The Ultimate Guide to Fund Terms

Key Takeaways:?What are the key terms of a venture fund? Can you explain them in plain language? What are some examples? Do you have a term sheet? (Yes, read to the end)

Key Terms: Advisory Committee ? Capital Commitments ? Carried Interest ? Clawback ? Conflicts of Interest ? Fund Size ? Fund Expenses ? Hurdle ? Key Person ? Management Fees ? Recycling ? Side Letters ? Suspension & Removal ? Time and Attention ? Valuation Policy ? Warehousing ? Waterfall

The Two-Sided Nature of Venture Capital

Venture capital has essentially two sides to it: Venture deals and venture funds.

The term “venture?deals” refers to investments in startups, while “venture?funds” refers to investments in funds. Both startups and funds share two sides of the same coin:

A lot has been written about startups, but not as much about fund law. This publication aims to fill that gap, starting with the key fund terms.

What are the Key Terms of a Venture Fund?

My recommended starting guide for new fund managers is?The Business of Venture Capital: The Art of Raising a Fund, Structuring Investments, Portfolio Management, and Exits?by Mahendra Ramsinghani.1

The Business of Venture Capital?is a great practical guide, particularly for first-time fund managers. It includes the essential terms of fund formation.

• For example, this exhibit highlights the most common terms negotiated between limited partners and general partners in a limited partnership agreement:2

• Another exhibit in the book illustrates the key terms of a venture fund:

Although these exhibits are good places to start, the primary source of the first exhibit appears to be based on an MBA survey taken in 2011, which is not currently available for download.3 ?That said, the legal concepts are sound and still applicable today.

Mastering The Key Fund Terms

Here’s a list of 10 key fund terms for emerging fund managers raising capital:

1. Advisory Committee (LPAC)
2. Capital Commitments
3. Carry
4. Clawbacks
5. Fund Expenses
6. Fund Size
7. Key Person
8. Management Fees
9. Side Letters
10. Waterfall

Let’s define each term starting at the top, in alphabetical order:

1. Advisory Committee (LPAC)

• Definition: A group of three or more members selected by the General Partner to independently review and approve certain fund transactions and matters.
• Explanation: The members of a Limited Partnership Advisory Committee (LPAC) are typically made up of limited partners (LPs), who serve voluntarily. The purpose of an LPAC is to provide guidance and oversight in three key areas:4

1. Conflicts of Interest: The LPAC may examine valuation methodology, firm policies and “principal transactions” to confirm GP and LP alignment.
2. Waivers of Restrictions: The LPAC may hold the authority to waive certain investment limitations in the partnership agreement (LPA), which allows the GP to manage the fund more effectively. This includes the ability to make non-standard investments, bypass investment caps and extend the term of the fund.
3. General Oversight: The committee can seek additional financial reporting, audits, provide information on defaults, non-standard fees and expenses, potential legal disputes and other significant events. LPAC members do not act as agents for the fund or serve as fiduciaries, but rather they promote transparency, governance and alignment of interests between the GP and LPs.

Example: During the closing process, the GP may wish to transfer “warehoused” assets into the fund—however, the law requires disclosure and consent prior to the transfer of such assets into the fund. An LPAC or Advisory Committee helps with that disclosure and consent process on behalf of the LPs.

2. Capital Commitments

• Definition: The total amount of money that an investor agrees to fund.
• Explanation: There are three key areas about capital commitments: (1) Timing, (2) Minimums, and (3) GP Commits
• Timing: LPs generally invest in funds in one of two ways:

1. 100% Upfront: All of an LP’s capital commitment may be required upon subscribing to the fund, just as startups would expect their investors to do.
2. Commit Now, Pay Later: But the far more common approach is for an LP to pledge their support to the fund and then make capital contributions over time. LPs wait to fund their investment until the GP has “drawn down” or “called” for their money through one or more “capital calls” or written notices.

• Example:?Capital Call notices might include the following information:

??Capital Commitment: $500,000 (100%)

??Capital Contributions to Date: $350,000 (70%)

??Remaining Commitment: $150,000 (30%)

??Capital Call Due by:?February 14, 2013

(Plus, the fund’s wire instructions)

• Minimums: Fund investors are often required to commit to a certain minimum investment amount.
• Example:

? Institutions/Entities: $1,000,000 minimum commitment

??Individuals: $500,000 minimum commitment

• GP Commit: The GP is expected to contribute money to the fund (“GP Commit”). The historical industry standard for the GP Commit is 1%, but that standard is being revaluated, particularly in light of calls for more diversity in emerging fund managers.5 ?
• For example, Courtney McCrea & Sara Zulkosky, co-founders and managing partners at Recast Capital, concluded that:

“The standard 1% GP commit is arbitrary at best—and creates significant barriers to progress—at worst.”6

3. Carry

• Definition: A percentage of profits earned by the General Partner that is separate from the management fees.
• Explanation:?Everyone knows the market standard rate for carry is 20%. Some firms charge a flat premium carry. But many emerging funds also use a performance hurdle to charge 25-30%. Carry is intended to incentivize GPs as “performance-based compensation.” In other words, carry is the GP’s profit share.

