Fund Expenses refer to the costs associated with operating a venture capital fund. They traditionally include expenses to complete investments by the fund, such as legal costs, and other ongoing operational expenses of the fund, such as an annual audit. Fund Expenses are commonly paid by the Limited Partners as defined by the Limited Partners Agreement (LPA).
Venture capitalists typically work to reduce Fund Expenses. Managers have discretion to pay for expenses out of pocket, and certain expenses can be unclear if they are Fund Expenses, such as paying for a general CRM system or attending a conference.
This article outlines some best practices for handling Fund Expenses by emerging managers.
What are Fund Expenses?
“Fund Expenses” is a commonly defined term in a Limited Partner Agreement to refer to any expenses incurred to set up and operate a fund, including Management Fees, taxes and accounting. Costs incurred to set up the fund are referred to as the “Organizational Expense,” and these defined Fund Expenses are normally capped in the LPA.
A definition of Fund Expenses from the Cornerstone LPA is below:
“Fund Expenses” means: (a) the Organizational Expenses, (b) the out of pocket or third party expenses incurred in connection with maintaining the organizational existence and continuing operations of the Fund including the preparation and delivery of reports to the Limited Partners, (c) any fees and expenses of third parties providing services to the Fund such as custodians, counsel and accountants, (d) expenses relating to the management of the Fund’s Investments, including researching any potential investment, (e) any taxes, fees or other governmental charges levied against the Fund or on its income, assets or operations (other than taxes or withholding attributable to a specific Partner), (f) Management Fees, (g) costs of insurance for the benefit of the Fund, (h) costs relating to indemnification or contribution by the Fund as provided under this Agreement, (i) costs of winding up and liquidating the Fund and amounts necessary for the establishment of reasonable reserves, and (j) all other reasonable and legitimate costs and expenses of the Fund in connection with this Agreement; provided that “Fund Expenses” shall not include any General Partner Expenses.
How are Fund Expenses paid?
Fund Expenses are paid from the fund bank account that investments are made from, and they are then allocated to Limited Partners pro rata. As an example, if there is one Limited Partner that has committed 10% of the fund and there is a $100 Fund Expense, that Limited Partner would be responsible for paying $10 of the $100 Fund Expense. If more Limited Partners join the fund and the 10% pro rate position decreases, then the new Limited Partners pick up their share of the Fund Expenses and the original Limited Partner will get a credit on their Capital Account.
How do you allocate Fund Expenses?
The LPA defines which expenses can be categorized as Fund Expenses, but certain expenses require a manager to make a subjective categorization. For example, a manager may go to a conference for learning and also for networking to meet new deals. Is this a Fund Expense or not?
Even when a LPA allows for an expense to be treated as a Fund Expense, managers often choose to pay for these expenses “out of pocket” using Management Fees to reduce the fees paid by Limited Partners. Below is a chart of typical expenses and how they are commonly paid for by emerging managers.
Categories of Fund Expenses
|Expense||Fund Expense?||Who Commonly Pays?|
|Laptops & Equipment||No||Manager|
|LP Events & Perks||No||Manager|
|Rent & Facilities||No||Manager|
|Software & Services||No||Manager|
|Deal Sourcing (T&E)||Yes||Manager|
|Deal Legal||Yes||Portfolio Company (Capped)|
|Deal Due Diligence||Yes||Manager|
|Fund Back Office||Yes||Fund|
|Fund Annual Audit||Yes||Fund|
|Management Fees||Yes||Fund (Capped)|
|Organizational Expenses||Yes||Fund (Capped)|
|Fund Annual Tax Work||Yes||Fund|
What are Fund Expense strategies?
Emerging managers work to keep Fund Expenses to a minimum. This lowers the expenses paid by Limited Partners and provides more capital for investments. Here are five common strategies to manage Fund Expenses.
