The legal structures of venture capital funds

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Thinking of starting your own venture capital fund? Diving into how VC funds work can make you question your grasp on the English language. There’s a lot of new vocabulary to get familiar with—like LPs, GPs, LPAs, and LLCs. There are venture funds, and venture firms. And by the way, why is everything located in Delaware?

Complicated? Definitely. Impossible? Definitely not. Taking a little time to get familiar with these terms—and the legal structures they describe—will give you insight into how to set up your own fund for the first time.

Here’s a glossary of a few terms that describe common legal structures and a rundown of how they work.

Limited partnerships

The core component of most venture capital funds is a limited partnership. This is a legal entity used for a wide variety of business purposes in the United States. It’s made up of at least one general partner (the GP) and at least one limited partner (an LP) doing business together.

The GPs and LPs of a limited partnership can be individual people. But both GPs and LPs can also be legal entities.

One of the benefits of a limited partnership is that it doesn’t pay taxes. Instead, the partners each pay taxes on proceeds they receive from the business. This is known as pass-through taxation. Other entities, such as corporations, pay taxes twice: once at the corporate level, and again at the individual participant level. This is often referred to as double taxation

The general partner (GP)

Typically, the GP of a venture fund is a legal entity established and run by people employed by the venture capital firm. In any limited partnership, the GP manages the partnership. As a result, the GP has unlimited liability for the partnership’s business operations. In other words, the GP assumes full responsibility for any business debts or legal liabilities.

The limited partner (LP)

A fund’s LPs are the investors who supply the VC with capital. These LPs can be individuals or legal entities. Often, LPs are institutional investors, such as pension funds, college endowments, trusts, insurance companies, health care systems, family offices, and sovereign wealth funds. Sometimes, venture capital firms also make investments into outside venture funds as LPs. 

LPs have limited liability in the partnership because they don’t take part in directing its business operations—they remain passive investors.  When a limited partnership has debts or legal liabilities, the amount that LPs are responsible for is typically limited to their investment stakes in the partnership, and does not extend to their assets outside the partnership. (The GP, on the other hand, would be on the hook for the full amount.) 

The limited partnership agreement

A limited partnership agreement (LPA) spells out what GPs and LPs can and can’t do in a limited partnership. This agreement includes rules for things like how someone becomes or is removed as a partner, what rights each partner has, what the scope of their activities may be, how investors make contributions to the partnership, how the partnership will distribute investment proceeds, and how votes will be conducted. 

The LPA also specifies partnership interests, which is the amount of the partnership each GP and LP owns. This percentage is usually relative to each partner’s contribution to the partnership. By setting up and signing an LPA, a partnership overrides the default rules that might be applicable by state law with the rules of its own agreement. 

An existing LPA can be modified by passing an amendment that adds, deletes, or modifies its terms. The partnership is then governed by the amended LPA. Partners can also discard the whole LPA (and any amendments to it) by replacing it with an entirely new agreement known as an amended and restated LPA. As of the date it’s enacted, the entity is then governed only by the amended and restated LPA (which is known as the A&R LPA).  

Limited liability companies

While venture funds are usually formed as a limited partnership, venture capital firms are commonly organized as limited liability companies, or LLCs. An LLC is another legal entity. It’s made up of members, rather than partners. Members can be individuals or legal entities.

Like a limited partnership, an LLC provides members with pass-through taxation. But unlike a partnership, it combines pass-through taxation with limited liability protection for all members. 

LLCs can consist of just a single member, or have multiple members. The members of an LLC can designate a manager to govern the LLC’s affairs. If they do, the manager doesn’t have to be a member of the LLC. 

The terms governing the LLC and its members are spelled out in an agreement called a limited liability company agreement or limited liability company operating agreement (generally known as the operating agreement). Like an LPA, this agreement governs the LLC in place of any default state rules. Members can change an operating agreement by amending it or by replacing it with an amended and restated operating agreement.

Why Delaware?

Many venture capitalists decide to form their firm and fund entities in Delaware. One reason for this is the robust history of decisions in Delaware state courts about business transactions. Those decisions interpreted Delaware rules and laws governing business transactions with more specificity than exists in other states—which gives businesspeople and lawyers more clarity on how their business decisions might be interpreted in court. Delaware has also streamlined the process for forming entities like limited partnerships and LLCs.  

How limited partnerships and LLCs shape venture fund structures

In venture capital, limited partnerships and LLCs are used to facilitate relationships between venture capitalists and third-party investors.  

First, one or more people who want to invest in private companies start a venture capital firm. They create an investment strategy, find an office, hire employees, buy computer equipment, subscribe to industry research, and so on. Rather than take on these expenses and liabilities personally, venture capitalist firms usually organize as an LLC, which provides each member the benefits of both limited liability and pass-through taxation. 

