Venture Capital activity, which includes investments in high-growth startups, is shaped and defined through a fundamental document known as the Limited Partnership Agreement (LPA). The LPA dictates the interactions, responsibilities, and rights of General Partners (GPs) and Limited Partners (LPs), providing a blueprint for venture capital operations.
This article is dedicated to unraveling the dense fabric of key economic terms that are enshrined in LPAs. It separates these terms into logical categories, including fund details, roles, financials, timeframes, and restrictions, offering an accessible guide for those new to the venture capital landscape.
Check out the Cornerstone LPA to learn more about actual Limited Partner Agreements.
Fund details guide the strategic and operational direction of a venture capital fund. This information outlines the main focus and target areas of the fund, such as sectors, investment stages, and territories. It is vital that General Partners and Limited Partners understand this information as it shapes the fund’s identity, investment strategy, and expected outcomes. These can get worked into the LPA through a number of means, including a definition of the fund Thesis,
The fund thesis delineates the investment focus of the fund. It details the sectors, stages, and geographic territories targeted by the fund. While sectors and territories can vary greatly, the stage of investment is usually focused on early stages such as Accelerator, Angel, Pre-seed, or Series Seed.
Understanding the roles and responsibilities of key persons and committees is crucial for successful fund management. Key persons typically are central decision-makers, and committees such as the advisory committee provide important guidance. The partnership representative handles tax matters, an important administrative task. All these roles together ensure smooth fund operation, so General Partners and Limited Partners must fully comprehend their significance.
Key individuals are the named persons in the LPA that are key decision makers. The departure of a key individual puts the fund at risk, which is why they are named, and there are usually protective provisions in the case of a departure or death, such as entering limited operations mode.
The Advisory Committee, also known as the Limited Partner Advisory Committee (LPAC), consists of select individuals who provide strategic advice and guidance as representatives of the limited partner interests. They are called upon as needed to vote on operational matters and resolve potential conflicts of interest, thereby ensuring the integrity and optimal performance of the fund.
The partnership representative is a person appointed to interact with the Internal Revenue Service (IRS) on behalf of the partnership. The representative must be capable of handling all tax-related matters efficiently, though, often, this is a ceremonial position since it is required by law.
Financial terms are core to a venture capital fund, affecting both profitability and operational fluidity. They include carried interest, management fees, commitment percentages, and more. These aspects govern how profits are shared, how funds are managed, and the overall financial structure of the fund. General Partners and Limited Partners should understand these terms to accurately gauge financial commitment, potential return on investment, and risk.
Carried Interest Percentage
The carried interest percentage is the portion of the profits that the General Partner receives. The typical carried interest percentage in the industry is 20%. However, it can vary from 10% to 25%.
The management fee is an annual charge determined by multiplying a particular percentage by the total capital commitments from all Limited Partners. The standard industry rate during the investment period is 3.5%, and it drops to 1.0% during the post-investment period.
GP Commitment Percentage
The GP Commitment Percentage refers to the share of the fund’s total capital that the General Partner commits to contribute. It usually falls within 0.0% to 1.0%, with 1.0% being the industry standard.
Maximum Portfolio Investment Percentage
The maximum portfolio investment percentage is the highest portion of the fund’s total commitments that can be invested in a single portfolio company. The industry standard is 10%, but this percentage can range from 5% to 25%.
The recycled amount refers to the portion of distributions owed to Limited Partners that can be reinvested in the fund. Usually, no amount is recycled for new managers. However, if specified in the LPA, it could be between 10% and 20%.
Financial statements are quarterly or annua reports, including balance sheets, income statements, and cash flow statements, as well as portfolio markups. They can be certified by the General Partner, the industry standard, or audited or reviewed by a Certified Public Accountant.
Timeframes offer critical temporal structure to the life of a venture capital fund. They specify periods for fundraising, investing, and fund duration, along with potential extensions. These timelines coordinate the activities of General Partners and Limited Partners, guiding when to raise funds, when to invest, and the overall lifespan of the fund. Knowledge of these timeframes is key to managing expectations, planning strategies, and meeting responsibilities.
Fund duration defines the venture capital fund’s lifespan, usually counted from the initial closing date. Typically, it lasts 10 years, an industry standard. However, it may also be set to 8 or 12 years.
Fund Duration Extension
The fund duration extension is a provision to lengthen the fund’s lifespan. The standard extension period in the industry is two one-year periods. Nevertheless, it can be set to zero years, meaning no extension, or one year.
The fundraising period refers to the time frame during which the fund collects commitments from limited partners. The industry standard is 18 months starting from the initial closing date. However, it can be set to 9 or 12 months.
The investment period refers to the time frame during which the fund can make investments. It typically spans 4 years for new managers, which is the industry standard, starting from the initial closing date. It can also be set to 3 or 5 years.
Capital Call Notice Period
The Capital Call Notice Period is the specified duration within which Limited Partners must deliver cash to the Fund following a Capital Call Notice. The industry standard is 15 days, though it can be either 10 or 30 days.
The fiscal year is a 12-month accounting period, used for financial reporting. The typical end-date for the fiscal year in the industry is December 31. Nevertheless, it could also end on June 30 or September 30.
>>> The Post-Investment Period is the phase following the Investment Period until the end of the fund life. The fund is typically not making new investments during this time. Normally, managers charge less management fees during this period.
Understanding restrictions is essential to avoid legal issues, financial mishaps, or strategic misalignments. They can include prohibited sectors for investment, caps on organizational expenses, and triggers for initiating a successor fund. These terms provide necessary boundaries for investment activities and fund expenses. General Partners and Limited Partners must be aware of these limitations to operate within legal and agreed-upon parameters, ensuring a successful and compliant venture capital operation.
Prohibited sectors are industries or fields where the fund is not allowed to invest. This restriction may be due to regulatory considerations, ethical stance, limited partner requests, or risk profile. Prohibited sectors usually covers sectors such as alcohol, gambling, weapons, and digital currencies.
Organizational Expenses Cap
The organizational expenses cap is the upper limit on fees, costs, and expenses related to forming the fund and offering partnership interests. The industry standard cap for new managers is $50,000, although it can be set as high as $75,000 or $100,000.
Successor Fund Threshold
The successor fund threshold, defined in the LPA, is a predetermined percentage of Total Capital Commitments invested or allocated towards portfolio investments and fund expenses. Once this specific threshold is met, the GPs may begin the creation of a new fund. While the industry norm is typically 70%, this could vary and may be set at 0% or 50%.
The venture capital industry is full of terms and phrases that may seem arcane to newcomers. However, understanding these terms, particularly in the context of a Limited Partnership Agreement, is vital for participating effectively in this space. From the finer points of fund details to the broad strokes of financial reporting, these concepts form the bedrock of any venture capital undertaking. As a novice, your familiarity with these terms will not only make the industry more accessible but will also pave the way for your successful participation in venture capital investment opportunities.