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Starting (and Running) a Venture Capital Fund: The Complete Guide
May 9, 2024
Shayn Fernandez at Junto Law
We’re teaming up with our friends at Junto Law to publish a three-part series on legal (and non-legal) aspects of starting (and running) a venture capital fund. Junto Law supports emerging founders and funders as they form, fund, and scale their ventures. They offer fixed-fee packages and courses that promote communication, efficiency, and transparency. Junto allows you to spend your time growing your business instead of worrying about the bill.
Throughout the series, we will discuss (1) the legal structures and players, (2) the common and important terms, and (3) the regulatory hurdles.
Part I: Legal Structures and Players
What Are VC Funds?
Venture Capital funds, or VC funds, are used to pool capital from investors and deploy it into companies identified by the venture capitalist, or VC.
A venture capital fund is a type of private fund that: (i) holds itself out to investors as pursuing a venture capital strategy, (ii) holds at least 80% of its assets in "qualifying investments" (e.g., equity or cash), (iii) does not hold debt of more than 15% of its aggregate capital contributions and commitments, (iv) the interests of the Fund are not readily redeemable, except in extraordinary circumstances, and (v) is not registered under the Investment Company Act of 1940
An investor's investment into the VC fund ("Fund") is known as a capital commitment and is made in exchange for an interest in the Fund.
Investors do not typically pay capital commitments at the outset or all at once. Instead, capital calls are made over the Fund's investment period, which is the period in which the VC is authorized to deploy capital (e.g., 3-5 years).
This allows for investors to avoid having their money lay dormant while the VC identifies investment opportunities.
Capital calls are also helpful to the VC, who does not want to start the clock on its internal rate of return by calling capital before it is ready to be deployed.
Venture Capital funds, or VC funds, are used to pool capital from investors and deploy it into companies identified by the venture capitalist, or VC.
A venture capital fund is a type of private fund that: (i) holds itself out to investors as pursuing a venture capital strategy, (ii) holds at least 80% of its assets in "qualifying investments" (e.g., equity or cash), (iii) does not hold debt of more than 15% of its aggregate capital contributions and commitments, (iv) the interests of the Fund are not readily redeemable, except in extraordinary circumstances, and (v) is not registered under the Investment Company Act of 1940
An investor's investment into the VC fund ("Fund") is known as a capital commitment and is made in exchange for an interest in the Fund.
Investors do not typically pay capital commitments at the outset or all at once. Instead, capital calls are made over the Fund's investment period, which is the period in which the VC is authorized to deploy capital (e.g., 3-5 years).
This allows for investors to avoid having their money lay dormant while the VC identifies investment opportunities.
Capital calls are also helpful to the VC, who does not want to start the clock on its internal rate of return by calling capital before it is ready to be deployed.
Venture Capital funds, or VC funds, are used to pool capital from investors and deploy it into companies identified by the venture capitalist, or VC.
A venture capital fund is a type of private fund that: (i) holds itself out to investors as pursuing a venture capital strategy, (ii) holds at least 80% of its assets in "qualifying investments" (e.g., equity or cash), (iii) does not hold debt of more than 15% of its aggregate capital contributions and commitments, (iv) the interests of the Fund are not readily redeemable, except in extraordinary circumstances, and (v) is not registered under the Investment Company Act of 1940
An investor's investment into the VC fund ("Fund") is known as a capital commitment and is made in exchange for an interest in the Fund.
Investors do not typically pay capital commitments at the outset or all at once. Instead, capital calls are made over the Fund's investment period, which is the period in which the VC is authorized to deploy capital (e.g., 3-5 years).
This allows for investors to avoid having their money lay dormant while the VC identifies investment opportunities.
Capital calls are also helpful to the VC, who does not want to start the clock on its internal rate of return by calling capital before it is ready to be deployed.
Structures and Players
Structures and Players
Structures and Players
As we will discuss throughout this series, there are few technical barriers to becoming a VC.
While there are plenty of regulatory hurdles to becoming a VC, there are no required licenses, specific education, or testing requirements. A VC isn't even required to be an accredited investor independently. In fact, the VC may qualify as an accredited investor simply by raising a Fund above $5M or being a knowledgeable employee of the Fund (more on this in Part III).
So far, we've used the term VC generically, but many different people and entities contribute within VC.
As we will discuss throughout this series, there are few technical barriers to becoming a VC.
While there are plenty of regulatory hurdles to becoming a VC, there are no required licenses, specific education, or testing requirements. A VC isn't even required to be an accredited investor independently. In fact, the VC may qualify as an accredited investor simply by raising a Fund above $5M or being a knowledgeable employee of the Fund (more on this in Part III).
So far, we've used the term VC generically, but many different people and entities contribute within VC.
As we will discuss throughout this series, there are few technical barriers to becoming a VC.
While there are plenty of regulatory hurdles to becoming a VC, there are no required licenses, specific education, or testing requirements. A VC isn't even required to be an accredited investor independently. In fact, the VC may qualify as an accredited investor simply by raising a Fund above $5M or being a knowledgeable employee of the Fund (more on this in Part III).
So far, we've used the term VC generically, but many different people and entities contribute within VC.
General Partners ("GP")
General Partners ("GP")
General Partners ("GP")
The founders of the VC firm are often considered the "VC," but the more precise title for the founders of a VC firm is general partner or GP. The GPs usually wrap themselves in a legal entity–most commonly, an LLC (e.g., Junto GP I, LLC), to limit liability and operate through a corporate existence.The GP designation also denotes its role in the traditional fund structure–as the general partner of a limited partnership.
In the traditional fund model, the Fund is organized as a Delaware limited partnership, which is structured to include a general partner (e.g., GP entity) and one or more limited partners (i.e., the investors).
In a Fund that is formed as a limited partnership, the GP has the power and authority to manage and act on behalf of the Fund, making investment decisions, signing contracts (e.g., the Investment Management Agreement with the Management Company), filing tax and regulatory filings on behalf of the fund, and deploying the Fund property.
The Fund investors grant broad discretion and authority to the GP in managing the Fund, however, the Fund's governing documents (in a limited partnership, the Limited Partnership Agreement) do include important restrictions on GP authority without the investors' consent. For instance, the GP may be limited to making investments consistent with a particular Fund thesis, which may be based on stage (e.g., seed, growth, late-stage), industry sector (e.g., enterprise SaaS, biotechnology, blockchain, clean-tech), or philosophy (e.g., geographic-based).
The founders of the VC firm are often considered the "VC," but the more precise title for the founders of a VC firm is general partner or GP. The GPs usually wrap themselves in a legal entity–most commonly, an LLC (e.g., Junto GP I, LLC), to limit liability and operate through a corporate existence.The GP designation also denotes its role in the traditional fund structure–as the general partner of a limited partnership.
In the traditional fund model, the Fund is organized as a Delaware limited partnership, which is structured to include a general partner (e.g., GP entity) and one or more limited partners (i.e., the investors).
