by Scott Kupor
Governance: How Is the GP-LP Relationship Managed?
Now that we’ve covered the big-picture economic issues that the LPA is intended to address, let’s shift to some of the governance issues. That is, how is the relationship between the LPs and the GP managed?
We’ve already noted above that the LPs’ engagement is by definition limited—to preserve their lack of legal liability, they need to have a pretty light hand on the levers of the fund management. But, understandably so, LPs don’t want to just hand over the money with no strings attached.
So the LPA does put in place a few guardrails. These are as follows.
1. Investment Domain
This may sound obvious, but the LPA will define the areas of investment for the GP and any hard-line restrictions on that. For example, is this a life sciences fund or a generalized information technology fund? Are there restrictions on stage—i.e., can the GP invest in seed- versus early-stage venture companies versus later-stage companies? Although most venture firms by definition invest in private companies, some LPAs will allow the GP to invest a portion of the funds in publicly traded securities. What about geographic restrictions—can the GP invest in China-domiciled companies from this fund? The type of investment can also be defined—is the GP allowed to invest in equities only, or can she also invest in debt or debt-like securities?
In general, the GP wants to leave the definitions as broad as possible—and most LPs in fact want to do the same. After all, what LPs really want is the GP’s best investment ideas, period, so the restrictions are mostly intended to prevent too much style drift and to keep the GP focused on her best ideas in the domains in which she is supposed to be an expert.
As an entrepreneur, when you investigate whether a particular GP is appropriate for your business, you’ll want to understand whether you fit into their investment domain. There’s no sense in your wasting your time pitching your life sciences company to a firm that simply can’t (by virtue of its LPA) or won’t invest in you, regardless of how exciting your company may be.
2. Best Ideas
Speaking of “best ideas,” how do we make sure the GP’s best ideas go into the fund itself versus her taking them directly for her own benefit? In some cases, GPs have either invested their own money alongside a fund investment or declined to make the investment via the fund and instead invested personally in the company. Most of the time there is nothing nefarious going on here, but it raises the question of conflicts—how do I as an LP know that I am getting the GP’s best ideas in the fund versus the GP potentially cherry-picking her best deals to invest in with her own money outside of the fund? So, many firms have a restriction in their LPA that limits this activity or, at a minimum, requires disclosure to the LPs at the time of the investment.
We talked earlier about Accel Partners and their tremendous success in early-stage investing at Facebook. Well, alongside that fund investment, the firm’s managing partner at the time, Jim Breyer, invested about $1 million of his own money for a 1 percent stake in the company. We know how that turned out: a return on the investment of about one thousand times for Jim, depending on when he sold it. Understandably, some of Accel’s LPs were concerned about this investment in that it presumably meant that, absent Jim’s decision to invest personally, $1 million could have been invested by the Accel venture fund into Facebook, the value of which would have accrued to the fund’s LPs. Facebook of course turned out to be such a hit for Accel and its LPs that I suspect any hurt feelings were quickly forgotten, but nonetheless, LPs have become more sensitized to this issue of GP co-investments alongside fund investments.
3. I Work Hard for the Money
This, of course, is what the LPs want their GP to do for them. But just in case, the LPs have a few mechanisms to hold the GP’s feet to the fire.
First, the LPA generally says that the GP has to devote “substantially all” of her efforts to running the firm. Go coach your kid’s soccer team on the weekends or sit on a nonprofit board here and there, but otherwise direct your energies full-time to investing on behalf of the LPs. This seems pretty noncontroversial (although sometimes you might be surprised). Being a GP should be a full-time job.
What happens if either the GP is no longer satisfying this obligation or the LPs collectively decide that the GP has lost her mind and is no longer a good steward of their capital? Well, just as in any good relationship, separation and divorce are always options.
In VC land, “suspension” is our version of separation. Suspension comes into play if any or some combination of the GPs are no longer devoting substantially all their time to the affairs of the fund. We call these GPs (or combination of GPs) the “key men” (and, yes, I realize that is not gender neutral, but old habits die slowly in the private equity world). If this happens, most LPAs will have a defined voting threshold by which some set of LPs (often at least one-half or two-thirds) can invoke a suspension. During a suspension period, the key men need to present a plan to the LPs for how they are going to remedy the situation or, if they are unable to do so, the LPs can initiate divorce proceedings. This often requires some even higher supermajority of the LPs to vote to dissolve the fund.
Most states have what are called no-fault proceedings for married couples looking to get divorced. In essence, this means you don’t have to come up with a specific reason for the divorce; one party can simply decide they are done with the marriage and begin the legal proceedings to dissolve the marriage. Just as with most real marriages, we also have “no-fault” divorce provisions in the LPA. Obviously, the threshold for voting among the LPs is pretty high here (often more than 80 percent), but there often is a mechanism by which the LPs can just say to the GP: “Thanks for playing, but we want out.”
