See if this scenario sounds familiar: You just turned 30 and are either a successful entrepreneur who made a fortune developing a very popular gaming app, or you’re one of the early employees at an emerging technology company that just achieved “unicorn” status.
In either scenario, you’ve made your fortune (at least enough to live on comfortably for the next few years). And, having reached a very important milestone in your life (either making your first million or turning 30, you choose), you’re eager to see how the other half lives — by forming your own VC fund and becoming a venture capitalist!
You could go it alone, but what’s the fun in that? Instead, you decide to team up with two of your closest friends and set out to raise your initial $50 million early stage VC fund. But despite what you learned from watching reruns of Schoolhouse Rock, three is not “the magic number.”
Nor, for that matter, is two, four or five. That’s because forming a private investment fund with one or more partners raises a number of issues that, if not thought through and addressed early on, could raise serious problems down the road for you and your co-partners.
Fund lawyers divide these issues into three categories: (1) economic issues; (2) control/operational issues; and (3) issues concerning restrictive covenants.
Sound confusing? Well, if you keep reading, and get sound advice from legal counsel well-versed in these issues (for example, this author), you’ll quickly learn how to make the right decisions and end up with terms for the governing document of your General Partner (GP) entity that really add up.
Issues surrounding the economics of a fund GP entity — in particular, how the profits (otherwise known as the “carry” or “carried interest”) are to be divided and the GP capital commitment allocated — are often the most difficult for a new GP team to resolve. Of these issues, how the “carried interest” from the fund will be split among the team members is probably the thorniest.
By way of background, general partners of funds are typically entitled to 20 percent or more of the profits generated by a fund. Although, inevitably, each team member brings a different set of skills to the enterprise (and, therefore, adds varying amounts of value to the business), in my experience, teams for first-time fund sponsors typically take an egalitarian approach to dividing up the “carried interest” and tend to split the “carried interest” pool evenly (or as close to evenly as possible). Thus, if the carry for a particular fund is 20 percent, one-third of the 20 percent would be allocated to each of the three team members.
In subsequent/follow-on funds, as the size of the team grows, the math becomes much more complex. In my experience, and as set forth in numerous surveys on the topic, the fund’s 20 percent or more “carried interest” pool for more mature fund sponsors is typically allocated as follows: (1) Managing GP/CEO ~ 45 percent; (2) Senior Partner(s) ~ 30 percent; (3) Mid-Level Partner ~10 percent; and (4) Junior Partner ~ 5 percent.
Thus, the Managing/Senior Partner(s) typically take around 70 percent of the entire “carried interest” pool. For both first-time funds and subsequent/follow-on funds, outside investors (and in particular, institutional investors) will take an interest in the overall allocation.
As such, the allocation should be consistent with the role/importance of the various team members as it reflects on the culture of the firm. In the private equity world, my colleagues and I sometimes see “deal-by-deal” allocation of “carried interest,” but most often, people get percentages of the collective pool, as that model encourages more of a collaborative environment.
Forming a private investment fund with one or more partners raises a number of issues.
Finally, sometimes my clients set aside a certain percentage of the 20 percent or more “carried interest” pool (e.g., 5-10 percent of the pool) to be allocated to strategic advisors that may, on occasion, help the GP entity source particular investment opportunities or otherwise provide strategic advice. In those situations, that percentage may be allocated on a “deal-by-deal” basis in order to more accurately reflect the actual value that has been provided by the strategic advisor.
Having settled on how the “carried interest” pool is to be divided, the second question that needs to be answered is how should the “carried interest” pool vest? Once again, in the context of a first-time fund, I typically recommend a straight-line vesting period commensurate with the investment period of the fund (or slightly longer).
For example, if the fund has a five-year investment period, I often suggest either a five-year vesting period with 20 percent vesting on an annual basis, or a six-year vesting period with 16 ⅔ percent vesting on an annual basis.
In the context of more mature fund sponsors, I often see vesting of five-six years for Senior Partners and six-seven years for Junior Partners. In situations where there is a concern that one or more partners may not be completely committed to the enterprise, I may recommend either “cliff-vesting” or “back-end loaded vesting.”
As the name suggests, a “cliff-vesting” structure is one where the entire portion of the “carried interest” pool (or a significant percentage) becomes fully vested at a specified time rather than becoming partially vested in equal amounts over a period of time.
“Back-end loaded vesting” is one where a smaller percentage vests in the early years and the vesting percentage increases over time (e.g., 10 percent vesting the first four years and 20 percent vesting the next three years).
