The Structure and Activities of Venture Capital Funds

The Organization of Venture Capital Funds

The basic principle underlying the structure of venture capital funds is the creation of a distinction between the passive investors (the limited partners) and the fund managers (the general partners and the management company). The actual structure of the funds is determined according to the identity of the investors and the specific legal restrictions to which they are subject.

A venture capital fund is usually a private corporation organized as a limited partnership, or a company taxed as a partnership, such as an LLC (limited liability company) (see Chapter 2 on types of corporations for a discussion of the nature of LLCs). Being organized as a partnership excludes taxation at the level of the fund in the form of corporate tax, enables the partners to offset losses incurred against their capital gains, facilitates the dissolution of the partnership from the points of view of corporate and tax law, and protects the limited partners against legal liability.

Some of the funds are now registered as partnerships, usually in Delaware. Others organize several partnerships in order to meet the tax needs of the investors in the funds, who come from different countries and are subject to different tax liabilities (some are exempt from tax in their respective jurisdictions of incorporation). The investors in the fund are the limited partners (LPs); the general partner (GP) is a separate company (often an LLC), which is usually the fund's management company (the fund managers).

In other cases, the managers organize another company which is defined as the fund manager or investment consultant and receives some of the fund's income. The separation between the management company and the general partner is made when the general partner comprises other entities besides the fund managers (in some cases leading, value-adding investors are joined as general partners and not only as limited partners). The general partner and the management company are organized to enable the daily management of the fund to be performed in return for the management fees. This arrangement also facilities the distribution of the fund managers' profit-sharing component.

Figure 10-2 presents the typical structure of a venture capital fund. For the sake of simplification, the diagram presents the structure of a single fund, although funds usually manage several parallel funds with different legal structures and methods of management in order to meet the needs of different investors from the legal and taxation points of view.

Figure 10-2. Typical structure of a venture capital fund

The legal significance of the fact that the investors are limited partners of the venture capital fund, whereas the general partner is (or may be) the fund manager, is that although the profits of the fund are distributed among all the partners, it is only the general partner whose legal liability is not limited to the capital invested in the partnership. As demonstrated below, the management of a venture capital fund involves many strategic and managerial decisions which are much broader than the decisions involved in the management of a mere traded-securities portfolio. Therefore, the fund manager is also far more exposed to the risk that decisions will be regarded as incorrect in retrospect.

As mentioned above, in order to minimize its liability, the general partner usually protects itself by being organized as a limited company. In other words, the general partner and the fund manager will themselves be companies, thus limiting their liability. Although venture capital funds have only rarely been sued, some recent cases have included venture capital funds which invested in companies that were a party to the complaint. For instance, the Hummer-Winblad fund is a party to the complaint filed by music companies in the United States against Napster, the company which enables the transfer of duplicated music files in violation of their creators' copyrights. In loose terms, the claim against the fund was that it financed a company whose core business involved the violation of copyright law and that since this activity was known to the fund, it was an accomplice to the crime.

Raising Capital for Venture Capital Funds

The main sources of capital for venture capital funds are large institutional investors such as pension funds and insurance companies. Most institutional entities in the United States and a large part of corporate investors invest in venture capital funds, as do high net-worth individuals. As discussed above, in the last decade, pension funds have constituted the largest group of investors in venture capital funds, with a share more growing to be higher than 40%. Another 30% is invested by operating companies, 15% by private investors, 10% by not-for-profit organizations such as universities' endowments), and 5% by foreign and other investors.

As opposed to other investors, many of the institutional investors are suitable for venture capital investments since their investment horizon is relatively far. The obligations of pension funds, for instance, extend over many years, and they can dedicate a material component of their capital to long-term investments. Because they are not that concerned about short-term illiquidity, investments which offer high returns in the long-term, albeit volatile and illiquid in the short-term, appeal to them.

