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An overview of US venture capital funds

What are the characteristics of US funds? How are they structured? What should investors expect in terms of liquidity and capital calls? What are 'US funds' limitations? Jennifer Post from US law firm Edwards & Angells offers investors an introduction to general legal, business and tax issues in relation to US formed venture funds.

The U.S. venture capital industry has grown from a relatively small investment pool in the 1960s and 1970s into a significant, mainstream, component of institutional and corporate investment in the U.S. Commonly known as ‘private equity funds', venture capital funds focus on the purchase of unregistered equity securities from small, rapidly growing companies. A venture fund will typically provide management support in the development of such ‘portfolio' company's technology, product or services. Venture funds are generally defined by their willingness to sustain significant risk and illiquidity with the expectation of high returns over the long term, under the management of professional investment managers. Venture funds formed in the U.S. are subject to various federal and state regulations, including the Securities Act of 1933, the Investment Company Act of 1940 and the Investment Advisors Act of 1940. In addition, venture funds formed in the U.S. are subject to taxation in accordance with the Internal Revenue Code.

Variety of U.S. Funds

There are many types of venture capital funds in the U.S., but the most significant concentration of venture investment resources will be found in venture funds independently organized as limited partnerships for the sole purpose of investing money in private equity securities. These venture capital funds are typically organized as limited partnerships in which a venture capital ‘firm' acts as the general partner and investment advisor. Limited partnership interests in the fund are sold privately to institutions and high net worth individuals. The structure of the fund as a limited partnership carries important and beneficial tax attributes for the investors. While many venture funds are organized as independent organisations without affiliations to larger institutions or corporations, venture funds may also be affiliates or subsidiaries of large financial service institutions, such as commercial banks, investment banks or insurance companies, or may be the investment subsidiary or sister organisation of well established corporations. Venture organisations affiliated with financial service organisations or corporations are sometimes referred to as ‘corporate venture funds.' 

Some U.S. venture capital funds are formed as a ‘fund of funds',a partnership organized to invest in other venture capital funds. ‘Fund of fund' investments provide investors with significant diversification and an ability to invest small amounts into a wider variety of funds. Finally, venture funds in the U.S. can be organized to take advantage of the Small Business Investment Company Act (or SBIC) program in which a venture fund may supplement its own ‘private funds' with federal funds and leverage its investment resources. Funds organized to utilize SBIC programs, however, must comply with strict the regulatory provisions of the SBIC, as administered by the Small Business Association. One such regulation limits the investments of such SBIC funds to portfolio companies that are ‘qualified' under the SBIC, therefore limiting the scope, amount or diversity of the fund's investments.

Structure of the fund and its investors

Although the structure of each private equity fund is driven by its underlying business strategy, a typical independent venture fund in the U.S. is organized as a limited partnership with one or more general partners (or affiliated management companies) that control the investment activities of the fund. The governing document of the fund for legal, business and tax purposes is the limited partnership agreement, which is heavily negotiated by the limited partners and the general partner during the formation of the venture fund.  Most venture funds formed as limited partnerships in the U.S. are created under Delaware law, which provides a favorable and well developed statutory scheme. In recent years, changes to the Internal Revenue Code in the U.S. have opened the door to creating venture funds as limited liability companies, which allows tax advantages similar to those afforded by limited partnerships. However, limited partnerships continue to be the industry standard for creating venture funds in the U.S.

The General Partner

The general partner of the venture fund (limited partnership) is the person or entity that exercises exclusive investment and management control over the fund. Investment advice may also be rendered for the fund by a management company, often affiliated with the general partner. Under U.S. law generally, only the general partner and not the limited partners may exercise investment and management control over the partnership. The general partner of a venture capital limited partnership can be an individual, but is usually organized as some type of legal entity - a limited partnership, limited liability company or corporation. Forming the general partner as an entity helps to shield the individuals who ultimately control the venture fund from the liabilities associated with acting as the general partner of the partnership.

The general partner of the fund is compensated for its investment advice and services, and for the administration of the venture fund. Management compensation is provided in several ways. Many funds will compensate the general partner with a management fee, payable in cash periodically (monthly or quarterly). The fee may be a percentage of the value of the fund at the end of the relevant period, or a straight percentage of paid-in capital. In addition, the general partner is usually entitled to a percentage of the overall profits of the fund - typically up to 20 per cent - known as a ‘carried interest.'  Many funds compensate the general partner with a combination of the two, negotiating the fees and carried interest percentages during the formation of the fund. The carried interest should be viewed as significant since the limited partners usually contribute 100 per cent of the capital of the venture fund, although it is not uncommon to see the general partner contribute up to 5 per cent of the capital where the investors of the fund are primarily wealthy individuals (and not institutions) or where the fund is under $100 million in total capital.

