Note: This article is the tenth in an ongoing series on venture fund formation and management. To learn more about managing a fund, download this free eBook today Venture Capital: A Practical Guide or purchase a hard copy desk reference at Amazon.com.
If you make a simple mistake while driving, like hitting some black ice you didn’t see, and you skid off the road into a ravine and total your car, assuming no injuries, that’s a bummer and a major inconvenience for you. But cleaning the mess up is not super complicated. You need to work with your insurance company to get the car replaced. It’s paperwork, but you are the only affected party and you can work through it in a pretty straightforward manner.
But if you borrow your friend’s car and do the same thing, sorting out the legalities can be significantly more complicated. Even if the friendship survives, you are going to have to sort it out with two different insurance companies - establish that you had permission to drive the car, that the accident was not negligent or reckless, and that your friend’s insurance company (and probably yours too) is on the hook to reimburse your friend up to the limits of the insurance. It is going to be a pain and, unlike the situation where you wreck your own car and have no one to blame but yourself, in this case your friend is affected, and they do have someone to blame: you.
Those same dynamics apply to fund investing. If you lose your money betting on a startup, you have no one to blame but yourself and, assuming no malfeasance on the part of the startup, the legal analysis is not all that complicated. It’s whoopsie-daisy and bye-bye money and then you are done. However, if you start an investment fund and collect and lose other people’s money, that’s a very different story. And guess what? There is no insurance policy in this context to bail you out.
The legal documentation around your fund, and your compliance with its requirements, are the closest thing you’ve got to insurance. These documents are your only protection for having lost someone else’s money. These documents need to make it abundantly clear that your investors (LPs) understood and willingly accepted the risk of loss. They also need to make the terms of that risk acceptance very clear, and your conduct needs to comply with those terms.
Most early stage investors really prefer to avoid mundane tasks related to legal and accounting issues. But when you think of the documentation around your fund through the lens of the car accident analogy, it makes it a bit easier to get motivated. And that’s a good thing because, unfortunately, these issues can’t be ignored unless you want to end up in jail or slapped with a nasty lawsuit or a large fine. You are taking a ton of risk with other people’s money. That is not a trifling matter.
The good news is that if you get a little help from competent experts, setting up and managing a venture fund does not have to be too complex from either a legal or an accounting standpoint. Venture funds have been around for many decades, and there are well-defined rules and regulations already in place (including the SEC’s new 2023 reporting requirements for private funds), as well as many advisors who can provide good starting points and walk you through the process. Needless to say, you must engage some good advisors and do what they say!
In this article, we will walk you through the main issues related to fund creation, governance and accounting for ordinary stand-alone VC funds. Corporate, university-affiliated, accelerator-affiliated, social impact and government funds are going to have a few additional special provisions and some slightly different issues to contend with, so we will address them separately. Having a good overview of the process and knowing a bit about each of these areas will help you get started, keep your perspective and ask the right questions when you meet with your attorneys and accountants. And, doing it by the book will not only keep you out of hot water with your LPs, it will keep you out of trouble with the S.E.C. and the I.R.S.
One overarching regulatory concept to keep in mind is that a major goal of your fund design will be to ensure that you are not legally considered a mutual fund or hedge fund. Under the Investment Company Act of 1940 (“1940 Act”), mutual funds are extraordinarily tightly regulated in order to protect individual investors. You do not want your fund to be considered a mutual fund. Hedge funds are also tightly regulated because of their potential to wreak havoc on the markets. However, luckily, there is a very workable exemption for venture capital funds (recently clarified in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and then
further supplemented with new rules on required reporting in 2023) provided they comply with certain guidelines (such as identifying yourself as a VC fund, not holding more than 20% of the fund in one asset, not using debt to fund investments, focusing on private company stocks not public company stocks, and not registering under the 1940 Act). Compliance with these guidelines is not difficult, but it needs to be hardwired into your fund documents. So, at the risk of sounding like a broken record, we will point out again, it is important to have competent experienced counsel and to do what they say!
Christopher, what are the major topics covered by the legal documents that set up a venture fund?
The paperwork around a venture fund can appear somewhat intimidating, but the documents are not actually that complicated conceptually. As noted in this article on fundraising, the fund documents can take the form of a limited liability company (“LLC”) operating agreement, a limited liability partnership (“LLP”) operating agreement or a more traditional limited partnership agreement. Or they can be a mixture of some or all of the above where an LLC serves as the GP under a traditional partnership agreement. But regardless of the form recommended by your counsel, they are really only going to cover three basic foundational concepts:
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How the money comes to you
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What you agree to do with it while you have it
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How you give the money back to your LPs.
From the 36,000 foot level that’s all there really is. You give me money, I invest it, I give you back your principle and some profits and keep a little for myself for my trouble. Of course, each of these concepts involves quite a few underlying nuances, so naturally each is broken down further into quite a few subtopics which map to one or more sections in the fund operating documents. To provide you with some familiarity, we will summarize the primary ones here (leaving some minor ones out in the interests of clarity and brevity). As you are skimming through, keep in mind that each one relates to one of the three main buckets above (money going in, money being used, money going out).
So what are the key sections that virtually all early stage venture fund documents will include?
Corporate and Legal Formalities - This section covers the formation of the fund itself as a legal entity and related housekeeping issues such as:
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The name of the fund and those of the GPs and LPs
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The fund’s offices and addresses
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The designation for an agent for the service of process in the event of a legal dispute
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The form of corporate entity legal residence, and
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The character and purpose of the company.
Capital contributions, membership (or partnership) interests, capital accounts and tax and related matters - Here the documents talk about:
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How and when investors will contribute capital
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How those contributions will translate into legal ownership of a portion of the fund, and
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How that ownership will be recorded and tracked.