The share of universities in the mass of investments has been on the rise in recent years, and large universities invest up to around 20% of their endowments in private equity funds, including venture capital funds. In principle, universities are an optimal source of venture capital investments since their investment horizon extends further than that of any other institutional investor. They usually do not utilize the actual endowments (the principal), since they are typically limited to using only a certain percentage of the return they yield. Therefore, investments bearing a high long-term return, and which lock up the money for several years, are suitable for this risk profile. The universities with the largest endowments such as Columbia, Yale, Harvard, and Stanford are also the ones that invest larger percentages of their money in venture capital.

Money is usually raised by way of private placements, although some funds have also raised capital from the public. Capital-raising is made pursuant to a PPM (private placement memorandum) or offering circular, since a private placement is not required to be registered with the SEC. Funds are investment companies, as defined in the Investment Company Act of 1940, that are subject to the rigorous registration and reporting requirements imposed by this law on financial holding companies. Fund managers are therefore required to obtain an exemption from these requirements. Usually, a special exemption given to private equity funds whose securities are held by no more than 100 investors (the Private Investment Fund Exemption) is used, or an exemption given to institutional investors or high net-worth individuals (the Qualified Purchaser Fund Exemption). A fund manager is also required to obtain an exemption from the requirements imposed on investment advisers under the Investment Advisers Act of 1940.

According to the fund's partnership agreement, the investors undertake to invest money in the fund (capital commitments). The capital which is actually invested in the fund by the investors is known as the capital contribution. According to common practice, the investors provide the money for each investment pursuant to a "capital call" made by the fund manager. In this way, investors' capital is not frozen as long as it is not needed for investments.

According to the partnership agreement, the capital received from the investors is used by the general partner for its investments in companies, and a pre-determined percentage is used to finance the current expenses incurred by the management of the fund.

How Venture Capital Funds Work

There are various types of venture capital funds which are distinguishable by several characteristics, such as the type of companies in which they invest, the stage at which the investment is made (i.e., the early or late phases in the company's life), and the degree of their involvement in the management of the company.

A fund's modus operandi is affected not only by its own characteristics, but also by the business environment in which it operates and by the composition of its investors and management team. For example, some funds tend to choose certain industry segments in which they are interested in investing and actively search for companies which suit that profile. This mechanism is known as theme investment, and it differs materially from the more passive mode of investment used by funds which invest in broad fields from among the deal flow of investments they are presented with. In addition, considerations of taxation and restrictions on the investments stipulated in the fund's investment guidelines (see below), limit different investors to certain funds. For instance, many pension funds in the United States are not allowed to invest in non-U.S. companies.

As mentioned above, venture capital funds are often organized as partnerships; their organizational documents regulate not only their methods of operation, but also the relationship between the limited partners (the investors) and the general partner and fund manager. The partnership agreement is founded upon the desire to ensure that the manager will dedicate the better part of his time and expertise to the fund's benefit, and will attempt to avoid conflicts of interests between his activity within the fund and other activities (sometimes as the manager of previous funds). The fund's organizational documents regulate the following principal issues:

• The period of time fixed for the fund's existence A typical venture capital fund is founded for a period of seven to ten years. Usually, the fund invests in companies in the first third of its lifetime, nurtures them in the second third, and uses the remaining time to exit the investments. Once the investments have been exited, the fund dissolves.

• Investment decision-making Decisions to invest in companies are made in accordance with the fund's investment charter, as defined in the fund's investment guidelines. When capital is raised for the fund, the fund managers present investors with a profile of the investments on which they intend to focus according to the fund's investment guidelines, which are similar to the investment guidelines of pension funds or mutual funds.

  The fund's management company (the fund manager) examines investment opportunities received by the fund. It is entrusted with screening the investments, scrutinizing them, managing the investment process, and monitoring and supporting the investment after it is made. The internal mechanism for making investment decisions differs from one fund to another, but it usually includes receiving the investment committee's approval for each investment made by the fund.