Caps – The most common strategy to manage Fund Expenses is to set caps. LPAs typically set an Organizational Expense Cap at $50,000, $100,000 or occasionally at $150,000 for more complicated formations, and these are normally set at or below market rate, often requiring managers to go out of pocket on the setup. Managers typically set an informal annual cap for the operating budget of the fund, and these are also traditionally set at or below the expected budget, forcing managers to go out of pocket, as well. If a fund has multiple partners, there may also be a cap per partner on spending per year. The Fund Expenses for ongoing fund operations are not typically capped in the LPA, as there can be unexpected expenses relating to liquidity events, lawsuits, etc.
Policies – Another common strategy to manage Fund Expenses is to create policies about what can be charged as a Fund Expense. The LPA is often vague about what is and what is not a Fund Expense, allowing managers discretion on what to charge. Policies help the managers to set guidelines that help to meet the annual budget caps. For example, a fund may reimburse travel for Board Meetings at a coach ticket price, and then the partner may choose to fly business class by picking up the remaining ticket cost. Another example may be limiting conference attendance, deal legal and diligence expenses.
Consistency – A best practice is to ensure that Fund Expenses are consistent from year to year. For example, if you decide not to include travel and entertainment (T&E) one year, then you should not include T&E in another year. Similarly, if you are attending two conferences in a year and then jump to ten conferences the next year, that may be flagged by Limited Partners.
Management – Another best practice is to carefully manage the expenses with strict accountability. To help achieve this, new and emerging managers often pay for expenses out of pocket and then seek reimbursement according to their caps and policies, rather than changing expenses on a corporate card. Managers commonly go through line items on bills to see which individual charges are Fund Expenses, and which are not.
Sharing – The final best practice is to share certain expenses with other entities to reduce the Fund Expenses. When leading a deal, venture capitalists commonly have a cap on legal expenses, and anything above that cap is covered by the portfolio company. Another example is when a Limited Partner requires an audit, and the venture capitalist may ask the Limited Partner to cover some or all of the cost of the audit.
New managers commonly keep fund expenses to an absolute minimum and often pay for most of them with Management Fees, ensuring that Limited Partners do not get hit with any surprise fees and also have the most available capital to invest.
How do I manage Fund Expenses?
There are six steps to effectively manage Fund Expenses.
1. Read the LPA – The first step in a Fund Expense plan is to get your LPA and read all of the language that governs Fund Expenses. LPAs either have very defined and complicated Fund Expense rules, or they provide more discretion for managers. The Cornerstone LPA provides more discretion for managers.
2. Set the Organization Expense Cap – The next step is to research your anticipated closing expenses, which includes all of the legal formation and costs for closings, and then set a reasonable Organization Expense Cap in the LPA. This is normally set at $50K, $100K or $150K, depending on the complexity, and, when you are discussing higher levels, Limited Partners may push back on the costs.
3. Develop an Annual Budget – Develop a budget for the annual costs of operating the venture capital fund, which is different from building a venture capital firm. The costs of operating a fund for a new or emerging manager include back office vendors, deal legal, deal diligence, taxes, conferences, travel and entertainment. New and emerging managers often do not pay salaries, and they typically have smaller fund sizes and smaller Fund Expense budgets.
4. Create a Fund Expense Strategy and Cap – Decide how much of the annual Fund Expense budget will be covered by Limited Partners and how much will be covered by the Managing Partners from the Management Fees and other resources. Then, create an annual Fund Expense cap for Limited Partners to pay based on the allocation, and consider, if necessary, caps for partners with the fund.
5. Track the Fund Expenses – Implement systems to track and reimburse Fund Expenses on a quarterly and annual basis. Collect all receipts and invoices that can be considered a Fund Expense, and track them within your annual budget. When any Fund Expenses are looking to be over budget, work with the vendors or partners to reduce the costs or adjust the budget and the caps accordingly.
6. Develop Fund Expense Policies – After collecting some real expenses and experience, work to set up Fund Expenses policies to keep costs within the target annual cap. As more expenses are accrued and more experience is gained, work to update your annual expense cap and policies to keep Fund Expenses to a minimum.
Fund Expenses become easier to manage over time. If you have questions about Fund Expenses, please leave them in the comments below. Good luck!