Often the management fee and carried interest of the general partner are subject to limitations. In many venture funds the carried interest allocation is made only after the value of the fund's assets exceed a certain amount. That prevents the allocation from being made if the limited partners have suffered a loss. In addition, the limited partnership agreement may provide that if distributions or allocations are made to the general partner and it is later determined that certain hurdles or profit goals have not been met on the behalf of the limited partners, those allocations and distributions must be restored to the fund, known as a ‘claw back' provision.

The Limited Partners

Large private venture capital funds are usually composed of limited partners who are either large institutions or high net worth individuals. Fund investors are typically sophisticated investors who can sustain significant risk of loss of capital. U.S. venture fund investors include employee benefit plans, insurance companies, banks, pension plans, university endowments, trusts and individuals. Institutional investors such as pension plans and insurance companies generally have large pools of cash that require deployment in investments that will yield high returns.

The sophistication of the limited partners as investors is a necessary prerequisite to avoiding burdensome compliance items with the Securities and Exchange Commission. Accordingly, large venture capital funds deal exclusively with investors that are ‘accredited' within the meaning of the Securities Act of 1933, which generally means they have substantial net worth, are sophisticated in investments of the type being made and are able to sustain the risk of loss of their entire investment. Dealing solely with ‘accredited' investors greatly reduces the disclosure obligations of the venture fund during the formation process and avoids the necessity of registration of the limited partnership interests with the Securities and Exchange Commission (and the corresponding state securities commissions in any state where an investor is resident).

In accordance with prevailing U.S. partnership laws, limited partners cannot participate in the management of the partnerships; doing so could jeopardize the partnership status of the fund for tax and other purposes. Notwithstanding, limited partners of U.S. venture funds sometimes enter into ‘side letters' with the general partner which may allow the limited partner, for example, to participate in an advisory board for the fund or receive confidential investment information. In addition, most venture capital limited partnership agreements provide that  certain actions of the general partner (such as appointing a successor general partner), or amendments or modification of the limited partnership agreement, require the consent of the limited partners.

Generally, limited partners are prohibited under the terms of the limited partnership agreement from transferring  (or selling) their interests in the fund without the consent of the general partner.

Tax Considerations

Venture capital funds in the U.S. are formed as limited partnerships in order to obtain the favorable tax benefits of being ‘flow through entities' under the Internal Revenue Code. Accordingly, U.S. venture funds are structured so that no tax is payable at the fund level and all items of income, loss, deduction, gain and credit are recognized by the limited partners (and to the extent there is a carried interest, the general partners) directly in accordance with their capital accounts or other formula set forth in the fund's limited partnership agreement. By forming the fund as a ‘flow through entity' the fund and the investors avoid double taxation on the assets and profits of the partnership.

An even more superior tax result is achieved for investors who are themselves tax exempt organisations. In the case of such tax exempt organisations, the fund and the investors need to limit and control the generation of ‘unrelated business taxable income' (UBTI) by the fund, which would be taxable income to those entities. UBTI could be generated if, for example, the gains are produced from debt financings or if the gain is produced as a result of the fund operating an ‘active business.'  There are some methods that may be used to avoid UBTI and UBTI treatment may vary depending upon the individual investor's own tax status. However, tax-exempt investors in private equity funds will seek to negotiate parameters into the fund's limited partnership agreement that would serve to limit the likelihood of the fund's investments generating UBTI for those investors.

In addition, another important advantage of the flow-through status of the limited partnership entity is that foreign investors (i.e., non-U.S. citizens) may under certain circumstances avoid (U.S.) federal income tax for capital gains received from private equity funds provided certain conditions and limitations are met. For example, in order to avoid federal taxation the gain received cannot be ‘effectively connected' to an active business in the U.S. conducted by the fund or by an operating flow-through entity in which the fund is an equity owner. Also, the gain cannot be generated from an investment in a ‘real property holding company.'  In addition, foreign investors must review and understand the implications of local tax regulations and controlling tax treaties between the U.S. and their country of residence.   

Finally, another significant tax advantage of maintaining partnership status is that the partnership may generally distribute cash or property to the limited partners on a tax free basis. This is an important aspect of the venture fund structure since many venture capital funds will distribute equity securities of its portfolio companies directly to its partners, in lieu of liquidating such securities and distributing cash. That type of ‘in-kind' distribution of securities generally results in a favorable tax outcome for the investor.