• The measure of involvement of the limited partners In a limited partnership (as opposed to an LLC), the limited partners refrain from getting involved in the management of the partnership in order to avoid personal liability and enjoy the tax benefits of a limited partnership. Consequently, the involvement of the limited partners in the daily management of the fund is formally limited to representation on the fund's advisory board. In practice, fund managers often consult with and update the investors. The contact with investors is based not only on the desire to maintain good relations with them, since such investors may also invest in follow-up funds of the fund managers, but also on the recognition of the value which such investors can provide to the fund and to its portfolio companies. Therefore, the investors in the fund may be large financial entities which could help portfolio companies with future financing; they may be large companies of strategic significance, which may cooperate with or buy portfolio companies; and they may be private investors, well-supplied with money and connections, who may assist in various ways. Therefore, despite the investors' limited legal status, their involvement in and ties with the fund may run very deep.

• The ability to dissolve the partnership The partnership agreement sometimes addresses the right of the limited partners to dissolve the partnership in the case of a material change in the composition of the management company or the general partner, or in the case of poor performance.

• The maximum investment in any single company Limitations are usually imposed on the maximum scope of a single investment or several investments, in order to reduce the risk of a sweeping failure if such company sinks.

• Use of debt Venture capital funds are usually limited in leveraging their investments (in other words, they cannot borrow money or use the fund's investments as collateral in order to invest in additional companies). The reason for this is that it is the investors who need to decide upon their level of leverage in their investments, which naturally increases the risk in the investments. Given such a decision, the fund managers are supposed to invest the money in the field with which they were entrusted and for which they were appointed.

• Re-investment of profits The general partner may at times have an incentive to invest the fund's profits rather than distribute them, since investing the profits could yield another distribution of profits (although it also postpones the distribution of profits to the general partner). An investment of profits usually requires the approval of the limited partners' advisory board, and is sometimes prohibited after a certain amount of time or after a certain percentage of the capital has already been invested. Sometimes the fund's regulations allow a re-investment of funds which were gained by a fast exit (for instance, an investment in a company which was bought out one year after the investment, with nine years remaining until the dissolution of the fund).

• Private investment by the general partner In many cases, the general partner is interested in investing his own money together with the fund in a certain investment. This may give rise to the fear that the general partner will use the fund's money to cultivate the private investment, and will dedicate a large amount of time to the particular company in which he has a private interest. In many cases, the private investment is limited in size (1% of the fund's investment) and may require the approval of the advisory committee. An alternative method is to require that the general partner invest together with the fund, i.e., make a proportionate investment in all of the fund's investments in order to prevent him from choosing only the best investments (known as "cherry picking"). Another method of overcoming conflicts of interest is having the general partner invest in the fund itself (usually 1% of the fund).

• Future raising of capital by the general partner After the majority of the fund's money has been invested, the general partner may seek to establish a new fund. The general partner is obliged to continue managing the fund in accordance with the customary professional rules. The partner will therefore be allowed to raise additional funds only if he can guarantee that the previous funds will continue to receive the required level of attention. In many cases, this matter is handled by defining a certain percentage of the fund's money, and only after investment of this money is the manager allowed to solicit additional money.

• Investments with other funds of the fund manager Some fund managers manage several funds, the capital of which was raised at different times. In order to prevent a situation in which the manager will tend to invest in companies in which he had already invested, although the investment is not sufficiently attractive objectively, the approval of the advisory board is often required before a fund can invest in a company in which a previous fund of the manager's had invested.

• Other occupations of fund managers Partnership agreements may contain terms and conditions limiting the scope of the fund manager's business activities outside the fund. These restrictions are relieved after a substantial part of the fund's capital has been invested.

• The addition of other general partners The approval of a majority of the limited partners is often required for any material change in the identity of the partners managing the fund, be it the replacement or the addition of partners.

• The fund's management fee Funds customarily charge annual management fees of 1.5 3% of the size of the fund. The definition of the size of the fund varies from one agreement to another: In many cases, it refers to capital commitments, in others to actually invested capital, and in others to the value of the managed portfolio, which naturally changes as a result of capital-raising rounds in the portfolio companies. Often, the initial definition of the management fee is valid for 3 5 years and is based on the capital commitments until the end of the period during which the fund is supposed to invest the money. In some cases, uncalled capital commitments and capital actually invested in portfolio companies are weighted at different rates. Later on, the management fee is based on the capital under management (in other words, exits made by the fund which are allocated to the limited partners reduce the basis for the calculation of the management fee). Management fees are usually collected at the beginning of each quarter. Since a venture capital fund closely monitors its investments until it exits them, management fees continue to be collected in the years following the full investment of the fund's money, but are almost always reduced, reflecting the reduced required efforts in screening investment opportunities.