In a Fund that is formed as a limited partnership, the GP has the power and authority to manage and act on behalf of the Fund, making investment decisions, signing contracts (e.g., the Investment Management Agreement with the Management Company), filing tax and regulatory filings on behalf of the fund, and deploying the Fund property.
The Fund investors grant broad discretion and authority to the GP in managing the Fund, however, the Fund's governing documents (in a limited partnership, the Limited Partnership Agreement) do include important restrictions on GP authority without the investors' consent. For instance, the GP may be limited to making investments consistent with a particular Fund thesis, which may be based on stage (e.g., seed, growth, late-stage), industry sector (e.g., enterprise SaaS, biotechnology, blockchain, clean-tech), or philosophy (e.g., geographic-based).
The founders of the VC firm are often considered the "VC," but the more precise title for the founders of a VC firm is general partner or GP. The GPs usually wrap themselves in a legal entity–most commonly, an LLC (e.g., Junto GP I, LLC), to limit liability and operate through a corporate existence.The GP designation also denotes its role in the traditional fund structure–as the general partner of a limited partnership.
In the traditional fund model, the Fund is organized as a Delaware limited partnership, which is structured to include a general partner (e.g., GP entity) and one or more limited partners (i.e., the investors).
In a Fund that is formed as a limited partnership, the GP has the power and authority to manage and act on behalf of the Fund, making investment decisions, signing contracts (e.g., the Investment Management Agreement with the Management Company), filing tax and regulatory filings on behalf of the fund, and deploying the Fund property.
The Fund investors grant broad discretion and authority to the GP in managing the Fund, however, the Fund's governing documents (in a limited partnership, the Limited Partnership Agreement) do include important restrictions on GP authority without the investors' consent. For instance, the GP may be limited to making investments consistent with a particular Fund thesis, which may be based on stage (e.g., seed, growth, late-stage), industry sector (e.g., enterprise SaaS, biotechnology, blockchain, clean-tech), or philosophy (e.g., geographic-based).
Limited Partners ("LPs")
Limited Partners ("LPs")
Limited Partners ("LPs")
The most important players in a Fund are the limited partners or LPs, which are the Fund's investors.
Just as the existence of a startup may depend (at least to some extent) on the involvement of a VC, the VC is as much reliant on its LPs.
Typically, LPs are wealthy individuals, family offices, endowments, funds of funds, pensions, etc.
The most important players in a Fund are the limited partners or LPs, which are the Fund's investors.
Just as the existence of a startup may depend (at least to some extent) on the involvement of a VC, the VC is as much reliant on its LPs.
Typically, LPs are wealthy individuals, family offices, endowments, funds of funds, pensions, etc.
The most important players in a Fund are the limited partners or LPs, which are the Fund's investors.
Just as the existence of a startup may depend (at least to some extent) on the involvement of a VC, the VC is as much reliant on its LPs.
Typically, LPs are wealthy individuals, family offices, endowments, funds of funds, pensions, etc.
Many LPs look at VC investments as a piece of their overall investment portfolio (e.g., along with public stocks or bonds). They expect that the VC investment will generate outsized returns with the tradeoff of higher risk. Along with these expectations, LPs will have certain expectations related to the GP. For instance, the LPs will expect that the GP has some “skin in the game” by requiring the GP to contribute at least 1% of the Fund's capital contributions.This is particularly true for first-time fund managers who may not be able to point to a significant track record to garner LP trust.
Many LPs look at VC investments as a piece of their overall investment portfolio (e.g., along with public stocks or bonds). They expect that the VC investment will generate outsized returns with the tradeoff of higher risk. Along with these expectations, LPs will have certain expectations related to the GP. For instance, the LPs will expect that the GP has some “skin in the game” by requiring the GP to contribute at least 1% of the Fund's capital contributions.This is particularly true for first-time fund managers who may not be able to point to a significant track record to garner LP trust.
Many LPs look at VC investments as a piece of their overall investment portfolio (e.g., along with public stocks or bonds). They expect that the VC investment will generate outsized returns with the tradeoff of higher risk. Along with these expectations, LPs will have certain expectations related to the GP. For instance, the LPs will expect that the GP has some “skin in the game” by requiring the GP to contribute at least 1% of the Fund's capital contributions.This is particularly true for first-time fund managers who may not be able to point to a significant track record to garner LP trust.
Despite contributing almost all of the capital (e.g., 97-99%), LPs do not receive (and do not expect) substantial governance rights. Instead, the predominant rights of the LPs are economic in nature (e.g., the top tier of the distribution waterfall), which we will discuss in more detail in Part II.
Put simply, LPs rely on the GP and its team to handle the day-to-day operations of the Fund.
Despite contributing almost all of the capital (e.g., 97-99%), LPs do not receive (and do not expect) substantial governance rights. Instead, the predominant rights of the LPs are economic in nature (e.g., the top tier of the distribution waterfall), which we will discuss in more detail in Part II.
Put simply, LPs rely on the GP and its team to handle the day-to-day operations of the Fund.
Despite contributing almost all of the capital (e.g., 97-99%), LPs do not receive (and do not expect) substantial governance rights. Instead, the predominant rights of the LPs are economic in nature (e.g., the top tier of the distribution waterfall), which we will discuss in more detail in Part II.
Put simply, LPs rely on the GP and its team to handle the day-to-day operations of the Fund.
Management Company
Management Company
Management Company
In addition to the GPs, the Fund (directly and indirectly) relies on the individuals employed or hired by the GP to carry out and manage the Fund and VC firm.
For instance, VC firms often employ analysts, associates, and principals that identify and evaluate investments. A VC firm may also employ (or outsource) back-office support teams, including accountants, lawyers, and other administrative personnel.Some of these individuals may be granted a portion of the carried interest or carry paid to the GP (e.g., 20% of the profits generated from the Fund after returning capital to LPs (plus any preferred return), more on this in Part II). This right is usually subject to vesting (more on vesting in other contexts here).
Instead of housing these individuals within the GP entity, the VC often forms a management company (e.g., Junto Manager, LLC) to compensate and employ these individuals.The GP and the Fund often enter into an "Investment Management Agreement" with the Management Company. In this agreement, the Management Company is delegated to sourcing investments and is entitled to the Fund's management fees (more on this in Part II) and reimbursement of the costs and expenses of each Fund.A traditional (i.e., closed-end) structure is shown below:
The above image represents a traditional fund structure. In recent years, a variety of other structures have emerged with their own nuances, such as rolling funds, evergreen funds, syndicates, and DAO Investment Clubs.
In addition to the GPs, the Fund (directly and indirectly) relies on the individuals employed or hired by the GP to carry out and manage the Fund and VC firm.
For instance, VC firms often employ analysts, associates, and principals that identify and evaluate investments. A VC firm may also employ (or outsource) back-office support teams, including accountants, lawyers, and other administrative personnel.Some of these individuals may be granted a portion of the carried interest or carry paid to the GP (e.g., 20% of the profits generated from the Fund after returning capital to LPs (plus any preferred return), more on this in Part II). This right is usually subject to vesting (more on vesting in other contexts here).
