by Scott Kupor
And, no doubt, those high-return expectations will drive the behavior of VCs. Venture firms will continue to focus on the at-bats-per-home-run average and thus ultimately look for big enough markets that can sustain viable home-run companies. That’s how the world turns.
Importantly, as well, because Yale has a lot of its assets tied up in illiquid categories such as venture capital, it does ultimately care a lot about eventually achieving liquidity. In other words, Yale wants to be able to realize its 18 percent annual return in VC by tying up its money for longer periods of time, but in order to keep funding the university and reinvesting in its venture managers, it needs to eventually get liquidity from its earlier venture investments. And, again, that drives corresponding behavior among the VC firms—they need to either sell or take the companies in their portfolio public at some point in time in order to realize cash to provide back to Yale.
Time Is of the Essence
Thus, as a potential entrepreneur and a consumer of VC dollars, you need to be aware of the time constraints ultimately imposed on you. At some point in your company’s life cycle, the VCs will push for an exit to generate this type of liquidity. When that happens is a function of not only how the company is doing but also where a firm might be in its fund life cycle and how the rest of the companies in the fund are performing.
To this end, one thing for you as an entrepreneur to consider is how old the fund is from which you are receiving your investment. This is a perfectly fair question to ask of your potential VC partner at the time you are deciding whether you want to work with them.
We are going to cover the fund specifics in the coming chapters, but in choosing a firm to work with, it’s reasonable to ask where the firm is in the life cycle of that particular fund. If they are early in the fund, then they should have less pressure to return capital to, say, Yale (or their other LPs) and thus should put less pressure on you as the CEO to generate a near-term exit. But if they are later in the fund cycle and haven’t generated sufficient liquidity from other investments, the pressure for a more near-term exit could be more intense. While you may not be able to get all this information from a conversation with your prospective partner, there are some ways to get insight into these questions.
First, you should ask about the specific fund from which the VC is proposing to invest in your company—most funds are serially numbered with Roman numerals. You can then check the initiation of that fund to determine its age. As you’ll see later, funds tend to be ten years in life and often can get extended for a few years beyond that. But VCs are generally limited in how late into the fund they can make new investments (often only through years five or six). So if you are taking money from a VC and they are in the first three or four years of the fund, they are more likely to have both time and available capital to live with you for many years hence. But if they are just investing in your company for the first time in year five or six, things may be different.
That’s because—as we’ll discuss in more detail shortly—VCs tend not only to invest capital in startups earlier in the life of a fund, they also generally set aside “reserves,” expected monies that they anticipate they might invest in a startup over the course of its next several financing rounds. Thus, the later in a fund cycle your investment occurs, the greater the likelihood that the VC may also not have sufficient reserves to set aside for subsequent financing rounds.
It is true, by the way, that VCs can and often do invest in the same portfolio company in a subsequent fund, particularly if they run out of reserve capacity in the original fund that made the investment. However, this is not as easy as investing reserves out of the same fund as the original investment, in part because the mix of LPs could be different from one fund to the next and thus create potential conflicts between the funds.
For example, the VC may have invested originally in your company via its Fund I, a $300 million fund with twenty LPs who each invested $15 million in the fund. Several years later, your VC may have raised Fund II, a $500 million fund with fifty LPs (thirty of which were brand new to the VC), each investing $10 million.
In this case, if the VC proposes to invest additional monies into your company from its Fund II, the Fund I LPs might object because they feel as though they “own” that investment opportunity and will be receiving a smaller proportionate allocation of the investment if it goes into Fund II. By the same token, the Fund II LPs might object to the investment in their fund for fear that this new investment isn’t a great opportunity for the fund relative to other investments you could make; that is, they might think you are just trying to save a poor investment from Fund I by investing additional dollars via Fund II.
The other thing to think about—now that you understand how LPs like Yale think about their venture investments—is how well the overall firm has done over the years, and if they are likely to be able to raise new funds in the future as a result. As you’ve (hopefully) seen from our discussion about Yale, venture firms need to be able to generate high absolute rates of return to their LPs and ultimately do so via cash (versus just marking up the value of the illiquid investments on their financial statements). So if you are thinking that you might need more capital from your venture firm in the future—and in particular if you are receiving an investment later in the life cycle of a fund—you’ll want to assess the likelihood of the firm being able to raise its next fund.
This is admittedly a hard thing to dig into, in large part because the financial results of VC funds are generally not publicly available. In some cases, if the fund has public investors—e.g., public universities or state-run pension funds—these entities are required to disclose some level of financial performance on their websites or otherwise make it available to those who inquire. But in the vast majority of cases, your best bet here is to just do reference checks on your proposed VC partners with others in the community to at least get a sense, reputation-wise, for how the firm is doing.
