the management of the fund.
- A key feature of limited partnerships is that investors are protected from personal liability (the caveat being that they are restricted from participating in any management decisions of the fund). Since GPs directly manage all fund operations, fund managers may end up personally responsible for debts and obligations unless they find another way to dodge liability. The answer usually comes in the form of a fund management company, which is a limited liability company in charge of sourcing investments, hiring principals, associates, and other employees, and overseeing administrative and operational practices.
- The general partnership entity is self-explanatory.
Compensation to the GP
Most fund managers are paid on a “two and twenty” fee scheme:
- Every year, 2% of LP investments go into the fund management company to be used for fund operations.
- When profits are realized, GPs are entitled to 20% of the profits, with the remaining 80% paid out to the investors.
In practice, what this means is that fund managers must limit their salaries and expenditures as they grow the fund and its portfolio companies, but are entitled to a nice payout once the fund wraps up. The limited partnership agreement prevents GPs from splurging on themselves before achieving results. Of course, not all funds incorporate this fee scheme, and it is up to fund managers to decide how to compensate themselves as they fundraise from LPs.
SEC Filings
This is where things get more complicated. Prior to raising money from investors, a venture capital fund must have the right internal and external documents in place to approve the offering. Internally, the GPs must have agreed on the target amount and terms of the fundraising round in accordance with any management agreements they may have. Externally, the GPs must have made certain filings with the Securities and Exchange Commission (SEC):
- Under SEC rules, fund managers are considered to be investment advisers. This means that they have to provide investors with quarterly statements and follow other compliance requirements unless they qualify for a registration exemption. Luckily, to support innovation, the United States has special rules for venture capital funds. GPs of venture capital funds may apply to be exempt from having to register as investment advisers.
- If the fund intends to resell or transfer the securities of its portfolio companies to other investors as part of its business model, then the GPs must register as broker-dealers.
- The fund must make a public offering of its partnership units or interests before it can fundraise from LPs. This is usually done through Regulation D and, if applicable, Blue Sky filings, which can be made online. If the forms are filled out correctly, the filings can be approved within a day. Once the approval goes through, the fund can technically raise from an unlimited number of accredited investors, though the SEC has placed a 250 cap on venture capital funds with $10 million in investments.
Conclusion
While this article outlines the key steps in fund formation, by no means do the rules apply to every fund. As long as fund managers can get investors on board, they are free to design a fund structure or compensation scheme that works for them. Furthermore, many funds are structured in a way that is far more complicated than what I described above, such as when they are international or when they have sub-funds grouped in various combinations, which lends room to considerable creativity.