The life cycle of the fund; fundraising, capital calls, liquidity and multiple fund management.

Life Span

Independent venture capital funds formed in the U.S. are typically organized as a fixed term partnerships having a life span of between seven and ten years.

Fundraising. The management firm, or prospective general partners, are usually active in the ‘fundraising' aspect of the venture capital fund formation. The fundraising function involves the management company (or general partners) seeking out and identifying qualified investors for the fund. The fundraising usually involves distribution of a written description of the fund, known as a ‘book' or ‘offering memorandum' which describes the fund's proposed investment strategy, as well as the experience and expertise of its general partners, and proposed rates of return and distribution formulas for capital and profits. The offering memorandum must comply with the regulations of the Securities Act of 1933.

Subscriptions for limited partnership interests in U.S. venture capital funds are usually made in significant dollar increments. For example, it is not uncommon to see a minimum investment subscription amount of $250,000 depending upon the overall size of the fund. Smaller funds, naturally, would require smaller minimum investment amounts. Conversely, larger funds composed primarily of institutional investors may require larger minimum subscription amounts sometimes as large as $1 million or more. The fundraising process and the gathering of subscriptions from potential investors is a process that may take from several weeks to several months depending upon general market conditions and the targeted aggregate capital of the fund. In addition, depending upon the overall target size of the fund, a venture capital fund may have anywhere from a few investors or up to one hundred limited partners or more. Naturally, from the point of view of administering the fund, fewer investors are preferable. However, increasing the number of investors accepted to participate may increase the overall capital of the fund. The number of investors in a fund can also effect certain regulatory items, discussed below.

Generally, the venture capital fund will be formed with a total capital size limit. Accordingly, ‘over-subscriptions' may be rejected by the fund's managers once the aggregate capital of the fund has been subscribed for. Conversely, most funds require a minimum aggregate capital subscription to ‘close' the fund and begin investing in portfolio companies.

Institutional investors (and to a lesser degree, high net worth individuals) will often make their investment decisions via an investment advisor known as a ‘gatekeeper' who is charged with determining how to allocate and invest the resources of the investor. Recall that institutional venture capital investors often have very large sums of cash which must be invested, but these institutions themselves are not investment oriented companies (i.e., endowments,, pension plans, etc.). Accordingly, these investors will retain gatekeepers who are the ultimate decision-makers with respect to subscribing for limited partnership interests in newly formed venture capital funds. Gatekeepers are adept in evaluating the track record of venture firms, private equity market trends and most importantly, the expertise and reputation of the fund's general partners and management.

Capital Calls

Investors in U.S. venture capital funds generally are not required to invest 100 per cent of their capital contributions at the initial closing of the fund. Rather, the limited partnership agreement of the fund will set forth requirements for ‘capital calls' on its limited partners. The general partners will determine from time to time, or upon a fixed schedule, to ‘call' the needed investment capital from the limited partners. Generally, such capital calls correlate to pending investments in portfolio companies. Accordingly, the fund manager's selection of investors in the fund may turn on whether the managers have confidence that the subscribing investors will be able to timely meet the capital calls going forward. Many limited partnership agreements provide for penalties against the limited partners if they fail to meet capital calls on a timely basis. Such penalties may include loss of rights to participate going forward, return of capital and exclusion from the fund's profits going forward.

Liquidity

U.S. venture capital funds traditionally make investments in illiquid securities, generally involving a long-term holding. It is not unusual for initial investments of the fund to take years to produce returns either in the form of marketable securities or cash. Once the portfolio companies begin to undergo ‘liquidation events,' such as public offerings or merger or acquisition transactions, the fund may elect to distribute cash or property (in most cases marketable securities) to its limited partners in accordance with the fund's distribution formula. The timing of such distributions is generally discretionary on the part of the general partners but may be negotiated as part of the limited partnership agreement. In any event, upon the winding up of the limited partnership entity at the expiration of its term, all cash and securities (and other property) held by the partnership must be distributed to the limited partners, save for any amounts reserved for wind-up expenses and compensation of the general partner.

Multiple Funds

Many large independent venture capital firms in the U.S. operate more than one fund simultaneously. Accordingly, they may have funds which are ‘fully committed' but not yet invested, as well as funds which are fully invested but not yet in a distribution mode. Accordingly, sophisticated venture capital firms in the U.S. oversee multiple funds in various stages of fundraising, investment and distribution. Multiple funds under common management will often be subject to limitations on co-investments (or common investments) among the funds. These limitations are primarily the result of the general partner's fiduciary duty to the limited partners of each fund. Finally, multiple fund venture capital firms often create ‘side funds' for the purposes of allowing individual general partners an opportunity to invest side-by-side with the primary venture capital fund.