The LPA often runs over one hundred pages, so I haven’t done full justice to it by simply giving you a few-page rundown. Nonetheless, this is sufficient for informing one factor that you as an entrepreneur need to think about when choosing your venture partner.
GP-to-GP Relationships: The Equity Partners Agreement
We’ve spent a lot of time talking about the relationship between LPs and GPs, and rightly so, as they are codependents. However, equally important is the way that GPs within a firm interact with one another: they are, after all, partners. Conveniently, the legal document that governs their relationship is often called the equity partners agreement.
But not all partners are created equal. Some partners may have only an economic interest in the fund but not have any other governance rights. This means that they cannot legally bind the fund to make an investment (or get rid of it), nor be involved in hiring or firing other partners. Some may have full economic and governance rights and some may be in between.
You, as an entrepreneur, are unlikely to know any of this since these agreements are not publicly filed, but it’s an important thing for you to understand. Being aware of this will help you understand the decision-making process inside a firm.
This is no different from what you would want to know if you were selling software to an enterprise customer—Who are the economic buyers, the champions within the account, etc.? Organizational dynamics matter in decision-making, so at least ask the question of how a venture firm makes a decision if you are going down a funding path with that firm.
The equity partners agreement also spells out the economics of the partnership; that is, how does the carried interest pie get split? There are a ton of flavors here, but they range from fully equal partnerships (where everyone has the same share of carry) to multitiered partnerships (where longevity or performance might dictate differing shares of the pie).
Just as is the case with founders and employees of startup companies (more on this later), most GPs have to vest their share of the carry pool over time. “Vesting” means that you accrue ownership over a specific period of time, such that if you leave the firm before that time expires, you would have earned only that proporti
on of the carry that equates to your time at the firm. Recall that the life of most of the funds is ten years, so naturally some venture firms want to ensure that GPs are financially incented over the life of the fund by having a ten-year vesting period. But, again, different firms handle this differently.
While most venture firms expect GPs to make a long-term commitment when they decide to join the firm, it does happen that GPs sometimes turn over during the life of a fund. In addition to the vesting issues noted earlier, you as an entrepreneur may be affected if the partner who sits on your board (or sponsored your investment) leaves the firm. In some cases, GPs retain their existing board seats in exchange for the firm’s agreement to continue vesting their economic interests in the funds in which they participated. Other times, the GP takes on a new full-time role that may require a time commitment from her that is inconsistent with retaining her board seats. In that case, you may have a new GP assigned to your board to take the place of the former GP.
The final piece of the GP puzzle is “indemnification.” Remember that in the GP-LP relationship, the GP has legal liability if things go south. To incent people to want to be VCs (just as we do with boards of directors), GPs can be indemnified from legal liability, meaning that they do not have to worry that their personal financial resources could be called upon to satisfy financial liabilities of the fund. We’ll come back to this later when we talk about the fiduciary duties of a GP—both to the fund and to the shareholders of the companies on whose boards they sit—and dive deeper into what this actually means in practice for GPs.
We’ve spent enough time for now talking about LPs and GPs. Time to move to what I’m sure you’ve been waiting for, and the most important part of the venture capital ecosystem—the startup!
CHAPTER 6
Forming Your Startup
Starting a company comes with no shortage of poetic adjectives. Great founders are innovative, brave, inspiring, and visionary. Their ideas are groundbreaking and world changing.
So I’m sorry to throw a wet blanket on the heroic journey of starting a new company by kicking it off with a visit to your lawyer’s office, and by talking about things like tax and governance.
But it’s critical to the health of your future company to understand how to set up your business. So let’s eat our broccoli together.
The first part of this chapter is going to focus on some of the tax and corporate governance implications of how many entrepreneurs choose to set up their businesses. It is admittedly a US-centric view of these issues, so, in the interest of transparency for any non-US readers, you may want to consider whether this first section is relevant to your entrepreneurial journey. For the US audience, I offer no such hall pass.
What Form Should Your Company Take? Spoiler: C Corp
GPs and LPs decided that a partnership was the best corporate structure for their relationship, so why are most startup companies formed as traditional C corporations?
There are lots of reasons, but probably the most fundamental is that the C corp is a good vehicle for companies that are focused on building long-term equity value in the business versus distributing profits directly to shareholders. Remember that when we talked about a partnership, one of the features was that the earnings of the company are passed through to the company’s owners. This makes partnerships a very tax-efficient way to distribute profits to their owners—the cash can flow through, along with the tax liability, so there is no second-level corporate tax. That’s a good thing.
