VC Investing for Individuals - Fund Structure (Part 1 of 4)

This is the first post in a four-part series to help individuals understand the ins and outs of investing in early-stage VC funds.

As Outbound Capital enters its fourth year, and after speaking with hundreds of prospective individual Limited Partners (LPs), it has become obvious to me - a solo General Partner (GP) - that there is a dearth of information on the financial, tax and professional benefits of investing in VC funds as an individual accredited investor.

Investing in VC funds has historically been the domain of institutional LPs - pension funds, college and nonprofit endowments, insurance companies and family offices. This is mainly because traditional VC funds raise quite a bit of money (100s of millions to 10s of billions of dollars) and the investors who could meaningfully participate tend to be big institutions with a mandate to invest part of their portfolio in venture capital.

The recent trend of the solo GP raising micro-funds of $50M or less has opened the VC asset class to accredited individual LPs who are able to write smaller checks into these micro-funds. Yet, given the lack of historical participation, accredited individuals often must invest significant energy into understanding the basics of VC funds before they can effectively evaluate an opportunity.

In this four-part series I will unpack some of the financial, tax and professional development benefits of investing in VC funds as an accredited individual LP. Since most micro-funds necessarily invest in early-stage startups, the focus of this series will be on early-stage VC funds. At a hight-level, we will discuss:

• Fund structure - Part 1 of 4
• Financial and diversification benefits - Part 2 of 4
• Unique tax opportunities - Part 3 of 4
• Professional development opportunities - Part 4 of 4

VC fund structure

In this first post, I'd like to start with a brief discussion on the structure of VC funds and the relationship between the LPs and the GP.

Venture capital funds are structured as limited partnerships. Limited partnerships are the corporate structure of choice for most private funds - hedge funds, private equity funds and venture capital funds. The limited partnership structure allows the GP, who sponsors the fund, to raise capital from investors and provides the legal framework for the relationship between the GP and the LPs. Limited partnerships are pass-through entities for tax purposes, so no tax is levied at the partnership level, which avoids double taxation.

The LPs are the investors in the VC fund and provide the majority of the capital that the fund invests in startups. Their risk is limited to the capital that they put into the fund and they are passive investors. The GP is the sponsor of the fund and also provides capital into the fund. The GP takes on the liability for the fund and actively makes the investment decisions.

This structure allows the fund sponsor to pool capital to invest in startups that are a fit with the fund's strategy, and to distribute capital back to LPs when a startup in the fund's portfolio is acquired, goes public or their shares are sold on the secondary market. The fund typically invests in 25-30+ startups to spread the risk of startup investing across many different startups and increasing the chance of investing in a highly successful startup.

VC funds are usually set up as closed-end vehicles with a 10-year lifetime. New startup investments are made in the first 2-4 years of the fund's life and returns are expected in the later years.

Fund docs and capital calls

The standard documents that individuals LPs must become familiar with are the Private Placement Memorandum (PPM), the Limited Partnership Agreement (LPA), and the Subscription Agreement and Investor Questionnaire (Sub Doc). The PPM describes the fund's offering, the LPA governs the relationship between the GP and the LPs, and the Sub Doc is how LPs subscribe to the fund.

LPs attest to being accredited investors or a qualified purchasers and indicate how much capital they want to commit to the fund when they fill in the Sub Doc. If their subscription is accepted by the GP, they will officially become LPs in the fund.

GPs typically do not require the entire amount of the LP's commitment to the fund upon subscription. The capital is 'called' over the first 2-4 years of the fund's life, when the fund is making initial investments in startups. This provides LPs with the opportunity to invest the capital they have earmarked for the fund in other liquid investments in the meantime.

In the next post, I'll discuss the financial and portfolio diversification benefits of investing in a VC fund as an individual LP. The potential for high returns are what most people think about when they think about investing in a VC fund, but there are many additional financial, tax and professional development benefits that are not as obvious.

Legal disclaimer: This is in no way an invitation or solicitation to invest in Outbound Capital's VC funds.