Distribution Economics

There are multiple ways in which a venture capital fund can formulate distributions of cash or property to its limited partners. Some distribution methodologies provide for the return of all of the capital to the limited partners before the general partner receives a carried interest distribution. Conversely, some funds permit the general partner to receive part or all of the carried interest distributions prior to the return in full of the capital to the limited partners. Distributions may be made in cash or marketable securities (generally publicly traded and immediately saleable securities). Some venture capital funds may offer a preferred return for the limited partners. Preferred returns can be in the form of cumulative ‘interest' on the capital for each year that the capital is invested in the fund combined with a percentage of the profits of the fund (usually an 80/20 split, 20 per cent being the general partner's carried interest). Yet other venture capital funds will offer no preferred return but make distributions on a straight percentage basis between the limited partners' ownership interest and the general partner's carried interest. In addition, funds that offer preferred returns sometimes allow the general partner to ‘catch up' on allocations until it has received the full percentage of its allowed carried interest, once the limited partners have received their preferred return in full. Yet another methodology involves having distributions made to all limited partners on a pro-rata basis based on their capital contributions until a minimum internal rate of return is achieved, and thereafter the profits of the fund are distributed based on an allocation between the limited partners' right to profits and the general partner's carried interest.

The provisions of the limited partnership agreement addressing economic rights including return of capital and profit distributions are often important selling features of the fund in the fundraising process and heavily negotiated in the limited partnership agreement. These terms are often influenced by economic terms currently offered in the fundraising marketplace generally, since funds must compete for subscriptions from qualified venture capital investors.

Investment Strategies and Limitations

Strategies. Most venture capital funds limit their investments to specific industries or industry sectors. This allows the fund to develop and maintain highly focused management expertise in order to yield the greatest possible return for investors. In addition, some funds specialize in early stage financing of newly formed companies, while other s focus on later stage or ‘mezzanine' financings. In addition, some venture firms focus exclusively on buy-out transactions. While venture capital funds invest heavily in technology companies, venture funds also invest in a wide variety of other industries. There are also ‘niche' funds which have a specialty focus, such as maintaining ‘socially responsible' or ‘eco-friendly' investing policies.

Limitations

The terms of the limited partnership agreement will typically limit the amount the fund may invest in any one portfolio company in order to assure diversification of the fund's investments. Such limits can range between five and twenty percent of the fund's aggregate assets. U.S. venture capital funds also tend to limit investments in foreign jurisdictions (unless specifically created for that purpose), although investments in Canada are becoming increasingly popular in the current U.S. private equity market. Venture capital funds tend not to invest in publicly traded securities since such securities generally will not yield the rates of return which venture funds traditionally seek. Notwithstanding, some U.S. venture funds do buy securities in ‘P.I.P.E.S.' transactions (private investments in public equity securities) as an alternative to buying equity securities of privately held companies. Finally, limited partnership agreements often restrict ‘co-investments' by funds under common management, as they are often seen as involving conflicts of interests between and among the general partners and managers of the various funds.

In addition to these investment limitations, venture capital funds are usually prohibited from borrowing money themselves or guaranteeing the obligations of others (including portfolio companies) in excess of between ten and twenty percent of the fund's overall aggregate assets.

Regulatory Considerations

Securities Act

As discussed above, the offering of limited partnership interests in the fund must comply with the Securities Act of 1933. Accordingly, all investors in the fund must be ‘accredited' investors within the meaning of the Securities Act. Essentially, this means that the investors must have significant net assets and be sophisticated in high-risk investments in private equities.

ERISA

To the extent that investors in a venture fund are pension plans and other employee benefit plans regulated by the Employee Retirement Income Security Act of 1974 (ERISA), the venture capital fund must comply with ERISA fiduciary duty requirements for all assets of the fund ‘associated with the ERISA investor' unless the fund is specifically exempt from this requirement. ERISA generally imposes strict fiduciary standards on the management of ERISA ‘plan assets' in order to safeguard those who participate in employee benefit plans. Accordingly, venture firms which seek to have ERISA regulated plans invest in their funds must be prepared to address the ERISA requirements which include fiduciary duty rules, limits on self-dealing and certain prohibited transactions, reporting and disclosure regulations, limitations on incentive fees or other profit based compensation as well as other ERISA compliance requirements in the limited partnership agreement. These aspects of ERISA compliance are generally negotiated into the limited partnership agreement at the time of the fund formation.