Example: Let’s look at a hypothetical fund named?Emerging Ventures.

Emerging Ventures closes a $100 million fund. The carry is set at 20% but increases to 30% once the fund “returns 3x or more” (Distributed to Paid-In Capital, or?DPI ). The fund returns $320 million in net profits, after paying expenses and management fees, but before investors are paid back.

How much carry is the GP of Emerging Ventures entitled to?

If the fund’s net profits are $320 million, the first $100 million is distributed to the investors and the remaining profit is split depending on whether the premium hurdle is triggered.

With $220 million left, LPs would be distributed?$176 million?($220 million * 0.80) and the GP would be distributed?$44 million ($220 million * 0.20). Since $276 million in distributions is 2.76x—less than 3x DPI—the GP carry is 20%.

In sum, the GP of Emerging Ventures would be entitled to 20% of the profits—or $44 million—after management fees and expenses have been accounted for.

• Why do they call it “carry” or “carried interest”?

The origin story of carried interest ?supposedly dates back to?the Middle Ages. ?During the Renaissance, merchants transporting “carried goods” needed a way to incentivize sailors to set sail and return with the goods back to home port.

For example , Venetian ship owners would send empty ships to Constantinople to load spices and silk from the far east. Crew members faced months-long journeys with risks of disease, pirate attacks, mutiny and shipwrecks from bad weather. For those risks, and to align incentives, the crew was rewarded with?a share of the profits. The split was 20% . And even if this historical account is not entirely accurate, it serves as a useful reference to compare the concept of carry today.?

4. Clawbacks

• Definition: Clawbacks are generally a General Partner’s obligation to return excess carry back to the fund.
• Explanation: Clawbacks are in reference to the GP’s obligation to return carry to the LPs because the GP received more carry than is allowed in the LPA. In other words, in situations where the GP receives funds before carry is “in the money.”
• Key Concepts: Clawbacks are found when: (1) a “hurdle” exists (2) expenses or liabilities are greater in later years, and/or (3) the fund distributes carry on a?per deal basis?rather than on?the fund as a whole?basis (see?“Waterfall,”?at the bottom).
• Hurdle (Preferred Return): A hurdle is a fixed minimum rate of return that must be reached before the GP earns carry. The range of hurdle rates is between 6% to 8%, but most US venture capital funds do not use hurdles (but ~33% still do).7
• Fund Expenses: A fund can incur greater expenses in the later years of the fund, such as increased legal, audit and accounting fees, which can lead to a decrease in the overall profitability of the fund and could result in the general partner receiving distributions in excess of their allocated carried interest %.
• Deal-by-Deal Carry: Let's assume in a deal-by-deal carry waterfall (in which the GP initially receives carry at the same time as LPs), the GP is entitled to 20% carry on $50 million in profits from a $100 million fund. However, if the fund experiences a slowdown and doesn't achieve its expected profit returns, the GP's $10 million carry distribution may be recalled. This means that the GP’s receipt of carry is conditional and fully realized only if the fund returns 1.5x+ ($100m + [40m/80%]) = $150m or more.8
• A problem with clawbacks is enforcing them. In the past, an escrow account would be setup to hold back funds. Today, GPs just promise to give the money back, take it out of their management fees, or sign some form of personal guarantee. None of these options are ideal, which is why many funds put up guardrails to delay paying carry until they are “in the money.”

