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An introduction to understanding venture capital funds

Creating and managing a venture fund is not any easy task. Selecting one can be even more complex. There are numerous accounting, tax and business issues that need to be addressed. Joel Press and Bonnie Kennedy from Ernst & Young offer some initial insights.(Extract)

This article is extracted from Private Equity and Venture Capital with the kind permission of Euromoney Books (a division of Euromoney) for further information about this title.

A venture capital fund is basically a vehicle through which high net worth individuals tax exempt organisations, and other institutions can invest their capital in through a group of unique individuals known as venture capitalists. The terms venture capital fund, venture fund, and investment partnership are used interchangeably in this chapter as these terms are commonly used throughout the industry. Investing in an investment partnership requires a great deal of acumen, patience, and hard work. There are many choices to review and problems to avoid in selecting an investment partnership. Among the issues concerning the appropriate selection of investment
vehicles are: investment strategy, tax efficiency and compensations to the general partner.

This chapter addresses these issues along with several others to provide stimulus to ask the right questions in selecting the appropriate venture fund.

Business considerations and accounting

Raising capital and marketing

The confidential offering document is one of the principal vehicles through which the venture fund is introduced to potential investors. This document presents a general overview of the fund, including its investment objectives, fees and expenses, risk factors methods of allocating profits and losses, minimum investment and tax status, as well as the biographies and additional information about the key investment-making individuals. The offering document is an overview designed to provide potential investors with a summary of the key elements needed to make an investment decision. The partnership agreement is drafted concurrently and is the governing legal document.

A term sheet, which is an outline of the economic terms of the venture is generally the first piece of marketing data that is presented to lead investors. At one point the term sheet is very tentative and gives large investors the opportunity to negotiate the terms of the deal.

It is generally a good idea from the fund's marketing standpoint and from an investors viewpoint that any general partners have a significant amount of personal capital invested in the partnership. Some investment partnerships will require that a general partner commit at least 1 per cent of the total commitments in the partnership.

Structure

The basic type of investment vehicles are

fund of funds;
offshore funds;
corporate ventures;
government affiliated funds.

Investment partnerships

The traditional venture fund structure in the United States is in the form of a limited partnership with fewer than 100 limited partners. In the last few years, many venture funds have been structured as limited liability companies (LLCs). The difference between these forms of organisation has to do with liability, taxation issues and management responsibility. The limited partnership still remains the predominant organisational form. As a limited partnership or LLC, the taxable character of all items of income and expenses are passed through to the individual partners at their pro-rata share. A fund with fewer than 100 limited partners or members generally operates without regulation by the Securities and Exchange Commission (SEC) in the United States. Traditional venture funds are closed-end funds which require the participants in the fund to remain in the partnership until its termination.

The limited partnership or LLC has a general partner(s) or managing member(s) which can be either individuals or some form of legal entity, for example, a LLC or a corporation. The general partner/managing member typically receives an incentive allocation of profits which retains the same tax character as those of the partnership or LLC. In addition, management fees, which are generally 1 to 2 per cent per annum of capital commitments or assets under management, are normally paid by the partnership or LLC either to the general partner(s)/managing member(s) or to an entity controlled by the general partner(s)/managing member(s).

The limited partnership or LLC is typically organised to terminate within a period of seven to 10 years from inception. All partners/members make commitments to the fund at the beginning of the fund. These commitments are called or taken down during the life of the fund, typically at the discretion of the general partner/managing member. A general partner/managing member will typically make a ‘capital call' when cash is needed for an investment. When capital calls are made, partners/members need to be able to provide large amounts of cash at very short notice.

If a limited partner/member is not able to provide the cash at the time of a capital call, most partnerships/operating agreements specify that the general partner/managing member may charge the limited partner/member interest on the amount called or take the necessary procedures to ensure that such limited partner does not receive gains related to the investment. In cases where a limited partner/member remains in default on his obligation to meet a capital call, draconian measures may be imposed, including forfeiture of the partner's interest in the fund.

Fund of funds

In recent times there has been a proliferation of fund of funds, which are a variation of the traditional venture fund. Simply stated, a fund of funds is a venture fund which invests in other venture funds. The principal advantage for an investor in a fund of funds is that it enables the investor to utilise several investment disciplines within one investment vehicle. A fund of funds also allows an investor to gain access to popular fund managers whose funds are no longer accepting investors or have large minimum investment requirements. A fund of funds differs from the traditional venture fund in the structure of the management fees and the incentive allocations paid to the general partners/managing member. Fund of funds fees charged by general partners/managing members are typically a percentage of net assets under management, and, while older fund of funds did not utilise an incentive allocation to the general partner/managing member, the newer ones are using some sort of incentive fee above a hurdle rate (a predetermined level of profit to limited partners/members) before the general partner/managing member receives an incentive fee.

Offshore funds

US domestic venture funds normally are not marketed to foreign investors because they expose foreign investors to US income tax rules and regulations. To remedy this, many investment managers create offshore funds. Offshore funds provide a mechanism for organising pools of money in an unencumbered
regulatory environment. Offshore funds can essentially make the same investments as domestic funds, and indeed their portfolios often are a mirror image of the domestic fund92s. Until recently, the Internal Revenue Service (IRS) had determined that an offshore fund could be exempt from US income taxes provided it adhered to a list of rules commonly known as the ‘ten commandments'. These rules require that certain activities of the fund be performed offshore. Over the last few years, the IRS and many state legislatures began repealing the ten commandments allowing the activities of offshore funds to be performed domestically.

Recently, the IRS published new proposed regulations which provide that a foreign partnership must file a US partnership tax return if it has gross income derived from sources within the United States (such as interest or dividend income) or it has gross income that is effectively connected with the conduct of a trade or business within the United States. The US source income may also be subject to withholding. To prevent
effectively connected income, offshore funds that hold investments in operating entities structured as partnerships (flow-through entities) must be careful to structure the investment through a drop-down entity set up as a corporation. For example, an investment in XYZ Partnership, an operating entity, should be held by the drop down corporation, XYZ Holdings Corporation, and, in turn, XYZ Holding Corporation is
held directly by the offshore fund. This limits the offshore fund from trade or business income generated by XYZ Partnership. However, the rate of return on the investment in XYZ Partnership is also affected since the operating income of XYZ Partnership is held by XYZ Holdings Corporation and does not pass down to the offshore fund until XYZ Holdings Corporation is liquidated.

Corporate ventures

These are typically affiliated with a non-financial corporation or a business development programme. These investment vehicles will typically invest in companies that can provide strategic technologies or cost savings to the investing corporations. In contrast with the other types of investment vehicles that invest
primarily outside capital, corporate ventures are organised solely with corporate capital.

Government affiliated funds

Some venture funds are affiliated with federal, state or local programmes. The affiliation provides additional funding for the partnership provided that the partnership follows the guidelines established by the programmes.

One common government programme in the United States, the Small Business Investment Company (SBIC), is administered by the Small Business Administration (SBA). Partnerships affiliated with the SBIC need to prepare and file annually special forms and financial statements with the SBA.

Joel Press & Bonnie Kennedy, Ernst & Young LLP

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