Obviously, if all goes well and you never need to raise money again, none of these things may matter. But that’s not likely the case—and that’s not a statement of any entrepreneur’s likelihood of success. Rather, most entrepreneurs tend to raise money at least once or twice after the initial funding round, because if they are doing well, they’ll want to accelerate the growth and fuel that with additional capital, and if they are not doing well, they will need the capital to get to the next set of milestones. Thus, at least in the early years of a company’s life, access to capital is critically important.
CHAPTER 5
The “Limited” Edition: How LPs Team Up with VCs
We’ve been talking a lot about LPs, and rightly so, because without LPs, venture funds would not exist. But it’s the VCs who are on the hook to generate the high returns that LPs are looking for. So let’s turn our attention to the venture funds themselves and explore the dynamic between the funds and the LPs.
You may wonder why you, as a busy entrepreneur, should care about the relationship between an LP and a VC. Well, because the LPs are the ones giving VCs the money to invest in you. They are also the ones that the VC needs to pay back, at huge multiples. So naturally how the VCs get paid, and with whose money, will have an impact on how they interact with their portfolio companies—you!
What Does “Limited Partner” Mean?
We’ve been using the term “limited partner” without any discussion of what this means. “Limited” is intended to describe the governance structure that exists between LPs and venture funds.
The LPs in fact have a “limited” role in the affairs of the fund in two important ways.
First, they have limited governance over the affairs of the fund. In the main, this means that LPs have no say over the investments that the fund chooses to make. As long as the fund invests in the set of things that are prescribed by the fund parameters, the LP is essentially investing in what’s often called a blind pool—blind, that is, to the LP itself, which has no ab
ility to weigh in on investment decisions. Similarly, the LP has limited ability to influence the decision to exit an investment and determine the manner and timing of whether to distribute the proceeds of that investment. As we’ll explore in a little bit, there is a formal document that defines with more nuance some of the LPs’ rights, but the fundamental way to think of LPs is as passive investors—they are along for the ride on which the venture fund decides to embark.
Second, as a result of their limited governance, LPs enjoy the protection of limited liability from a legal perspective if something goes wrong. For example, if a portfolio company or other investor sues the venture fund for some action it may have taken (or failed to take) to protect the interests of shareholders, the LPs are basically immune from any potential liability. Simply put, LP passivity is rewarded by also shielding them from any downstream liabilities to which the venture fund might be exposed.
If the LPs are by definition passive and shielded from liability, someone else must step into the fray—cue the VC fund. More specifically, cue the general partners (or GPs), the senior members of the fund who are responsible for finding investment opportunities, managing them during the lifetime of the opportunity, and ultimately generating a return of capital back to LPs to compensate them for the time and risk of being investors. And the GPs also take on all the liability if things go wrong.
This hardly sounds as though the LPs and GPs are partners, but this is legally what they in fact are. The legal entity that binds the LP and GP is a partnership—if you followed the 2017 tax reform discussion in DC, you’ll know that partnerships (and other similar entities) are euphemistically referred to as “pass-through entities.” That means that, unlike C corporations (which is what Amazon, Facebook, Apple, Google, and most other publicly traded companies are), partnerships don’t pay taxes. Instead, the earnings of a partnership “pass through” to the underlying owners of the partnership, in our case the LPs and GPs. Each of the parties then reports the earnings on their respective tax filings.
Why is that a good thing? Well, first, it means that you avoid the dreaded double taxation of corporate earnings. If you own shares of Facebook and the company earns a dollar, it pays corporate taxes on that dollar (it used to be 35 percent and now is 21 percent after the 2017 tax reform bill); then, if Facebook decides to distribute some of its earnings to you as a shareholder, you pay tax a second time once you receive that distribution. In contrast, LPs and GPs pay tax only once on earnings.
Second, and of particular relevance to a number of LPs in VC funds, many LPs are tax-free entities. Specifically, university endowments and foundations are nonprofit entities that don’t owe Uncle Sam any taxes on earnings. So passing through income to them means they avoid taxes altogether.
The LPA: The Rules of the Road
We said before that the LP invests into a blind pool and basically cedes control over that money to the GPs, but it’s not quite that simple. LPs don’t just part with billions of dollars without some say in the matter. The limited partnership agreement (or LPA) is the legal document that formally lays out the rules of the road—the economic relationship between the LP and the GP and the governance relationship between the LP and the GP.
Let’s turn to the LPA and start with the economic terms. You care about this as an entrepreneur because financial incentives matter at all levels. Incentives drive behavior, and how a VC gets paid will affect how she interacts with your startup.
The Management Fee
A cornerstone of the economic relationship is the management fee that the GP charges the LP. Most GPs charge an annual management fee that is calculated as a percentage of the capital that the LP has committed to contribute to the GP over the life of the fund. Typical VC firms charge 2 percent annually, although some firms are able to charge as much as 3 percent.
Notice we said that the percentage amount is multiplied by the capital that the LP has committed to contribute over the life of the fund. We need to explain a new concept here to understand the economics, “calling capital.”