Instead of housing these individuals within the GP entity, the VC often forms a management company (e.g., Junto Manager, LLC) to compensate and employ these individuals.The GP and the Fund often enter into an "Investment Management Agreement" with the Management Company. In this agreement, the Management Company is delegated to sourcing investments and is entitled to the Fund's management fees (more on this in Part II) and reimbursement of the costs and expenses of each Fund.A traditional (i.e., closed-end) structure is shown below:
The above image represents a traditional fund structure. In recent years, a variety of other structures have emerged with their own nuances, such as rolling funds, evergreen funds, syndicates, and DAO Investment Clubs.
In addition to the GPs, the Fund (directly and indirectly) relies on the individuals employed or hired by the GP to carry out and manage the Fund and VC firm.
For instance, VC firms often employ analysts, associates, and principals that identify and evaluate investments. A VC firm may also employ (or outsource) back-office support teams, including accountants, lawyers, and other administrative personnel.Some of these individuals may be granted a portion of the carried interest or carry paid to the GP (e.g., 20% of the profits generated from the Fund after returning capital to LPs (plus any preferred return), more on this in Part II). This right is usually subject to vesting (more on vesting in other contexts here).
Instead of housing these individuals within the GP entity, the VC often forms a management company (e.g., Junto Manager, LLC) to compensate and employ these individuals.The GP and the Fund often enter into an "Investment Management Agreement" with the Management Company. In this agreement, the Management Company is delegated to sourcing investments and is entitled to the Fund's management fees (more on this in Part II) and reimbursement of the costs and expenses of each Fund.A traditional (i.e., closed-end) structure is shown below:
The above image represents a traditional fund structure. In recent years, a variety of other structures have emerged with their own nuances, such as rolling funds, evergreen funds, syndicates, and DAO Investment Clubs.
Conclusion
Conclusion
Conclusion
A VC Fund is used to pool capital from LPs, which is then called over the investment period by the GP to be deployed into startups.
Although the term VC is often used generically, there are various players under that umbrella, including the GP, the Management Company, and the other stakeholders of the GP or Management Company (e.g., principals, associates, advisors, back office)–each with a unique role.
In Part II, we will dig deeper into some key terms related to starting and running a venture capital fund.
A VC Fund is used to pool capital from LPs, which is then called over the investment period by the GP to be deployed into startups.
Although the term VC is often used generically, there are various players under that umbrella, including the GP, the Management Company, and the other stakeholders of the GP or Management Company (e.g., principals, associates, advisors, back office)–each with a unique role.
In Part II, we will dig deeper into some key terms related to starting and running a venture capital fund.
A VC Fund is used to pool capital from LPs, which is then called over the investment period by the GP to be deployed into startups.
Although the term VC is often used generically, there are various players under that umbrella, including the GP, the Management Company, and the other stakeholders of the GP or Management Company (e.g., principals, associates, advisors, back office)–each with a unique role.
In Part II, we will dig deeper into some key terms related to starting and running a venture capital fund.
Part II: Key Terms
Part II: Key Terms
Part II: Key Terms
In Part II, we will focus on all things terms. Particularly two buckets: (1) economic or financial terms and (2) other terms, such as those related to governance, structural, and regulatory terms
In Part II, we will focus on all things terms. Particularly two buckets: (1) economic or financial terms and (2) other terms, such as those related to governance, structural, and regulatory terms
In Part II, we will focus on all things terms. Particularly two buckets: (1) economic or financial terms and (2) other terms, such as those related to governance, structural, and regulatory terms
Economic Terms
Economic Terms
Economic Terms
Fund Expenses
Fund Expenses
Fund Expenses
Starting and running a venture fund can be expensive. Luckily for the GP, many fund expenses are paid out of the capital contributions of the LPs. Fund expenses are the costs incurred for the day-to-day operation of the fund, including organizational expenses (e.g., the costs and expenses in forming the fund) and operational or administrative expenses (e.g., sourcing investments, legal fees), and accounting fees (e.g., tax returns, audits, financial statements). Fund expenses do not ordinarily include expenses related solely to the GP, such as office space or salaries.
Fund expenses are paid directly out of the LPs’ capital contributions, meaning that a GP does not invest the full amount of capital that they raise. These costs and expenses are separate from the management fees.
Starting and running a venture fund can be expensive. Luckily for the GP, many fund expenses are paid out of the capital contributions of the LPs. Fund expenses are the costs incurred for the day-to-day operation of the fund, including organizational expenses (e.g., the costs and expenses in forming the fund) and operational or administrative expenses (e.g., sourcing investments, legal fees), and accounting fees (e.g., tax returns, audits, financial statements). Fund expenses do not ordinarily include expenses related solely to the GP, such as office space or salaries.
Fund expenses are paid directly out of the LPs’ capital contributions, meaning that a GP does not invest the full amount of capital that they raise. These costs and expenses are separate from the management fees.
Starting and running a venture fund can be expensive. Luckily for the GP, many fund expenses are paid out of the capital contributions of the LPs. Fund expenses are the costs incurred for the day-to-day operation of the fund, including organizational expenses (e.g., the costs and expenses in forming the fund) and operational or administrative expenses (e.g., sourcing investments, legal fees), and accounting fees (e.g., tax returns, audits, financial statements). Fund expenses do not ordinarily include expenses related solely to the GP, such as office space or salaries.
Fund expenses are paid directly out of the LPs’ capital contributions, meaning that a GP does not invest the full amount of capital that they raise. These costs and expenses are separate from the management fees.
Management Fees
Management Fees
Management Fees
Most VCs charge an annual management fee that is calculated as a percentage of the capital commitments of an LP over the life of the fund. Management fees are payable by the LPs to the Management Company out of the capital contributions. The standard management fee in VC is 2% annually. Regardless of how the VC chooses to call capital, the Management Company is entitled to take an annual management fee on the full amount of the capital commitments.
Management fees are ordinarily paid to the Management Company as compensation for its services. The Management Company can use this pool of money to operate the fund and to cover the costs and expenses associated with its services (e.g., compensating employees, travel expenses, and other day-to-day expenses).
Similar to how fund expenses reduce the overall amount of dry powder, or cash available to be deployed into investments, it may not be advantageous for the VC to take the entire management fee. For instance, for a $50M fund with a 10-year life, the aggregate management fees would be $10M–which may drastically cut the amount of dry powder, and thus the number of investments possible.
To address this, the limited partnership agreement (“LPA”) often provides that the management fees may be recycled (e.g., used to make investments)–thereby increasing the capital deployed and increasing the odds of generating a profit.
Most VCs charge an annual management fee that is calculated as a percentage of the capital commitments of an LP over the life of the fund. Management fees are payable by the LPs to the Management Company out of the capital contributions. The standard management fee in VC is 2% annually. Regardless of how the VC chooses to call capital, the Management Company is entitled to take an annual management fee on the full amount of the capital commitments.
Management fees are ordinarily paid to the Management Company as compensation for its services. The Management Company can use this pool of money to operate the fund and to cover the costs and expenses associated with its services (e.g., compensating employees, travel expenses, and other day-to-day expenses).
