Business Lawyers in Columbus, Ohio
By Drew Stevens - May 31, 2020 - Startups + VC
In this latest installment of our checklist for starting a venture capital fund, our Columbus venture capital lawyer will dive into some of the core structuring considerations in forming the venture capital fund itself.
In our previous posts, we have covered structuring the venture capital general partner entity, as well as a general overview of starting a venture capital fund.
Typical Legal Structure of a Venture Capital Fund
Oftentimes, regardless of where the venture capital fund and general partner operate and have their offices, the venture capital fund itself is usually a Delaware limited partnership.
Why Delaware? There are a number of misconceptions when it comes to domicile in Delaware. Contrary to the belief of some, Delaware is not particularly cheap to form legal entities in. Further, Delaware does not offer any kind of “tax haven” or specific tax advantages, as compared to filing in other states.
In reality, the primary advantage that Delaware is known for is its well-developed corporate and business law. From its statutory law on legal entities, to its renowned court system, to its detailed business case law, Delaware law possesses both a certain historical pedigree and a contemporary approach that is relied upon by complex and sophisticated business ventures. Venture capital is no exception to this.
Key Structuring Considerations of the Limited Partnership Agreement
A limited partnership is structured by a limited partnership agreement. With a limited partnership, the entity is comprised of a general partner and limited partners. There are a number of key structuring considerations that a good limited partnership agreement should address, so as to give clarity to the rights of the limited partners and the authority of the general partner. The following are six areas that you’ll want to keep in mind when drafting your limited partnership agreement.
1. Organizational Matters
Typical organizational matters addressed in the limited partnership agreement include the purposes of the fund, how limited partners are admitted, and the term of the fund. For example, limited partners are usually admitted at the general partner’s discretion. With the term of the fund, a traditional term is ten years, with possibility for an extension or two, based on the approval of the general partner, or in some cases, the limited partners.
2. Capital Commitments
A venture capital-oriented limited partnership agreement will usually be very clear on the expected minimum capital contributions for both the limited partners and the general partner. With the limited partners, the minimum capital contribution is usually a specific dollar amount. For the general partner, the capital contribution can be the lesser of a certain percentage of the overall funds raised or a certain dollar amount.
Arguably one of the most important sections of the limited partnership agreement is the section that speaks to how everyone gets paid – how distributions are made. Also referred to as the waterfall, the section on distributions will have a number of provisions that articulate the priority of distributions.
For example, a more traditional distribution structure usually specifies that the limited partners will first receive distributions equal to their capital contributions. Thereafter, eighty percent of the net proceeds are distributed to the limited partners and twenty percent of the net proceeds are distributed to the general partner as the general partner’s carried interest.
4. Management of the Fund
Typically, a limited partnership agreement in the VC context stipulates that the general partner has complete authority and control when it comes to the management of the venture capital fund. This includes the ability to open up and operate bank accounts, borrow money, enter into certain guarantees with respect to portfolio investments, admit and remove limited partners, and enter into any contracts on behalf of the fund.
Also covered in the management section is the management fee. The market rate for the general partner management fee has traditionally been two percent of aggregate capital commitments of the limited partners.
5. An Advisory Board
Some limited partnership agreements will provide for an advisory board. The general partner may choose to appoint an advisory board, which is usually comprised of individuals who have industry experience in the sectors that the funds seeks to invest in. The structure of advisory boards can run from informal to formal, but general partners typically stipulate that an advisory board is solely advisory in nature and the board has no legal authority to bind the fund or make decisions on behalf of the fund.
One of the biggest provisions that savvy limited partners will want to see in a limited partnership agreements is the clawback provision. The clawback provision is a protection for the limited partner that can help to normalize the returns over the life of the fund between the limited partners and the general partner.
As a fund operates, the fund will realize certain proceeds as it liquidates and exits certain investments. Say, for example, the first three exits in portfolio companies results in net proceeds, which are distributed according to the 80/20 split. However, then further suppose that the next five exits result in a loss. Over the aggregate, the result is that the general partner has been paid too much carry. To correct this, the excess carry can be “clawed back” from the general partner and returned to the fund.
Venture Capital Attorneys Columbus Ohio
Forming a venture capital fund can be an incredibly complex endeavor. If you think you need assistance with the formation of your fund, contact our venture capital law firm in Columbus, Ohio.