Classic How To: Set Up A Venture Fund

Generally, the first step in setting up a venture fund is finding a lawyer to prepare your legal documents. Your lawyer will help you decide a number of items. You will generally save some time and money by thinking about these issues before meeting with your lawyer.

Structure

Most venture capital funds are structured as limited partnerships. Limited partnerships generally have two types of investors: limited partners and a general partner. Limited partners are generally non-active investors who commit to invest a fixed amount of money to the fund (capital commitment) in exchange for a pro-rata share of the economics of the fund (e.g. proceeds from sales, dividend income, interest income). The liability of each limited partner is limited to his/her/its commitment to the fund. Fund’s generally have one general partner. The job of the general partner is to manage the fund’s investments. Generally, a general partner will make a capital commitment of one percent of the commitments of all partners. For example, if the limited partners were to commit $99 million to a fund, the general partner would commit $1 million.

I have seen funds that are structured as LLC’s and Small Business Investment Companies (SBICs) as well as Business Development Companies. You should speak with your lawyer about the pros and cons of each structure.

Fees

Generally the general partner gets paid in two ways:

Management Fee – The general partner (generally through its affiliate, the management company) receives an annual management fee equal to two to two-and-half percent of committed capital. For example, if the fund had total commitments of $100 million and a two percent managment fee, the fund would pay the management company $2 million per year. The management fee is intended to cover the operating costs of the management company including investment personnel salaries, rent, utilities, etc…

Carry – The general partner generally receives 20% of the profits of a fund. The general idea is that if the fund is profitable, the general partner will receive a reward. For example, if a fund was able to pay $200 million in distributions to investors who contributed $100 million, 20% of the $100 million gain ($200 million in distributions – $100 million in contributions) or $20 million would go to the general partner.

Some funds will have hurdle rates that require the fund pay back not only the contributions of the limited partners but also provide them with some return on their investment (e.g. 8% per year) before a carry allocation is paid.

Other expenses 

Some other expenses that are not related to the management company are as follows:

Audit and Tax Fees – These are the amounts paid to an outside CPA firm to have the fund audited and tax forms (referred to as schedule k-1’s) prepared. (Side note: Limited partnerships are passthrough entities for tax purposes meaning the income and expenses are passed on to the partners. The Schedule k-1’s tell each partner how much he or she owes.)

Due Diligence Expenses – These are out of pocket expenses for travel and advice that the employees and members of the management company or general partner incur when looking at companies to invest in.

Legal Fees – These are the legal fees incurred by the fund.

Organizational and Syndication Costs – These are the costs related to structuring a fund including legal costs and the costs of recruiting limited partners to invest in the fund.

Legal Documents

The lawyers usually prepare three main legal documents for a fund:

Partnership Agreement – This agreement spells out all of the operational rules of the partnership. It would include the formulas for calculating the carry and the management fees. It would also detail limitations in the amounts and types of investments that the general partner is allowed to make.

Offering Document (Private Placement Memo) – This is the marketing document for the fund. Unlike mutual funds which are heavily regulated, venture funds are generally not registed. In exchange for the lack of regulatory burden, venture funds must avoid marketing in general. Venture Funds are allowed to put together private placement memos which are designed to provide a potential investor with all of the information that such investor may require including explanations of the fund structure, its strategy and management.

Subscription Documents – These are the documents an investor must fill out in order to invest in the fund. It includes personal information including contact information and tax identification numbers. It also includes the investors commitment amount. It includes a questionaire designed to determine whether or not the investor is qualified to invest in the fund.

It is important that you hire lawyers with fund knowledge and experience to get this document right.

Source: Wiki,  Author unknown.

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