• Exit Another important component of a fund manager's work is his responsibility for deciding upon an exit for the fund's investments. Venture capital funds exit their investments by selling shares in initial or secondary public offerings, selling the company, or distributing the shares among the investors in the fund. In recent years, many funds have chosen to distribute shares among their investors instead of selling them and distributing the sale proceeds.

Distribution of Profits and Compensation of Fund Managers

The mechanism of compensating venture capital fund managers is designed to tie the manager's compensation to the fund's performance over time and to indemnify him for the effort exerted in the daily management of the fund. As mentioned in the previous subsection, the compensation of fund managers is composed of annual management fees which are usually measured as a percentage of the fund's capital and are used to cover the fund's expenses, and of a certain percentage of the fund's profits after reimbursement of the investments (carried interest). The measurement of performance is typically based on the cumulative return on all of the fund's investments, and not on any individual investment.

The definition of the basis on which performance-based compensation is distributed is usually founded on the capital invested in the fund (capital contribution). Such distribution is often made after the investors are guaranteed a certain minimum return. This minimum return is usually determined as a function of the return on government bonds. Also, the management fees are often deducted when the profit for distribution is calculated. The measurement of the return is based on the return accumulated over time, which includes the profits earned by actual exits from the fund's investments, in addition to the unrealized profits distributed among the fund's investors by way of traded shares (payment in kind). It is important to note that the general partner is often also an investor in the fund and thus enjoys also a share of the profit as an investor as well. If, for instance, the general partner invested in the fund 1% of its capital, and the compensation is 20% of the accumulated profit, then the general partner will receive 20%+80%*1% = 20.8% of the fund's profits.

This explanation is given at the level of general principles, and it should be noted that return arrangements often incorporate other calculation components which address, for example, cases in which the fund distributes profits over the years. It is common to provide the fund managers with some or all of their share in profits from exits that are distributed to the investors over the lifetime of the fund, and it might be the case that such profits will eventually exceed the compensation the fund managers are entitled to. Such a pattern is observed in 2002, with funds who raised capital in the 1990s had some phenomenal performance in their early years, and hence provided their managers with high cash compensation, yet later on had poor performance, and therefore the fund managers might be required to return some of their earnings.

The fund manager usually receives at least 20% of the fund's net cumulative return, namely, the return received from exits after all capital investments are returned to the limited partners. In fact, it is well documented that approximately 80% of funds give their managers a share of 20 21% of the return after the return of the capital invested and minimum return arrangements, as determined in the fund's partnership agreements. In the late 1990s, an increase has been visible in the percentage of the profit which remains in the hands of the managing partner. When the investors in the fund are guaranteed a high minimum return, it is customary to determine a scaled profit distribution to fund managers, the actual rate of which may even be higher than the said rates. However, following the rude awakening era of 2001 and 2002, the rate of profits allocated to the funds' managers is reduced back to its historical norm. Furthermore, some of the leading funds had even reduced the management fees they charge.

The management of venture capital funds involves high current expenses which include, besides the payment of salaries to the employees and general partners, legal costs, travel and convention costs, and payments to outside advisers. In addition, considerable costs are associated with each specific investment. If the transaction materializes, the company in which the investment is made usually indemnifies the fund for its direct costs, but the fund bears the costs of transactions which are not consummated, and of course costs which cannot be directly attributed to a specific deal. The management agreement between the investors and the entities involved in the management of the fund determines which expenses are included in the management fees and which costs are reimbursed on a current basis by the investors. Either way, such reimbursed expenses are usually deducted for the purpose of calculating the carried interest.