5. Fund Expenses

• Definition: Fund expenses are costs associated with the operation and maintenance of a fund, such as legal fees, accounting fees, and other admin costs.
• Explanation: Fund expenses are typically separated into two categories: Organizational Costs (often subject to a Cap) and Operating Expenses (uncapped). These expenses are directly paid by the fund’s investors through their capital contributions.
• Key Concepts: Organizational Costs, Placement Fees & Fund Expenses
• Organizational Costs:?A cap on organizational costs refers to a limit set on the amount of fees, costs and expenses that the fund will pay for the formation and organization of the fund. Any expenses that exceed that cap will be covered by the GP, and sometimes through a management fee offset.
• Placement Fees: Fees paid to placement agents—such as third party brokers to market and raise capital for the fund—are typically paid by the GP, sometimes through a management fee offset
• Fund Expenses: The core out-of-pocket costs incurred in forming and maintaining the fund such as:
• audit fees
• bank fees, custodial costs
• cost of liability and other insurance premiums
• costs associated with Advisory Committee meetings
• professional fees including legal, accounting, bookkeeping
• filing fees, securities disclosure expenses, compliance costs
• costs and expenses associated with any transfer or sale of interests
• partnership taxes, franchise fees and tax costs and expenses, including tax penalties, assessed at the level of the partnership
• all other reasonable fees and costs that are normal operating fund expenses

6. Fund Size

• Definition: Fund size is the total amount of money raised from fund investors.
• Key Concepts:
• Targets,?Caps,?Minimums, and?Portfolio Construction
• Target: A fund’s target fund size is the amount of money a GP is looking to raise in the “investment deck”9 ?and in their term sheet, if available. However, the fund size is not just the amount raised for investment in startups. That might be called the investable capital.
• Caps: A fund’s cap is the maximum amount of money it can raise. This is important to ensure the fund is sized appropriately with regards to the capital needs of its portfolio companies.
• Minimums: A fund’s minimum is the lower limit of capital it needs to operate. This amount is less than the target fund size and usually reflects the needs of the LPs’ risk profile, not necessarily the capital needs of the GPs.
• Portfolio Construction: An industry term meaning the math and logic behind modeling a fund structure. A fund’s size contributes to its portfolio construction, as the saying goes, “your fund size is your strategy.”10
• Which fund size is appropriate? Relevant factors include:

—the number and type of investment targets

—the “check size” of each of those investments

—reserve amounts for follow-on opportunities (pro rata)

—the number of people working at the firm, including other GPs and partners

—management fees needed to sustain a full-time commitment11

• Fund size is not a good predictor of returns. Only the top 20% of all funds achieve 3x or greater returns—and on a net basis, that pool shrinks even further.

“There has been this narrative about investing in VC funds that you have to get into the top quartile (25%) or possibly the top decile (10%) in order to generate good returns.” —Fred Wilson, @AVC12

So?why?is 3x and the top quartile % the most talked about VC return profiles??Shouldn’t the benchmark for performance be based on alternative investment scenarios, where limited partners have equal opportunities to earn a return?

• A study published in 2020 found that?half of all venture capital (VC) funds outperform the stock market?(the “PME” or “public market equivalent,” which is the benchmark most institutions measure VC funds against).13
• This study was conducted by the National Bureau of Economic Research (NBER) with leading economists (including Steven Kaplan at the University of Chicago), based on a sample of hundreds of venture capital funds from 2009 to 2017.

Another study based on the same data source shows return multiple profiles for venture funds by size from 1978 to 2019:14

The return profile for venture funds of all sizes are similar, except in the full data set, only a small fraction of funds (0.1%) have multiple returns greater than 20-40x and they are found exclusively in box 4 (top right).

Emerging funds have a higher percentage of outsized returns, but larger growth funds deliver more consistent returns (for example, median returns of 1.86x for fund sizes $500m+ vs. 1.67x for funds under $250m).

In other words, emerging funds have a higher?slugging percentage, while growth stage funds have a higher?batting average.

“Your fund size is your strategy.” —Mike Maples Jr.

7. Key Person

• Definition: A key person is an individual or group of individuals who hold primary responsibility for the success or failure of a fund.
• Explanation: A “key person clause” is a contract provision found in most fund’s limited partnership agreements (LPA) that identifies the people “too important to fail” if they are no longer providing services to the fund. These terms are often used for funds with a single or dual GP or a fund in which its strategy hinges on one or more essential persons on the team.
• Key Concepts:
• Time Commitment,?No-Fault Trigger,?For?Cause,?Successor Funds, Suspension, Removal and Termination
• Time Commitment Test: The amount of time that key persons devotes to a fund varies greatly. Importantly, there are two relevant time periods for this test: During the active?investment period?and?after the end?of the investment period. Traditionally, this has been around three to five years, but the important point is GPs are generally expected to commit to less time in maintenance mode versus actively investing in companies. To make the rules clearer, a provision called “Devotion of Time” or similar may specify the minimum expected time commitment of the GP:

—All of business time

—Substantially all of business time [as is reasonably necessary]

—Substantial majority of business time

—Such time deemed “necessary to manage the affairs of the Fund.”