Similar to how fund expenses reduce the overall amount of dry powder, or cash available to be deployed into investments, it may not be advantageous for the VC to take the entire management fee. For instance, for a $50M fund with a 10-year life, the aggregate management fees would be $10M–which may drastically cut the amount of dry powder, and thus the number of investments possible.
To address this, the limited partnership agreement (“LPA”) often provides that the management fees may be recycled (e.g., used to make investments)–thereby increasing the capital deployed and increasing the odds of generating a profit.
Most VCs charge an annual management fee that is calculated as a percentage of the capital commitments of an LP over the life of the fund. Management fees are payable by the LPs to the Management Company out of the capital contributions. The standard management fee in VC is 2% annually. Regardless of how the VC chooses to call capital, the Management Company is entitled to take an annual management fee on the full amount of the capital commitments.
Management fees are ordinarily paid to the Management Company as compensation for its services. The Management Company can use this pool of money to operate the fund and to cover the costs and expenses associated with its services (e.g., compensating employees, travel expenses, and other day-to-day expenses).
Similar to how fund expenses reduce the overall amount of dry powder, or cash available to be deployed into investments, it may not be advantageous for the VC to take the entire management fee. For instance, for a $50M fund with a 10-year life, the aggregate management fees would be $10M–which may drastically cut the amount of dry powder, and thus the number of investments possible.
To address this, the limited partnership agreement (“LPA”) often provides that the management fees may be recycled (e.g., used to make investments)–thereby increasing the capital deployed and increasing the odds of generating a profit.
Further, because most of the VC’s activity occurs during the investment period, the management fee may be reduced in later years (e.g., drop by .5% for periods after the investment period or for all times after the investment period, be measured as 2% of the unreturned capital to the LPs).
Further, because most of the VC’s activity occurs during the investment period, the management fee may be reduced in later years (e.g., drop by .5% for periods after the investment period or for all times after the investment period, be measured as 2% of the unreturned capital to the LPs).
Further, because most of the VC’s activity occurs during the investment period, the management fee may be reduced in later years (e.g., drop by .5% for periods after the investment period or for all times after the investment period, be measured as 2% of the unreturned capital to the LPs).
Carried Interest and Waterfall
Carried Interest and Waterfall
Carried Interest and Waterfall
Carry or carried interest refers to the portion of the fund's profits that the GP is entitled to keep out of the distributions paid through the waterfall.
The waterfall refers to the tiers of payments to be made through the Fund. Typically, LP capital is returned in its entirety, then profits are returned to LPs (typically 80%), and then carry to the GP (typically 20%).
When the GP can distribute these profits to itself, however, it is subject to significant negotiations with the LPs and outlined in the LPA.
To better illustrate the GP’s entitlement to carry and distributions under the waterfall, let's look at an example:
Example: Junto Ventures Fund I, LP is a $50M fund. The Fund invests $5M in a portfolio company (PortCo 1) which exists with a $30M distribution after three years.
In our example, the fund has received $25M in profits for its investment in PortCo 1, Inc.. If the GP can distribute, the LPs will receive $25M ($5M as a return on capital invested and $20M as 80% of the profit) and the GP would receive $5M (being, 20% of the profit).
A fund’s GP is often required to contribute a portion (e.g., 1%) of the total capital commitments (often referred to as the GP commit). For the purposes of returning capital in the first tier of the waterfall, the GP commit would be treated the same as the capital contributions of the LPs – so, the GP would be entitled to repayment of the GP commit prior to a distribution of profits to LPs).
The key, however, is whether the GP can distribute the $5M to itself, which largely depends on the status of its other investments.
Let’s look at a few scenarios:
If the investment in PortCo 1, was one of a few exits and the other investments yielded returns of, say, $100M, then it is clear that the GP is entitled to distribute the carry.
Conversely, if all the other investments were marked down to zero, the GP could not take any carry (i.e., the total amount returned was only $30M of a $50M Fund).
Those are relatively easy, but unlikely situations.
Instead, what if none of the other investments had matured at the time of the exit of PortCo 1–could the GP take carry? Typically, the LPA dictates that the GP can take carry on the exit from PortCo 1, so long as the portfolio's value on paper would still render the fund “in the money” for the purposes of the GP’s receipt of carry.
Carry or carried interest refers to the portion of the fund's profits that the GP is entitled to keep out of the distributions paid through the waterfall.
The waterfall refers to the tiers of payments to be made through the Fund. Typically, LP capital is returned in its entirety, then profits are returned to LPs (typically 80%), and then carry to the GP (typically 20%).
When the GP can distribute these profits to itself, however, it is subject to significant negotiations with the LPs and outlined in the LPA.
To better illustrate the GP’s entitlement to carry and distributions under the waterfall, let's look at an example:
Example: Junto Ventures Fund I, LP is a $50M fund. The Fund invests $5M in a portfolio company (PortCo 1) which exists with a $30M distribution after three years.
In our example, the fund has received $25M in profits for its investment in PortCo 1, Inc.. If the GP can distribute, the LPs will receive $25M ($5M as a return on capital invested and $20M as 80% of the profit) and the GP would receive $5M (being, 20% of the profit).
A fund’s GP is often required to contribute a portion (e.g., 1%) of the total capital commitments (often referred to as the GP commit). For the purposes of returning capital in the first tier of the waterfall, the GP commit would be treated the same as the capital contributions of the LPs – so, the GP would be entitled to repayment of the GP commit prior to a distribution of profits to LPs).
The key, however, is whether the GP can distribute the $5M to itself, which largely depends on the status of its other investments.
Let’s look at a few scenarios:
If the investment in PortCo 1, was one of a few exits and the other investments yielded returns of, say, $100M, then it is clear that the GP is entitled to distribute the carry.
Conversely, if all the other investments were marked down to zero, the GP could not take any carry (i.e., the total amount returned was only $30M of a $50M Fund).
Those are relatively easy, but unlikely situations.
Instead, what if none of the other investments had matured at the time of the exit of PortCo 1–could the GP take carry? Typically, the LPA dictates that the GP can take carry on the exit from PortCo 1, so long as the portfolio's value on paper would still render the fund “in the money” for the purposes of the GP’s receipt of carry.
Carry or carried interest refers to the portion of the fund's profits that the GP is entitled to keep out of the distributions paid through the waterfall.
The waterfall refers to the tiers of payments to be made through the Fund. Typically, LP capital is returned in its entirety, then profits are returned to LPs (typically 80%), and then carry to the GP (typically 20%).
When the GP can distribute these profits to itself, however, it is subject to significant negotiations with the LPs and outlined in the LPA.
To better illustrate the GP’s entitlement to carry and distributions under the waterfall, let's look at an example:
Example: Junto Ventures Fund I, LP is a $50M fund. The Fund invests $5M in a portfolio company (PortCo 1) which exists with a $30M distribution after three years.
In our example, the fund has received $25M in profits for its investment in PortCo 1, Inc.. If the GP can distribute, the LPs will receive $25M ($5M as a return on capital invested and $20M as 80% of the profit) and the GP would receive $5M (being, 20% of the profit).