Finally, I’m sometimes asked to build in the concept of accelerated vesting (for example, upon the death or disability of one of the team members), but often the partners leave issues like this to be decided when any such circumstance arises.
In sum, the vesting schedule (like the allocation of the “carried interest” pool) should be structured in a way to ensure that all team members are incentivized to stay through the most important years of the term of the private investment fund.
A third economic issue that the GP team needs to agree on at the outset of the formation of a fund is how the General Partners’ capital commitment (or the GP entity’s “skin in the game”) is to be funded. By way of background, most investors require that the GP entity hold a small percentage of the limited partner interests in a fund.
Although there is no hard and fast rule as to the amount of capital that the GP entity must commit, the amount is typically in the 1-5 percent range (with 1-2 percent being more the norm). Even though this may sound like a nominal amount, for a $50 million fund, a 2 percent capital commitment equates to $1 million.
So deciding which team members will fund this obligation (which is contributed at the same time the limited partners fund their respective capital commitments) is an important decision. Once again, teams managing first-time funds typically take a practical approach to this problem, often allocating this burden to whoever is able to pay it. That tends to change as the assets under management grow, at which point this responsibility tends to get allocated along the same lines as the allocation of the “carried interest” pool.
Finally, the governing document for the GP entity typically requires members of the GP entity to fund their share of the capital commitment even after leaving the firm — once again, to incentivize the team members to stay.
A fourth economic issue that the team members of a GP entity need to agree on is what to do with the management fee income (which, in a typical venture capital fund, is 2-3 percent of committed capital during the fund’s investment period and the same or slightly smaller percentage of invested capital during the fund’s harvesting period).
To the extent there are any excess management fees left after paying the costs of running the firm (including salaries), this income can be divided among the team members. In the context of a mature GP entity team (i.e., a team that has successfully raised a number of funds), these excess spoils are typically allocated only among the Senior Partners. In the context of a first-time fund, once again, this pool is most often allocated evenly among all partners.
There are economic issues around changes in the composition of the GP entity team.
A corollary issue with regard to management-fee-income is team salary. Because, in most situations, each team member will also be an employee of the management company entity, each partner will also be paid an annual salary. Here, I often suggest a more nuanced approach. If certain team members have a need for a higher salary (for example, to support a family), I often recommend allocating more salary to that person as an advance against such person’s share of the “carried interest” pool.
That sort of structure allows those team members who may need more income on an annual basis to receive it, without changing in any material respects the overall economic allocation of the fund’s profits among the team members.
Finally, there are economic issues around changes in the composition of the GP entity team — either that arise when new partners join the team, or that arise when one or more partners depart. Because the timing of these events is difficult to predict, teams often “kick the can down the road” and merely address it if and when the situation arises.
I will point out, however, that it is rare that a newly admitted partner will share in the economics of pre-existing investments. Instead, the members of the GP entity often create a separate “carried interest” pool with respect to investments made after a new person joins the team and decide how interests in future investments will be allocated (with the “carried interest” pool for existing investments remaining unchanged). Likewise, the departure of a partner in the GP entity while the fund is still active creates issues, as well.
For example, questions such as, “How will unvested carried interest from departed partners be reallocated?” and “Should the firm be able to repurchase interests from departed partners?” will need to be considered.
Having tackled the thorny issues related to GP entity economics, the next set of issues that need to be resolved center around investment decisions and the overall control of the GP entity. With respect to investment-related decisions, most GP entities form an “investment committee” (consisting of all senior team members) to decide which investments the underlying fund should make.
Many GP entities will put in place a “unanimous consent” or “unanimous consensus” mechanism, allowing one member to essentially veto a particular investment if he or she has reservations or concerns about it. Although this may mean that a fund may pass on certain investments even though a majority of the team members believe it’s a good bet, this type of structure forces the proponent of a particular investment to really make his or her case as to why the fund’s capital should be deployed to a potential portfolio company.
Another important issue with respect to control centers on the hiring/firing of team members and other employees. Here, questions such as, “What sort of approval will be needed to terminate a partner?” and “What sort of conduct should trigger this right?” are often the two forefront issues.
What constitutes “cause” often varies depending on the seniority of the person involved.
Once again, even though there is no “one size fits all” approach, there are certain truisms. For example, committing an act of fraud against the underlying fund or the GP entity — particularly acts that have a material adverse effect on the fund — will almost always constitute a “cause” event and give rise to a removal right. Likewise, conviction of most felonies — particularly ones involving the misappropriation of assets — usually results in the right to remove the team member from the GP entity.