• No-Fault Trigger: A related concept is a no-fault suspension or termination of the fund:
• The Institutional Limited Partners Association (ILPA) recommends that a vote of two-thirds in interest (66.67%) of the investors is required to suspend or terminate the investment period and a vote of three-quarters in interest (75%) of the investors is required to remove the general partner or dissolve the fund without cause.
• For Cause Events:
• Cause for removing a GP typically includes bad actions, such as fraud or gross negligence, rather than just poor performance. These actions, known as “for cause trigger events,” must be clearly listed in the LPA:

—Fraud

—Misconduct

—Gross negligence

—Breach of fiduciary duties

—Criminal Conviction

—Bankruptcy

• Successor Funds: After the fund is substantially invested, the time commitment test can be reduced or removed. Different thresholds may apply but generally if at least 70%-85% of the fund’s committed capital has been invested, committed or reserved for working capital purposes, the GP may reduce its role in managing the fund and start raising a new one.
• Suspension: If a GP violates the time or cause provisions above, one remedy is to suspend the investment period. The investment period is the time when the General Partner can make investments and it usually lasts for three to five years. When the investment period is suspended, the GP can no longer acquire new investments or call fees, but they can fund follow-on investments, expenses for existing portfolio companies, or investments that were in progress at the time of suspension.
• Removal and Termination: An extreme remedy is a replacement of a Key Person or removal of the GP by vote. For Cause events, where at least a majority of interest of the LPs consent, and No Cause events, based on a supermajority threshold (e.g.,?75%—see?No-Fault Trigger).

8. Management Fee

• Definition: A management fee is a fee charged to investors on a regular basis for the operation and maintenance of a fund.
• Explanation: The management fee is a fixed percentage charged by the fund’s management team for the services they provide. It is often issued to an affiliated “management company” for liability and tax purposes. Here are three key features:
• Amount: For venture funds, the management fee is based on a percentage of capital committed to the fund by an investor and ranges from 2% - 2.5% per year. However, some emerging fund managers may “front-load” their fees and ask for more upfront but reduce fees in later years by a certain amount.
• Timing: The fee is charged on a quarterly (or other periodic) basis, and is paid out of the LP’s capital contributions every year the fund is in operation.
• Step-Downs: After a certain period of time passes (typically, 5 years), the management fee may reduced, within a range of 0.50% to 1.50% per year.
• Key Concepts:
• Cashless Contributions,?Subscription Lines,?Note,?Fund Expenses
• Cashless Contributions: Contributions can be made by the GP either in cash or through a process called “cashless contributions.” With cashless contributions, the GP can reduce the amount they are otherwise required to contribute by up to 100%, which results an equal reduction of the management fee. This can be adjusted each year. The GP will be treated as if they had made the full GP contribution for all other purposes except for tax purposes (this arrangement raises important tax issues, please speak to a tax specialist about this).
• Subscription Lines:?An alternative to cashless contributions is a loan from the bank to pay for the GP Commit by leveraging future management fees.
• Promissory Note: An alternative to an outside line of credit is issuing a (full recourse) promissory note or loan from the fund to cover a portion of the GP Commit, such as 25% in cash and 75% through a note—provided it bears a sufficiently minimum federal interest rate necessary to avoid imputed interest.
• Fund Expenses: Management fees and fund expenses refer to different things. The?management fee?is used to cover management services, office salaries, and other GP expenses that are not charged directly to the fund.?Fund expenses?involve forming the fund and associated entities, legal costs, accounting hosting annual meeting for LPAC members, fund administration services and other miscellaneous expenses associated with conducting investment work and fund related work.
• What's the?key difference?between fund expenses and management fees?
• Management fees cover the management team’s?services?and?non-reimbursable?expenses while fund expenses cover the?day-to-day operations?of a fund.
• How can you make enough to support your fund full-time? Use a minimum fee:

Example: “The GP will receive a management fee calculated at an annual rate equal to 2.50% of the committed capital of the Fund, and the minimum annual management fee will be [e.g.,?$150,000] through the 5-year investment period.”

• Loans: Management fees are like loans. But there is no such thing as a free lunch. Many fund managers don’t realize that management fees?have to paid back to the LPs before?carry goes to the GP (see “Waterfall,” at the bottom):

Example: A $100 million fund that charges a 2% management fee over a 10 year investment period will have $20 million allocated to the management fee, leaving $80 million to invest (not including fund expenses). This means if only 80% of the fund is being deployed, putting the venture capitalists at a disadvantage as they will need to return?at least?1.25x to return the $100 million fund to their limited partners.