With a startup, though, in most cases we don’t really want to distribute profits to the owners, at least not in the early days. Rather, if we have profits (and, of course, most startups have losses in the early years), we would likely choose to reinvest those profits in the business to continue to grow its value. So, if we were lucky enough to generate profits but did not pass that cash through to the owners, we’d be creating a tax liability for the owners without the cash to pay Uncle Sam. That’s not a good thing.
Because most startups do in fact have losses in the early years, some entrepreneurs rightly wonder whether a pass-through structure, at least initially, would make more sense. With losses, a pass-through provides the owners an economic benefit, in that you can deduct those losses from other income on your tax returns. Theoretically, you could start life as a pass-through and later convert to a C corp once you are generating profits that you want to retain in the business, but in practice I have never really seen anyone do this. It’s a nontrivial thing to do the conversion from pass-through to C corp, and it creates all kinds of other issues when you are trying to allow equity participation for other employees.
The cost of course of being a C corp is that, when profits do get distributed from the C corp, we have to deal with the double taxation problem: profits are taxed first at the corporate level and then a second time at the individual owner’s level when paid out.
The non-pass-through nature of a C corp also lends itself well to the fact that many startup companies grant equity in the business to their employees—more on this later. A startup could issue partnership interests to employees, but it just makes things more complicated from a tax perspective (in large part because of the pass-through nature of partnerships).
A C corp is just a simpler mechanism through which to provide broad equity ownership to a startup’s employees. And a C corp does not have any limits on the number of shareholders that can be part of the organization; thus, as a startup hopefully grows, later employees can also benefit from potential equity ownership.
C corps also have several advantages for the VC firms that might invest in them.
First, C corps allow you to have different classes of shareholders with different rights. (Truth be told, as we talked about earlier, partnerships can have different types of partners with different rights as well, but the C corp structure has other advantages.) This is important because, as we’ll talk about later in our discussion on term sheets, VCs like to invest in what is called “preferred stock,” whereas most founders and employees hold “common stock.” Basically this allows different rights to be assigned to the different classes of shareholders; C corps permit and facilitate this.
The second advantage for VC firms comes back to tax—I know you never thought you were signing up to master the tax code when you picked up this book! Recall that many LPs of venture firms are tax-free (e.g., endowments and foundations). They enjoy the benefits of this tax-free status and don’t look favorably on GPs who threaten to interfere with this. Under US tax laws, pass-through entities (e.g., partnerships or limited liability companies) can cause even tax-free entities to have to pay tax on what is called “unrelated business income.” (“UBIT” is what the cool kids say.) If GPs invest in pass-through entities, they can therefore create this potential tax risk for LPs; investing in C corps raises no such issues. Thus, most GPs will avoid investing in pass-throughs as much as possible.
Carving Up the Ownership Pie
Okay, so we’ve got an entity—check! What else needs to happen as part of the company formation process?
Well, next up is how we divide ownership of the company. Most companies have more than one founder. And when you start a company, it’s you and your cofounder against the world. You will both sacrifice everything to build your vision. Sleepless nights, forgoing a social life, letting your health go to crap, and even neglecting your own family are all on the table to achieve your dreams, but it’s going to be okay, because you are in it together. Together forever.
But what if it’s not forever? What if you sacrifice everything and in two years your cofounder decides to quit to go find herself? What if her ego gets bruised, because you are the CEO and, as the company grows, she becomes less important? What if she develops a serious drug problem? What if she turns out to be not quite as talented as you thought?
Well, it can be okay. Or it can destroy your company. It all depends on how realistic you are when
you set things up.
Yes, breaking up is hard to do—whether in love or in business—but at least in business, there are some things founders can do proactively to lessen the pain. Think of it as a common-sense prenup to protect your company.
So what can you do to help ensure that founder breakups don’t end your startup dreams?
As with most things in life, a little planning between founders can go a long way toward ensuring that a breakup doesn’t crater your dreams of world domination.
And, from a more positive point of view, what can you do to encourage each other to do your best to make the company as successful as possible?
Founder Stock Vesting
The basic purpose of founder equity is to create long-term incentives. That’s the whole idea of vesting: you contribute to the success of the company by helping to grow the business, and you are rewarded over time with an increasing ownership position in the equity you helped create.
Founder stock (or equity) vesting differs in several ways from the GP vesting scenario we discussed in chapter 5 but is identical in its purpose. The rationale for vesting is to tie the founder to some defined term of employment before she can exit the firm and take 100 percent of her equity with her. Think of it as providing a long-term financial incentive for founders to behave as equity owners and do their best to increase the value of the firm for all shareholders.