A fund’s GP is often required to contribute a portion (e.g., 1%) of the total capital commitments (often referred to as the GP commit). For the purposes of returning capital in the first tier of the waterfall, the GP commit would be treated the same as the capital contributions of the LPs – so, the GP would be entitled to repayment of the GP commit prior to a distribution of profits to LPs).
The key, however, is whether the GP can distribute the $5M to itself, which largely depends on the status of its other investments.
Let’s look at a few scenarios:
If the investment in PortCo 1, was one of a few exits and the other investments yielded returns of, say, $100M, then it is clear that the GP is entitled to distribute the carry.
Conversely, if all the other investments were marked down to zero, the GP could not take any carry (i.e., the total amount returned was only $30M of a $50M Fund).
Those are relatively easy, but unlikely situations.
Instead, what if none of the other investments had matured at the time of the exit of PortCo 1–could the GP take carry? Typically, the LPA dictates that the GP can take carry on the exit from PortCo 1, so long as the portfolio's value on paper would still render the fund “in the money” for the purposes of the GP’s receipt of carry.
The Last Round Valuation model would look at the last round of an investment and mark the value of the investment based on the valuation in that round multiplied by the Fund’s ownership (e.g., if the last round was at a valuation of $100M and the Fund owns 10%, then the value of the investment is $10M (i.e., $100M x 10%).
Conversely, the Comparable Company Model looks at the key valuation metrics for similar publicly traded companies (e.g., ARR for a SaaS company) to determine a metric to apply to the portfolio company, subject to a discount for lack of marketability (e.g., the portfolio company securities cannot be readily be sold)
If it turns out that those paper marks were incorrect, and the final results were such that the GP would not have been entitled to take $5M as carry, the GP’s would need to give that money back. This is called clawback.
The GP could also be subject to clawback if the distribution waterfall provided for a hurdle or preferred return, and the final results of the investments did not clear the applicable threshold.
Hurdle Rate: Unless the Fund generates a return over a certain threshold (e.g., 6-8%) the GP is not entitled to take any carry.
Preferred Return: Similar to a hurdle in that it requires the GP to pass a certain annual threshold (6-8%), but also provides that the LPs receive all cash until that preferred return is exceeded, and the GP would only receive any carry over the preferred return.
Similar to the recycling of management fees, GPs are often entitled to re-invest the carry received on early investments. For instance, in our example, the GP could re-invest the $5M it received from the exit of PortCo 1, Inc. in hopes of generating even greater returns.
The Last Round Valuation model would look at the last round of an investment and mark the value of the investment based on the valuation in that round multiplied by the Fund’s ownership (e.g., if the last round was at a valuation of $100M and the Fund owns 10%, then the value of the investment is $10M (i.e., $100M x 10%).
Conversely, the Comparable Company Model looks at the key valuation metrics for similar publicly traded companies (e.g., ARR for a SaaS company) to determine a metric to apply to the portfolio company, subject to a discount for lack of marketability (e.g., the portfolio company securities cannot be readily be sold)
If it turns out that those paper marks were incorrect, and the final results were such that the GP would not have been entitled to take $5M as carry, the GP’s would need to give that money back. This is called clawback.
The GP could also be subject to clawback if the distribution waterfall provided for a hurdle or preferred return, and the final results of the investments did not clear the applicable threshold.
Hurdle Rate: Unless the Fund generates a return over a certain threshold (e.g., 6-8%) the GP is not entitled to take any carry.
Preferred Return: Similar to a hurdle in that it requires the GP to pass a certain annual threshold (6-8%), but also provides that the LPs receive all cash until that preferred return is exceeded, and the GP would only receive any carry over the preferred return.
Similar to the recycling of management fees, GPs are often entitled to re-invest the carry received on early investments. For instance, in our example, the GP could re-invest the $5M it received from the exit of PortCo 1, Inc. in hopes of generating even greater returns.
The Last Round Valuation model would look at the last round of an investment and mark the value of the investment based on the valuation in that round multiplied by the Fund’s ownership (e.g., if the last round was at a valuation of $100M and the Fund owns 10%, then the value of the investment is $10M (i.e., $100M x 10%).
Conversely, the Comparable Company Model looks at the key valuation metrics for similar publicly traded companies (e.g., ARR for a SaaS company) to determine a metric to apply to the portfolio company, subject to a discount for lack of marketability (e.g., the portfolio company securities cannot be readily be sold)
If it turns out that those paper marks were incorrect, and the final results were such that the GP would not have been entitled to take $5M as carry, the GP’s would need to give that money back. This is called clawback.
The GP could also be subject to clawback if the distribution waterfall provided for a hurdle or preferred return, and the final results of the investments did not clear the applicable threshold.
Hurdle Rate: Unless the Fund generates a return over a certain threshold (e.g., 6-8%) the GP is not entitled to take any carry.
Preferred Return: Similar to a hurdle in that it requires the GP to pass a certain annual threshold (6-8%), but also provides that the LPs receive all cash until that preferred return is exceeded, and the GP would only receive any carry over the preferred return.
Similar to the recycling of management fees, GPs are often entitled to re-invest the carry received on early investments. For instance, in our example, the GP could re-invest the $5M it received from the exit of PortCo 1, Inc. in hopes of generating even greater returns.
Other Terms
Other Terms
Other Terms
Fund Thesis and Strategy
Fund Thesis and Strategy
Fund Thesis and Strategy
GPs have considerable freedom in managing their fund and selecting investments. However, the LPA does impose certain restrictions on their ability to make investments outside of a specified scope, typically outlined in the "purpose" clause.
Investment limitations can differ in scope. For example, the LPA may broadly state that the fund will invest in "early-stage, privately-held companies," while others may be more specific, mentioning the stage, criteria, or industry (e.g., "venture capital investments in early-stage, privately-held companies focused on the healthcare technology").
The GP pitches LPs and raises the fund by describing its strategy and thesis. Central to this thesis is the industry (e.g., B2B SaaS), stage (e.g., seed), check sizes ($500k-$1M), and portfolio construction (e.g., 65% initial investment/35% follow-on reserves) strategies. LPs must evaluate a GP's thesis and strategy to ensure it aligns with their investment goals, as they are signing up for a blind pool of investments.
Side Letters
Side Letters
Side Letters
Side letters are agreements that grant additional rights to specific LPs. These agreements are similar to those received by the VC from a portfolio company. Side letters are usually only given to a select group of investors, such as the lead VC in a startup round or a prospective LP providing a significant investment. Side letters may also be granted to attract certain investors or to manage regulatory constraints on an LP's investment, such as those imposed by the Employee Retirement Income Security Act (ERISA).
Alternative Investment Vehicles
Alternative Investment Vehicles
Alternative Investment Vehicles
Certain LPs may be subject to legal, tax, or regulatory issues that make investing in the fund untenable–unless certain special purpose vehicles (“SPVs”) are used. The most common SPVs are parallel funds, feeder funds, alternative investment vehicles, and co-investment vehicles.