The fund may avoid compliance with certain ERISA regulations if it can qualify for one of three exemptions from compliance. Those exemptions are available if (i) the limited partnership interests of the venture fund are publicly offered; or (ii) the venture fund is a ‘venture capital operating company' (VCOC); or (iii) the benefit plan investors hold an ‘insignificant' interest in the venture fund. The most commonly relied upon exemptions are the VCOC exemption and the ‘insignificant' interest exemption since the vast majority of U.S. venture funds are not publicly held. A VCOC is generally defined as a venture fund in which 50 per cent of investments, measured by cost, are in qualified venture investments (that is, partnerships or corporations engaged in the production or sale of a product or service with which the fund has specific contractual rights to substantially participate in or influence the conduct of the management of the company) and the fund actually exercises these management rights in the ordinary course of the fund's business with respect to at least one portfolio company each year. As noted above, U.S. venture capital funds generally take an active, participatory role in the development of the portfolio companies in which they invest. This active participation helps the fund qualify for the VCOC exemption to the ERISA requirements. The other common exemption from ERISA requirements provides that as long as 25 per cent of the value of each class of limited partnership interests of the venture fund are held by benefit plan investors (ERISA qualified funds), the venture fund will not be treated as holding plan assets and will be exempt from ERISA fiduciary duty requirements. Funds which wish to avoid ERISA compliance requirements will seek to limit the total value of the fund held by ERISA qualified plans.

Investment Advisors Act

The other major federal U.S. regulatory concerns for venture capital funds are the Investment Company Act of 1940 and the Investment Advisors Act of 1940. Although the general partners render investment advice on behalf of the fund, a general partner may avoid registration as an investment advisor under the Investment Advisor Act if it satisfies the Act's ‘fifteen client exemption.'  This exemption allows the general partner to render investment advice provided that it has less than fifteen clients at any given time. One venture capital limited partnership would be deemed to count as a single client. Accordingly, provided the general partner is not rendering investment advice to more than fifteen funds (and/or other individual clients), the general partner should be able to avoid registration under the Investment Advisor Act.

Investment Company Act

With respect to the Investment Company Act, venture capital funds may generally avoid registration under the Act under one of two exemptions. The first exemption known as the ‘100 beneficial owners' exemption provides that the venture capital fund must have less than one hundred beneficial owners to qualify for an exemption from registration under the Investment Company Act. Generally, each individual investor, provided such investor owns less than 10 per cent of the aggregate limited partnership interests of the fund, would be counted as one beneficial owner. However, if multiple funds are under common management, the Investment Company Act will ‘integrate' all the beneficial owners of all of the funds creating a greater likelihood that there will be in excess of one hundred beneficial owners. Accordingly, when there are multiple funds under common management, it is more likely that the venture capital fund will not be able to qualify for the ‘100 beneficial owner's' exemption. The second possible exemption from registration under the Investment Company Act is the ‘qualified purchaser' exemption. In order to qualify for this exemption, all of the investors in the fund must be qualified purchasers as defined in the Investment Company Act. Although the definition is intricate, it essentially means that all individual investors (either alone or jointly with their spouses, family owned companies or family trusts) must have at least $5,000,000 of active investments. With respect to other entities not owned by individuals, such investors must have at least $25,000,000 in active investments. Occasionally, fund managers will arrange ‘side-by-side' funds in order to take advantage of the ‘100 beneficial owners' exemption and the ‘qualified purchaser' exemption where combining all such investors into one fund would eliminate the qualification for either exemption.

Copyright © November 2001 Edwards & Angell

Jennifer A Post is a partner in the Boston office of Edwards & Angell, LLP. She practices in the firm's venture capital, corporate and securities practice groups. Jennifer represents publicly and privately held technology companies in all phases of development.  She has extensive experience in transactional matters, such as venture capital financings, mergers, acquisitions and strategic alliances as well as early stage planning, partnering and private securities offerings. 

Edwards & Angell, LLP is a full service law firm of approximately 275 lawyers with offices in Massachusetts, Rhode Island, Connecticut, New York, New Jersey and Florida.  Edwards & Angell, LLP maintains a national practice in the areas of venture capital, insurance and reinsurance, litigation, commercial transactions, corporate, mergers and acquisitions, securities and patents and intellectual property.  For more information concerning Edwards & Angell, LLP, please visit www.ealaw.com.