There will typically be some language here about taxation of ownership interests earned through profits. And there will usually be some language governing situations where an investor defaults (i.e. does not honor one or more of his/her capital calls to supply funds.)
Profits, losses and distributions - Here is where documents will talk about:
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What the threshold for a profit is
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How ownership of those profits is allocated amongst the members of the fund
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How losses are calculated and allocated, and
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When, and under what circumstances, the General Partners running the fund may or should distribute cash to the investors.
Tax and Regulatory Allocations - Every agreement will have some long and thorny sections relating to handling and accounting for the impacts of various tax and regulatory events. The overall goals of this section are to:
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Maximize tax efficiency,
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Minimize workload for everyone, and
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Ensure the GPs have sufficient authority and flexibility to comply with tax and other regulatory requirements at all time.
So you will see some subsections devoted to tax issues and some of the terminology, borrowed from the tax code, can get extremely jargony and technical including provisions relating to: gross income allocations, loss allocation limitations, adjusted capital account deficits, minimum gain chargebacks, qualified income offsets, nonrecourse deductions, fund minimum gain, member nonrecourse debt, member nonrecourse deductions, reallocations due to I.R.S. adjustments, curative allocations, adjustments upon distribution of property in kind, allocation of capital gains to redeemed members, and tax withholding.
Fiscal Matters - All fund documents will include a section talking about:
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How the books of account will be kept by the GPs
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What the GPs will include in the fund’s financial statements
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When they will be submitted to the LPs
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How the GPs will maintain a list of the fund’s portfolio holdings, and
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How the GPs will maintain the fund’s bank account(s).
Fund Management - Here is where the documents talk about:
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Who the managers are (the GPs)
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What to do if one resigns or is replaced
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What the legal powers and duties of the manager are (i.e. their authority to use their discretion in running the fund, along with their duty of good faith in doing so).
Actions Requiring Consent - This section will outline what decisions require input from the LPs. Typical actions requiring consent would include:
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Making an investment larger than, say, 20% of the fund (which has S.E.C. classification implications)
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Taking on debt, or
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Adding new LPs or taking new money.
Compensation, Fees and Expenses - Here is where the agreement outlines the calculation and handling of the management fees and the fund’s other operating expenses. More detail on these items is found in Dividing the Pie: How Venture Fund Economics Work [Part I].
Manager Conduct - All agreements will have one or more sections talking about:
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Conflicts of interest
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The managers’ duty of care
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The use of agents by the managers to represent them
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Contracts with affiliates
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Managers’ meetings and decision-making, and
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What degree of business activity outside the fund a manager is permitted to have.
Investors/Members/Partners - Here is where the agreement will talk about:
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The investors in the fund (LPs); for example, whether there is more than one class of LP
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Limitations of liability for members
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Compliance with laws and obligations
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Restrictions on rights of withdrawal of funds
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Tax duties
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Attempted transfers of their LP interests
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Substitutions of a new LP for an existing one, and
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Voting on matters requiring votes.
Indemnification - This section is an important one. In legal terms, to indemnify someone is to agree to compensate or make someone whole (or to secure someone against legal liability for their actions) in relation to certain damages under certain conditions. All proper fund documentation will include an indemnification by the fund to the GPs for all their fund decisions and actions taken in good faith. This is really as close as you get to the insurance policy in the borrowed car scenario above. The indemnification section will basically say that the fund will pay the legal liabilities and expenses of the GPs in relation to any issues which arise as a result of their running the fund provided they were acting in good faith and running the fund according to the terms of the fund’s documentation. This means the fund is responsible (i.e. the money comes from the fund or its insurers) and that the LPs are not personally liable beyond what they have already put into the fund. If you are undertaking to raise a fund of other people’s money and invest it into risky startups, and you do not have an airtight indemnification clause, you are playing with fire. It cannot be said more plainly than this: do not do it.
Redemptions of LP Interests - Most agreements will have a section saying there are no redemptions of interests at an LP’s request (i.e. they cannot simply request their money back since it is either invested in or committed to highly illiquid investments), but that there may be mandatory redemptions of an LP’s interests by the GPs (i.e. expulsion) if it is in the interest of the fund, or necessary in order to have the fund comply with law or to avoid litigation or claims.
Dissolution of the Fund - This section talks about when it is permissible and/or required to dissolve the fund and what the process of dissolution and distribution of assets, profits and losses will be.
Additional Miscellaneous Legal Clauses - Believe it or not, despite having covered all of the above, there are still a variety of additional topics that most fund documentation will cover. In the miscellaneous section you will find discussion of:
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How the agreements are to be interpreted
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Whether they can be amended
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What state’s laws will be applied to them
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What the dispute resolution process will be, and
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How legal notices under the agreement will be given.
As overwhelming as all that sounds, it is really not as difficult as someone unfamiliar with the process might think. If you start to feel overloaded, remember that all of the topics fall into one of those three buckets at the beginning (money going in, money being used, money going out). And keep in mind that good lawyers will walk you through every step of it. In fact, they will likely have a template agreement to start the process and will ask you a series of questions to help them customize it to your needs. If you are patient and respond to uncertainty by asking them clarifying questions about the pros and cons or other implications of a decision, you will find that you can actually move through this quite easily. In fact, compared to fundraising, the documentation is a breeze!
In Part II of this article we'll address restrictions on the type of investors that can participate in a venture fund, governance standards, and key accounting issues.
Want to learn more about managing a fund? Download this free eBook today Venture Capital: A Practical Guide or purchase a hard copy desk reference at Amazon.com.