Parallel Vehicles
Parallel Vehicles
Parallel Vehicles
Parallel vehicles are typically established for LPs with a distinct tax status requirement that differs from other LPs. For example, if a fund has non-US LPs, it may be beneficial to create a parallel fund in an offshore jurisdiction (“Parallel Fund”), such as the Cayman Islands, that is more favorable to these LPs.
Aside from specific legal, tax, and regulatory differences, the Parallel Fund will have the same investment strategy and terms as the main fund. The Parallel Fund will also invest in the same assets and at the same time as the main fund. The allocation into an investment will be pro rata between the two funds based on their respective portion of the total capital commitments.
Feeder Funds
Feeder Funds
Feeder Funds
Another way to accommodate non-US LPS with unique legal, tax, or regulatory concerns is by using feeder funds. A feeder fund is an investment vehicle organized as a corporate taxpayer. Instead of investing directly into the fund, the LPs invest in the feeder und, which then invests into the fund. The feeder fund acts as a blocker in the relationship between the LP and the fund. Because the feeder fund is a corporate taxpayer, it will pay taxes on allocations and distributions, relieving the non-US LPs from filing and paying federal taxes in the US.
Alternative Investment Vehicles
Alternative Investment Vehicles
Alternative Investment Vehicles
Alternative investment vehicles are typically structured to address the legal, tax, and regulatory issues that may arise when certain LPs invest in a particular opportunity. While a Parallel Fund invests alongside the main fund in each investment, alternative investment vehicles are limited to a single, specific investment. In this way, alternative investment vehicles can provide a more focused approach for certain LPs, allowing them to tailor the investment to their specific needs and objectives.
Co-Investment Vehicles
Co-Investment Vehicles
Co-Investment Vehicles
Co-Investment vehicles are SPVs created to invest alongside the fund on specific investments. For example, an SPV may be used when the GP receives an allocation larger than the fund's limits. In this situation, the VC may establish an SPV to invest the additional amount with one or more LPs or non-LP investors (i.e., investors that are not LPs in the Fund).
Summary
Summary
Summary
In this post, we provided an in-depth overview of the legal and financial components of starting and running a venture capital fund. We also shed light on the expenses and management fees associated with the process and explained the concept of carried interest and waterfall. The article further highlighted how the GP's entitlement to carry and distributions are determined through negotiations with the LP and outlined in the LPA.
Part III: Legal and Regulatory Compliance
Part III: Legal and Regulatory Compliance
Part III: Legal and Regulatory Compliance
In this post, we will focus on the legal and regulatory aspects of raising and running a venture fund, specifically, the compliance obligations and regulations that impact a VC.
The Securities Act of 1933
The Securities Act of 1933
The Securities Act of 1933
The Securities Act of 1933 (the “Securities Act”) governs the offer and sale of securities by the fund to LPs.
Under the Securities Act, “securities” means “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
The SEC has used “investment contracts” to include a broad range of assets, contracts, instruments, and relationships as securities. Given this definition, an offer and sale of interests in a fund should be considered an offer and sale of securities.
In order to properly offer and sell securities under the Act, the fund (also known as the “issuer”) must do so under a valid registration statement or pursuant to an exemption from registration.
Given the regulatory and administrative requirements, registering fund interests is not practicable, so they are offered and sold through the exemptions offered by Reg D–commonly under Rule 506(b) and Rule 506(c).
The Securities Act of 1933 (the “Securities Act”) governs the offer and sale of securities by the fund to LPs.
Under the Securities Act, “securities” means “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
The SEC has used “investment contracts” to include a broad range of assets, contracts, instruments, and relationships as securities. Given this definition, an offer and sale of interests in a fund should be considered an offer and sale of securities.
In order to properly offer and sell securities under the Act, the fund (also known as the “issuer”) must do so under a valid registration statement or pursuant to an exemption from registration.
Given the regulatory and administrative requirements, registering fund interests is not practicable, so they are offered and sold through the exemptions offered by Reg D–commonly under Rule 506(b) and Rule 506(c).
The Securities Act of 1933 (the “Securities Act”) governs the offer and sale of securities by the fund to LPs.
Under the Securities Act, “securities” means “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
The SEC has used “investment contracts” to include a broad range of assets, contracts, instruments, and relationships as securities. Given this definition, an offer and sale of interests in a fund should be considered an offer and sale of securities.
In order to properly offer and sell securities under the Act, the fund (also known as the “issuer”) must do so under a valid registration statement or pursuant to an exemption from registration.
Given the regulatory and administrative requirements, registering fund interests is not practicable, so they are offered and sold through the exemptions offered by Reg D–commonly under Rule 506(b) and Rule 506(c).
Rule 506(b)
Rule 506(b)
Rule 506(b)
Rule 506(b) allows a VC to raise capital from an unlimited number of accredited investors and up to 35 non-accredited investors (more on this later).
Generally, a non-accredited investor must be a sophisticated investor who can evaluate the economic risks and merits of the proposed offering.
Rule 506(b) allows a VC to raise capital from an unlimited number of accredited investors and up to 35 non-accredited investors (more on this later).
Generally, a non-accredited investor must be a sophisticated investor who can evaluate the economic risks and merits of the proposed offering.
Rule 506(b) allows a VC to raise capital from an unlimited number of accredited investors and up to 35 non-accredited investors (more on this later).
Generally, a non-accredited investor must be a sophisticated investor who can evaluate the economic risks and merits of the proposed offering.
What is an Accredited Investor?
What is an Accredited Investor?
What is an Accredited Investor?
The SEC summarizes the definition of “accredited investors” as:
One of the benefits of Rule 506(b) is the streamlined process of validating an LPs status as an accredited investor.
The SEC summarizes the definition of “accredited investors” as:
One of the benefits of Rule 506(b) is the streamlined process of validating an LPs status as an accredited investor.
The SEC summarizes the definition of “accredited investors” as:
One of the benefits of Rule 506(b) is the streamlined process of validating an LPs status as an accredited investor.
Despite the ability, many issuers do not allow non-accredited investors to invest in a Rule 506(b) offering because the issuer must provide more detailed disclosures (e.g., two years of financial statements and a more detailed description of the issuer’s business and the risks involved). If an issuer makes these disclosures to non-accredited investors, it will also need to provide such information to its accredited investors.
The biggest limitation of Rule 506(b), however, is the prohibition on general solicitations and advertisements. In practice, this means the issuer must have a substantive and pre-existing relationship with the prospective investor. There can be a fine line between a substantive and pre-existing relationship and a general solicitation.
Generally, Rule 506(b) offerings cannot advertise the offering in the general media (e.g., tweet about the offering) or engage in cold outreach campaigns or solicitations (e.g., direct messaging a prospective LP on LinkedIn).
Despite the ability, many issuers do not allow non-accredited investors to invest in a Rule 506(b) offering because the issuer must provide more detailed disclosures (e.g., two years of financial statements and a more detailed description of the issuer’s business and the risks involved). If an issuer makes these disclosures to non-accredited investors, it will also need to provide such information to its accredited investors.