• Recycling Management Fees: Another way to conceptualize this: Brad Feld says his venture fund, Foundry Group, will reinvest its management fees, which aligns more with investors, increases returns for everyone and results in tax advantages. This process is known as “recycling” management fees. In other words, rather than receiving a management fee, they reallocate 100% of the management fee to fund more investments:
• Disclosures Please: But if you take 100% of the management fees upfront or recycle management fees, you must clearly disclose this and receive informed consent from your LPs—otherwise you could be in violation of securities laws.

9. Side Letters

• Definition: A side letter is a separate agreement that outlines different terms for an investor’s investment in a fund.
• Explanation: Institutional and large investors often ask for special rights through a side letter, which is just a short agreement that is negotiated with the investor’s fund documents. As Ramsinghani wrote in?The Business of Venture Capital:

"All LPs are equal, but some LPs are more equal than others". —Mahendra Ramsinghani (paraphrasing Animal Farm )

• Key Concepts: Co-Investment Rights, Reduced Fees, Information Rights and Confidentiality, Most Favored Nation
• Co-Investment Rights: The GP may offer certain investors the right to participate in co-investment opportunities, which are the ability to invest alongside the GP on a deal-by-deal basis. This allows the LPs to have more flexibility over where their money is allocated and gain more insights into a portfolio company’s performance. However, it can also present challenges for the GP in terms of managing the timing and due diligence process, and ensuring that the LP's involvement does not negatively impact the exit potential of a portfolio company.
• Reduced Fees: The GP may feel pressure to reduce or waive management fees or carry for LPs; however, it is generally a bad idea to offer investors a reduced fee or carry in the main fund because most large investors will negotiate a “most favored nation,” which means it’s not just giving one investor special rights, but all investors with side letters. However, GPs often reduce their carry in co-investments (10-15%), management fees are zero and expenses are often capped or a flat fee for special purpose vehicle (SPV) expenses.
• Information Rights and Confidentiality: The General Partner may agree to provide an investor with greater informational rights, such as the ability to request a description of the exact positions of the fund at any given time, while at the same time agreeing to strict confidentiality provisions (such as no press releases using the LP’s name without their prior written consent); and
• Most Favored Nation: This allows an investor to capture the best economics that the GP provides to any other investor. This clause is usually reserved for the largest or earliest investors.

10.?Waterfall

• Definition: A waterfall is the process and structure of sharing fund returns.
• Explanation: A waterfall distribution method is a way of dividing up profits among the LPs and GP in a venture fund.
• Key Concepts: There are two main types of waterfalls:?Deal-by-Deal,?Whole of Fund
• Deal-by-deal:?In this model, the fund’s profits are distributed after an exit of a portfolio occurs. GP clawbacks are often used in this model because taking carry early opens the possibility the GP does not reach its profit share at the fund level. However, to prevent clawbacks, a fair market value test might be applied before the fund has enough profit to distribute carry to the GP:

Example: Assuming the fair market value of the fund’s entire portfolio equals 125% or more, the GP can distribute carried interest to itself alongside investor distributions.

• Whole of Fund: A whole-of-funds model is the industry norm and requires the GP to first return 100% of the investor’s principal investments before the GP takes any profits. Only after that has occurred, then will the profits be split between the LPs and GP according to a pre-determined formula (e.g., 80% of profits to LPs, 20% of profits to GP).

Distributions are made in the following amounts and order of priority:

1. First, 100% to all partners (including the GP) in proportion to their respective capital contributions until the partners have received cumulative distributions equal to the sum of their capital contributions.
2. Thereafter, the balance (a) 20% to the GP (the “carried interest distributions”) and (b) 80% to the LPs in proportion to their respective aggregate capital contributions

• Further Analysis: The GP should never put themselves in a position that (a) leaves them exposed to return carry they did not earn, or (b) is tax disadvantageous.

—On the first point, we discussed the effects of “Clawbacks,” above.

—On the second point: The Securities and Exchange Commission (SEC) has suggested new rules that prevent GPs from reducing their clawback obligations by considering any taxes that may have applied to the GP, whether those taxes are actual, potential or hypothetical (as is often the case, the highest tax bracket is assumed).16 ?Those rules may go into effect soon. In addition, if carry is allocated before a three-year holding period has lapsed, the GP may also be paying ordinary income tax rates versus the long-term capital gain rates of carried interest.17

If you’re looking for additional reading content, I highly recommend reading?Law of VC #14 Episode -LPA terms for Emerging Managers and download this term sheet:

• Download LPA Term Sheet (2023)

Thank you for reading and those who responded to my open question for finding these key terms.

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Thanks,

Chris Harvey