When a GP closes a $100 million fund, it doesn’t collect $100 million up front from LPs. Rather, the LPs make a financial commitment over the life of the fund to provide the capital when “called” by the GP. The reason for this practice is simple—keeping cash idle in the GP’s bank account depresses the ultimate rate of return a GP can earn for its LPs. Just-in-time calling of capital eliminates this drag on returns. Typically most of the capital will be called over the first three to four years of the partnership, since that is when the lion’s share of the investing is likely being done by the GP.
So even though the GP is not investing (and thus not calling) all of the $100 million up front, the GP is able to take a 2 percent management fee, or $2 million per year, on the full amount of the committed capital. (It’s true that some VC funds charge the management fee on a pay-as-you-go basis, collecting the fee only against the actual monies invested. However, the typical pattern is to charge on committed capital.)
What is the management fee for? It’s the pot of money from which the GP pays the bills necessary to keep the lights on in the VC fund—employee salaries, office space and supplies, travel, and any other day-to-day expenses of the fund. As you can imagine, LPs want to keep this fee as small as possible since it can be a drag on overall returns of the fund.
It is the case, by the way, that the fee sometimes changes as the fund ages. If most of the money is being invested in the first three to four years of the fund, it follows that the GP is spending more time at the beginning of the fund evaluating and selecting new investment opportunities. LPs thus are willing to fund this activity by paying the full management fee. As the fund ages and more of the GP’s activity shifts to managing existing investments (versus finding new ones), many funds start to have a step-down in the fee.
The step-down is typically reflected in a few ways, sometimes in concert with one another. In the first instance, the 2 percent fee often gets reduced by 50–100 basis points in the later years of the partnership. The second mechanism to reduce fees is to change the application of the fee against committed capital to apply the fee only to the cost of the investments remaining in the portfolio. So, for example, if we were in year eight of our $100 million fund and all but one investment (for which we invested $10 million) had been sold off, the management fee might be applied only against the remaining $10 million versus the $100 million committed amount. Each of these bells and whistles is of course negotiated by the LPs and GPs at the time of the initial creation of the fund, so how they are resolved is often a function of the balance of power in the negotiation.
The final piece of the management fee puzzle comes in the form of ancillary fee waivers. It’s pretty unusual in VC funds (although more common in buyout funds), but sometimes a GP gets compensated by a portfolio company for her engagement with the company.
Perhaps, for example, the company grants the GP some equity or cash incentive for being on the board of directors. The question then becomes: What does the GP do with that compensation? In most modern LPAs, the GP can keep the compensation if she wants, but she needs to credit that fee against the management fees otherwise being charged the LPs. In other words, no double-dipping; if you get paid by the company, you deduct that compensation from what you charge the LPs so that the GP ultimately has the same amount of disposable fee income in either case. This economic incentive drives the behavior on the part of the GP that we see in most portfolio companies; that is, paying a GP to sit on the board is very unusual (other than post-IPO, where compensation is par for the course).
Carried Interest
The heart of compensation for GPs (at least for those who are successful investors) is carried interest. It’s rumored that the term “carried interest” derives from medieval traders who carried cargo on their ships that belonged to others. As financial compensation for the journey, the traders were entitled to 20 percent of the profits on
the cargo. That sounds very civilized, if not rich. I’ve also heard—although my Google search is failing me now—that the carry portion of carried interest referred to the fact that the traders were allowed to keep as profit whatever portion of the cargo they could literally “carry” off the ship of their own volition. I prefer that story.
Regardless of its historical origins, carried interest in the VC context refers to the portion of the profits that the GP generates on her investments and that she is entitled to keep. As with the management fee, the actual amount of carried interest varies among venture funds but often ranges between 20 and 30 percent of the profits.
As it turns out, how we define “profits” and how and when the GP decides to distribute those profits to herself and her LPs is a matter for negotiation in the LPA.
Let’s use a simple example to illustrate.
Go back to that $100 million venture fund we talked about before, and assume that we are in year three of the fund’s existence. The GP invested $10 million in a portfolio company earlier in the fund’s life, and now the company is sold for $60 million. So, on paper at least, the GP has generated a tidy profit of $50 million for that investment. She’s also invested the rest of the $90 million in other companies, but none of those has yet been sold or gone public. Ah, she can taste the carry check already!
But how does the money get divvied up between the LPs and the GP? Let’s assume that the GP has a 20 percent carried interest; in simple terms that means that when the fund earns a profit, 20 percent of that goes to the GP.
So, in our example, the GP is sitting on a $60 million check, of which $50 million represents profit, and wants to give 80 percent of the profit (or $40 million) to the fund’s LPs and keep 20 percent (or $10 million) for herself. The other $10 million in this example will go back to the LPs as a return of their original capital. We’ll come back to this later in this chapter and add some additional complexity.