The biggest limitation of Rule 506(b), however, is the prohibition on general solicitations and advertisements. In practice, this means the issuer must have a substantive and pre-existing relationship with the prospective investor. There can be a fine line between a substantive and pre-existing relationship and a general solicitation.
Generally, Rule 506(b) offerings cannot advertise the offering in the general media (e.g., tweet about the offering) or engage in cold outreach campaigns or solicitations (e.g., direct messaging a prospective LP on LinkedIn).
Despite the ability, many issuers do not allow non-accredited investors to invest in a Rule 506(b) offering because the issuer must provide more detailed disclosures (e.g., two years of financial statements and a more detailed description of the issuer’s business and the risks involved). If an issuer makes these disclosures to non-accredited investors, it will also need to provide such information to its accredited investors.
The biggest limitation of Rule 506(b), however, is the prohibition on general solicitations and advertisements. In practice, this means the issuer must have a substantive and pre-existing relationship with the prospective investor. There can be a fine line between a substantive and pre-existing relationship and a general solicitation.
Generally, Rule 506(b) offerings cannot advertise the offering in the general media (e.g., tweet about the offering) or engage in cold outreach campaigns or solicitations (e.g., direct messaging a prospective LP on LinkedIn).
Rule 506(c)
Rule 506(c)
Rule 506(c)
For many VCs, Rule 506(c) is the more appealing exemption because it allows the VC to advertise that it is raising a fund. This may be particularly important for VCs with large networks that want to leverage those networks to reach a broad base of LPs.
For many VCs, Rule 506(c) is the more appealing exemption because it allows the VC to advertise that it is raising a fund. This may be particularly important for VCs with large networks that want to leverage those networks to reach a broad base of LPs.
For many VCs, Rule 506(c) is the more appealing exemption because it allows the VC to advertise that it is raising a fund. This may be particularly important for VCs with large networks that want to leverage those networks to reach a broad base of LPs.
Form D and Blue Sky Filings
Form D and Blue Sky Filings
Form D and Blue Sky Filings
As part of a Reg D offering, VCs must file a Form D with the SEC within 15 days of the first sale (e.g., the initial closing) or a binding commitment to purchase securities (e.g., an accepted subscription agreement), whichever is earlier.
Form D requires the issuer to disclose certain information about the sale, such as the name of the issuer, the types and amounts of the securities offered for sale, and the number of accredited and non-accredited investors.
Securities offered under Rule 506 are considered "covered securities" under the Securities Act, which means they are exempt from state-level securities laws, also known as Blue Sky laws. However, state regulators may still require issuers to file certain state notices and pay associated fees.
Fortunately, the North American Securities Administrators Association Electronic Filing Depository (NASAA EFD) system offers electronic submission of Form D notice filings to participating state securities regulators.
As part of a Reg D offering, VCs must file a Form D with the SEC within 15 days of the first sale (e.g., the initial closing) or a binding commitment to purchase securities (e.g., an accepted subscription agreement), whichever is earlier.
Form D requires the issuer to disclose certain information about the sale, such as the name of the issuer, the types and amounts of the securities offered for sale, and the number of accredited and non-accredited investors.
Securities offered under Rule 506 are considered "covered securities" under the Securities Act, which means they are exempt from state-level securities laws, also known as Blue Sky laws. However, state regulators may still require issuers to file certain state notices and pay associated fees.
Fortunately, the North American Securities Administrators Association Electronic Filing Depository (NASAA EFD) system offers electronic submission of Form D notice filings to participating state securities regulators.
As part of a Reg D offering, VCs must file a Form D with the SEC within 15 days of the first sale (e.g., the initial closing) or a binding commitment to purchase securities (e.g., an accepted subscription agreement), whichever is earlier.
Form D requires the issuer to disclose certain information about the sale, such as the name of the issuer, the types and amounts of the securities offered for sale, and the number of accredited and non-accredited investors.
Securities offered under Rule 506 are considered "covered securities" under the Securities Act, which means they are exempt from state-level securities laws, also known as Blue Sky laws. However, state regulators may still require issuers to file certain state notices and pay associated fees.
Fortunately, the North American Securities Administrators Association Electronic Filing Depository (NASAA EFD) system offers electronic submission of Form D notice filings to participating state securities regulators.
Investment Company Act of 1940
Investment Company Act of 1940
Investment Company Act of 1940
The Investment Company Act of 1940 (“Investment Company Act”) regulates investment companies, such as those in the business of pooling assets from investors (e.g., mutual funds, private equity funds, hedge funds).
Similar to the reliance on exemptions under the Securities Act (i.e., Reg D), venture capital and other private equity funds typically rely on an exemption under the Investment Company Act, namely the exemptions under Sections 3(c)(1) and 3(c)(7).
The exemption a fund uses will depend on the nature of the fund and its LPs.
The Investment Company Act of 1940 (“Investment Company Act”) regulates investment companies, such as those in the business of pooling assets from investors (e.g., mutual funds, private equity funds, hedge funds).
Similar to the reliance on exemptions under the Securities Act (i.e., Reg D), venture capital and other private equity funds typically rely on an exemption under the Investment Company Act, namely the exemptions under Sections 3(c)(1) and 3(c)(7).
The exemption a fund uses will depend on the nature of the fund and its LPs.
The Investment Company Act of 1940 (“Investment Company Act”) regulates investment companies, such as those in the business of pooling assets from investors (e.g., mutual funds, private equity funds, hedge funds).
Similar to the reliance on exemptions under the Securities Act (i.e., Reg D), venture capital and other private equity funds typically rely on an exemption under the Investment Company Act, namely the exemptions under Sections 3(c)(1) and 3(c)(7).
The exemption a fund uses will depend on the nature of the fund and its LPs.
Section 3(c)(1)
Section 3(c)(1)
Section 3(c)(1)
Section 3(c)(1) is a common exemption for venture capital funds and exempts issuers that are not making or proposing to make a public offering of their securities and are limited to a certain number of investors.
For venture funds with less than $10M in aggregate capital contributions and uncalled capital commitments, the fund is limited to 250 “beneficial owners.”
For funds over $10M in aggregate capital contributions and uncalled capital commitments, the fund is limited to 100 “beneficial owners.”
Section 3(c)(1) is a common exemption for venture capital funds and exempts issuers that are not making or proposing to make a public offering of their securities and are limited to a certain number of investors.
For venture funds with less than $10M in aggregate capital contributions and uncalled capital commitments, the fund is limited to 250 “beneficial owners.”
For funds over $10M in aggregate capital contributions and uncalled capital commitments, the fund is limited to 100 “beneficial owners.”
Section 3(c)(1) is a common exemption for venture capital funds and exempts issuers that are not making or proposing to make a public offering of their securities and are limited to a certain number of investors.
For venture funds with less than $10M in aggregate capital contributions and uncalled capital commitments, the fund is limited to 250 “beneficial owners.”
For funds over $10M in aggregate capital contributions and uncalled capital commitments, the fund is limited to 100 “beneficial owners.”