On the other hand, personal felonies — for example, a conviction for driving under the influence of alcohol or driving while impaired — may result in a “black eye” for the management team but may not necessarily result in the culprit being removed. In addition, it’s important to note that what constitutes “cause” often varies depending on the seniority of the person involved, with more stringent standards being applied to the most senior partners.
Finally, all GP entities need to make some hard choices when settling on how the fund will be managed and operated. In my experience, control over the most important operational decisions often is held by the most senior members of the firm. The more material the issue, the more likely that any such decision will require “unanimous consent” or “unanimous consensus.”
Examples of these operational issues include the following:
- admission of new partners to the GP entity (including by way of transfer and by way of issuing new interests)
- negotiation of the fund terms with investors
- when to call capital from fund investors and the members of the GP entity
- voting the securities of portfolio companies and other management decisions at the portfolio companies
- selection of service providers and professional advisors
- timing and amount of distributions from the fund to the LPs and from the GP entity to its members
- incurring indebtedness or entering into contracts (for the GP entity or the underlying fund)
- liquidation-related decisions
- valuation of underlying fund assets/GP assets
- seeking an amendment to the underlying fund limited partnership agreement or the GP entity limited liability company agreement
- day-to-day and other decisions regarding the management of the GP entity or the underlying fund
Although this is not an exhaustive list, it should provide a good sense of the types of issues that a fund management team will need to address so that guidelines can be put in place as to who needs to be involved in making these various decisions and what sort of requisite threshold needs to be met to make them.
The final set of issues that the team members need to agree on at the outset of the formation of their GP entity involves ones related to what other activities team members may engage in — both while such team members are still involved in the enterprise and after.
During the period of time when a team member is still a part of the enterprise, it is important to clearly lay out the ground rules as to how much “time and attention” needs to be spent on fund-related business.
For example, will this be a full-time commitment of the team member, or something less? Even if it is a full-time commitment, what other activities outside the management of the underlying fund(s) may a team member pursue? Once again, there is no “one size fits all” approach, but at a minimum, there needs to be a certain level of commitment to the enterprise by all team members in order for the underlying fund to have any hope of success.
As a corollary issue, an agreement needs to be reached (and memorialized) as to which investment opportunities a team member must offer to the underlying fund(s) for consideration and which investment opportunities (if any) may be pursued by such individual outside of the fund.
In addition to the underlying fund limited partnership agreement containing restrictions designed to limit the possibility of “cherry picking,” the operative document of most GP entities (or written internal policies or the employee handbook) spell out these sorts of restrictions.
If there is any ambiguity as to whether or not these internal policies have been violated, it is very important for the agreement governing the GP entity to have some clearly defined dispute resolution mechanism — preferably arbitration, so that any such disputes can be resolved relatively quickly and in a confidential manner.
Having settled on conduct rules to be applicable while individuals are still members of the GP entity, it is just as important (if not more important) to have clarity — to the extent possible — as to issues that will arise if and when a team member is no longer with the GP entity. Two such issues are (i) covenants not to compete and (ii) covenants not to solicit.
The enforceability of “non-compete” and “non-solicitation” provisions vary from jurisdiction to jurisdiction.
Since the enforceability of “non-compete” and “non-solicitation” provisions vary from jurisdiction to jurisdiction (with California holding, on the one hand, that “non-compete” provisions are unenforceable except in very limited circumstances, but holding, on the other hand, through adoption of the Uniform Trade Secrets Act, that it is illegal for employees to misappropriate trade secrets from a former employer and use those trade secrets to solicit customers of the former employee), it’s important to consult with experienced counsel when addressing these issues in the operative agreement for a GP entity.
As such, as mentioned above, the better way to tackle these provisions might be to address the main concern — i.e., someone leaving the enterprise early — by putting in place an appropriate “carried interest” pool-vesting schedule, which can strongly incentivize a team member to think twice before leaving.
One issue that can be settled up front that will also weigh on any decision of a team member to leave a GP entity early involves attribution of the underlying fund’s track record. Here, the operative agreement of the GP entity can make it clear that all investment results are deemed to have been achieved as a result of the combined efforts of all team members, as opposed to just one or two. This pooling of attribution will make it much more difficult for a former team member to take the lion’s share of the credit with respect to successful investments (again, further incentivizing that team member to stay).
As you have seen, some of the solutions to these problems are to approach them in a way that incentivizes the team members to stick it out together as long as possible, as that is in the best interest of the enterprise as a whole. Others require a bit more creativity and need to be tailored on an entity-by-entity basis.
Either way, approaching these issues from the outset — or at least knowing why they are important in the life of your entity — will go a long way to forming a cohesive group that could be together and successful for a very long time.