While venture firms are typically structured as LLCs, their internal organization can vary a lot. Firms often differ in how they divide economic ownership and control, how they define misconduct, and how they address non-compete agreements, among other concerns. No matter how it’s organized internally, a venture firm’s LLC acts as the management company that will organize and operate one or more venture funds. Those funds are typically limited partnerships.  

The legal structures of venture capital funds 1

To understand how these structures work together, let’s consider an example. Let’s say that Krakatoa Management Company, LLC is the name of an imaginary venture capital firm. Informally, it’s known as Krakatoa Ventures. Krakatoa Ventures is organized as a Delaware LLC. It’s preparing to launch its second fund, called Krakatoa Fund II.

Deciding to create the fund as a limited partnership

To get Fund II up and running, Krakatoa Ventures needs access to a pool of money that it can use to make investments. That money will come from outside investors who aren’t members of Krakatoa Ventures. However, the firm doesn’t want each outside investor to be involved in the decision-making for each investment. This would be cumbersome, and it would expose the third-party investors to liability. That’s why a limited partnership works well for the formation of a venture fund: The partnership’s third-party investors will remain passive investors, while Krakatoa Ventures will make the day-to-day investment decisions. 

A limited partnership structure is also attractive because taxes pass through to each partner, so that Krakatoa and the fund’s LPs only pay taxes once. For these reasons, Krakatoa Ventures will establish Fund II as a limited partnership: Krakatoa Fund II, LP.

Creating a new LLC to act as the GP

Krakatoa Ventures intends to make investments on behalf of the fund, and to manage its day-to-day affairs—to act as the GP. However, if Krakatoa Management Company, LLC did that, it would be subject to the unlimited liability of the debts of that fund’s limited partnership. 

A venture capital firm may oversee multiple funds at the same time. Each fund has its own investment strategy, portfolio companies, risk profile, and investor base. Krakatoa Ventures already has a Fund I, and may consider launching a Fund III after launching Fund II. Rather than expose Krakatoa Ventures to the unlimited liability of each fund, the firm will instead form a new entity to act as the GP of each fund it manages. 

In a standard VC fund, the GP entity for the fund will also be formed as an LLC. Thus, Krakatoa Management Company, LLC decides to form Krakatoa Fund II GP, LLC, a Delaware limited liability company, to act as the GP of Fund II. 

Bringing the resources back in

Krakatoa Fund II GP, LLC is a legal entity that Krakatoa Ventures set up solely to isolate the liabilities of the fund. But it doesn’t have the operational resources to manage a fund: It doesn’t have employees looking for investment opportunities, subscriptions to data sources, an office, or any other tools. Setting up these resources for each fund would create enormous redundancies and be extremely costly. 

However, as the GP of the fund, Krakatoa Fund II GP, LLC has the legal authority to manage the affairs of the fund—which includes the ability to hire service providers. Krakatoa Fund II GP, LLC can therefore hire Krakatoa Management Company, LLC to manage Krakatoa Fund II, LP.

Setting it all up

The plan is ready, and now it’s time to put it together. Since you can’t form a limited partnership without a GP, Krakatoa Fund II GP, LLC needs to be formed before Krakatoa Fund II, LP can be formed. 

Then, Krakatoa Fund II GP, LLC (the GP of Fund II) will engage Krakatoa Management Company, LLC to provide investment management services for Fund II.  

The venture capital firm then acts as the management company for each of its funds, in accordance with the fund’s LPA, as well as the terms of the investment management agreement between the fund’s limited partnership and the VC firm. 

This way, the VC firm is still able to deploy its resources for the benefit of all of the funds it oversees, while shielding itself from liability from all of those funds. 

Setting up your venture fund

While the structure in our example is the most common, there are many ways to set up a venture fund. You might need to add even more layers of structure to accommodate regulatory rules, different types of investors (like tax-exempt investors), or entities formed in different jurisdictions, among other factors. 

Now that you have a sense of the basic structures of venture firms and funds, Carta can guide you through designing a fund structure that makes sense for you. The pre-close advisory team helps emerging managers form entities, understand key concepts in their entity documents, obtain tax identification numbers, and open bank accounts. We also help you prepare the management company, GP, and fund agreements.

By making sure your legal fund structure is set up to facilitate your investment goals, you can set your firm up for long-term success. 

To learn more or to get started today, visit https://carta.com/investors/.

DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta Inc. (“Carta”).  This communication is for informational purposes only, and contains general information only.  Carta is not, by means of this communication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services.  This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests.  Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor.  This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein. 

 

©2021 eShares Inc., d/b/a Carta Inc. (“Carta”). All rights reserved. Reproduction prohibited.

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