For instance, in a $50M fund, the 100 limit would impose an average check size of at least $500,000, which is well beyond the means of even those that are otherwise accredited investors.
For instance, in a $50M fund, the 100 limit would impose an average check size of at least $500,000, which is well beyond the means of even those that are otherwise accredited investors.
For instance, in a $50M fund, the 100 limit would impose an average check size of at least $500,000, which is well beyond the means of even those that are otherwise accredited investors.
When counting the number of beneficial owners entities are generally counted as a single investor unless the entity LP (a) was formed for the specific purpose of investing in the fund or (b) is a private investment company and owns 10% or more voting securities of the fund.
When counting the number of beneficial owners entities are generally counted as a single investor unless the entity LP (a) was formed for the specific purpose of investing in the fund or (b) is a private investment company and owns 10% or more voting securities of the fund.
When counting the number of beneficial owners entities are generally counted as a single investor unless the entity LP (a) was formed for the specific purpose of investing in the fund or (b) is a private investment company and owns 10% or more voting securities of the fund.
Section 3(c)(7)
Section 3(c)(7)
Section 3(c)(7)
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.” This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
The limits imposed by Section 3(c)(1) (as to the number of investors) and Section 3(c)(7) (as to status as a qualified purchaser) do not apply to a fund’s “knowledgeable employees” (i.e., such employees do not count toward the 100 limit).
These individuals have financial knowledge, expertise, and a close relationship with the fund, and therefore do not need the protection of the Investment Company Act.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Parallel Funds
Parallel Funds
Parallel Funds
In Part II, we discussed parallel funds but focused on the use of parallel funds in the context of non-US LPs.
However, parallel funds are also used to increase the number of LPs eligible to invest in a fund.
For instance, a GP may establish a Section 3(c)(1) fund and a Section 3(c)(7) fund to invest in parallel.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Investment Adviser Act of 1940
Investment Adviser Act of 1940
Investment Adviser Act of 1940
Unlike the Securities Act and Investment Company Act, which regulate the fund, the Investment Adviser Act of 1940 (the “Adviser Act”) regulates investment advisers, such as the management company providing investment advisory service to the fund.
Similar to the Securities Act and Investment Company Act, the Adviser Act provides paths to registration (i.e., registered investment advisers or IRAs) but is more often triggered by exemption (exempt reporting advisor or ERAs).
Dodd-Frank amended the Adviser Act to exempt investment advisers to venture capital and other private funds–specifically, the Section 203(l) and Section 203(m) exemptions.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Section 203(l)
Section 203(l)
Section 203(l)
Section 203(l) provides that an investment adviser solely to one or more “venture capital funds” is not subject to registration under the Adviser Act.
Generally, a “venture capital fund” is a private fund that:
Pursues a venture capital strategy;
Invests no more than 20% of the fund's capital contributions in non-qualifying venture capital investments (e.g., at least 80% of the portfolio is equity and convertible equity);
Is not significantly leveraged (e.g., does not borrow 15% of fund assets);
Only issues illiquid securities, except in extraordinary circumstances (e.g., not redeemable except in extraordinary circumstances);
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Section 203(m)
Section 203(m)
Section 203(m)
Fund managers can also claim an exemption under Section 203(m), which exempts an investment adviser of private funds if such adviser acts “solely as an adviser to private funds and has assets under management in the United States less than $150M.”
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Form ADV
Form ADV
Form ADV
Form ADV is not an application, and the SEC does not have the authority to deny an eligible adviser’s ability to take advantage of the exemption.
An ERA must file Form ADV within 60 days of relying on an exemption and file annual amendments within 90 days of the end of each fiscal year.
Part 1A of Form ADV requires information about an ERA’s beneficial ownership, clients, private fund information, employees, disciplinary actions, and certain business practices.
Notably, ERAs do not file Form ADV Part 2, which is for RIAs and requires a “brochure”–a plain-English narrative of its advisory business.
Form ADV must be submitted electronically through the Investment Adviser Registration Depository (IARD).
Like Blue Sky laws, advisers may be required to register or make certain filings under state law.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Other Notable Regulatory Regimes
Other Notable Regulatory Regimes
Other Notable Regulatory Regimes
CFIUS
CFIUS
CFIUS
The Committee on Foreign Investments in the United States (“CIFIUS”) is an interagency committee that evaluates certain foreign investments into U.S. businesses, and has the authority to mitigate security risks such as by enforcing divestiture.
Historically, the scope of CFIUS was reserved for defense contractors and controlled technologies under U.S. export laws. However, the 2018 enactment of the Foreign Investment Risk Review Modernational Act (“FIRRMA”) significantly expanded the application of CFIUS.
CFIUS has the authority to review “covered transactions,” which are transactions (e.g., M&A deals, joint ventures, and non-controlling investments) in which a “foreign person” could be deemed to control, directly or indirectly, a U.S. business engaged in matters concerning critical technology, critical infrastructure, or sensitive personal data or otherwise have access to material non-public technical information.
An entity may be considered a foreign person even if it is a U.S. entity and has its principal place of business in the U.S. if a foreign person is deemed to have control (e.g., board representation), access to “material non-public technical information“ or substantial decision-making authority.
Generally, if a transaction is a covered transaction and not otherwise exempt, it will be subject to CFIUS review.
CFIUS concerns may impact a VC’s ability to bring on certain GPs or grant increased information or oversight rights to LPs out of concern that such a person may render the fund a foreign person, which could impact the fund’s relationship with a startup (e.g., holding a board seat).
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Tax
Tax
Tax
VC funds are typically taxed as partnerships, and subject to partnership tax laws and reporting obligations.
However, many VC funds must also satisfy unique tax requirements to accommodate certain LPs (e.g., non-US investors).
Moreover, most VCs structure their investments to qualify as “qualified small business stock” to receive the tax benefits associated with QSBS.
Sufficit to say that the legal and compliance obligations related to tax are beyond the scope of this post, but we plan on addressing these considerations later.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Summary
Summary
Summary
This concludes our three-part series on starting and operating a venture capital fund. In this last part, we discussed various legal and compliance issues applicable to VCs (and their LPs). Specifically, we discussed the most common Reg D exemptions (i.e., Rule 506(b) and Rule 506(c)), the Investment Company act and the limits on the number of LPs in a fund, and the compliance hurdles of the Investment Adviser Act.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
About the Author
Hey, if you like this article, you can follow Shayn Fernandez on Twitter (I tweet about venture, web3, and sports (with plenty of dad jokes)), check out Junto Law, or set a time to chat.
Disclaimer from Shayn: While I am a lawyer who enjoys operating outside the traditional lawyer and law firm “box,” I am not your lawyer. Nothing in this post should be construed as legal advice, nor does it create an attorney-client relationship. The material published above is intended for informational, educational, and entertainment purposes only. Please seek the advice of counsel, and do not apply any of the generalized material above to your facts or circumstances without speaking to an attorney.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.
Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment.
The term “qualified purchaser” includes:
An individual investor or a family office with at least $5 million in investments.
The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.
Any entity where all owners are qualified purchasers.
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