How Venture Capital Funds Work

Question 1

How many entities make up the fund?

Answer 1

3 basic entities.

Management company
Limited partnership
General partnership entity

Question 2

Who owns the management company?

Answer 2

Usually owned by the senior partners.

Question 3

Which entity employs all of the people with whom people interact with at the firm, such as partners, associates and support staff?

Answer 3

Management company

Question 4

What is the limited partnership agreement?

Answer 4

A limited partnership vehicle that contains the investors in the fund (also called limited partners)

Question 5

What is the general partnership?

Answer 5

The legal entity for serving as the actual general partner to the fund.

Question 6

From what entities do venture capital funds raise money from?

Answer 6

Government and corporate pension funds, large corporations, banks, professional institutional investors, educational endowments, high-net-worth individuals, funds of funds, charitable organizations, and insurance companies.

Question 7

Does the VC keep cash on hand? What must the VC firm do each time it wants money to make an investment?

Answer 7

The VC firm usually keeps very little cash on hand and must ask its LPs every time it wants money to make an investment. This is known as a capital call.

Question 8

What are so-called “blind pool” funds?

Answer 8

A fund where money is committed by investors into a fund with a designated purpose but without knowledge of exactly how that money will be invested.

Question 9

What is the idea behind “capital commitments”?

Answer 9

Allows fund managers to have a pool of capital available without needing to manage short-term investments for a large pool of cash for which they’ve not yet sourced deals.

Question 10

Apart from the management company entity, what comprises what we call the ‘fund’?

Answer 10

General partnership and the LP

Question 11

What is carried interest?

Answer 11

Carry is the profit that VCs get after returning money to their investors (the LPs)

Question 12

Which of the three basic entities serves as the franchise of the firm?

Answer 12

The management company.

Question 13

Where do VCs salaries come from?

Answer 13

Fund’s management fees

Question 14

What are typical VC management fees?

Answer 14

Between 1.5 and 2.5 percent

Question 15

What is a clawback?

Answer 15

A provision in the LPA that requires a venture capitalist to refund fees to their investors if they charged a carry fee and ultimately failed to deliver the corresponding performance.

Question 16

What is the commitment period? On average, how long is it? What can be done during this period?

Answer 16

The commitment period is the length of time a VC has for identifying and investing in new companies in the fund. This is usually a period of 5 years.

Once the commitment period is over, the fund can no longer invest in new companies, but it can invest additional money in existing portfolio companies.

Question 17

What is the investment term?

Answer 17

The length of time that a fund can remain active.

Question 18

What is a typical VC fund investment term?

Answer 18

A typical VC fund has a 10 year investment term with two one-year options to extend, although some have three on-year extensions, or one two-year extension.

Question 19

What must be done to keep a fund operating past its investment term extensions?

Answer 19

LPs have to affirmatively vote every year to have the GP continue to operate the fund.

Question 20

What are the rights of the LPs in the event that a key man clause is triggered?

Answer 20

LPs have the right to suspend the ability of the fund to make new investments or can even shut down the fund.

Question 21

What is the difference between a general partnership and a limited partnership?

Answer 21

A general partnership is one where all partners participate to some extent in the day-to-day management of the business.

This helps to distinguish the difference between general and limited: the general partner is active, while the limited one is passive.

Limited partnerships are usually set up by companies that invest money in other businesses or real estate.

By remaining on the sidelines, the LPs liability is capped at the amount of his investment, while the GPs active status makes him liable for his business’ debts.

LPs have at least one GP who controls the day to day operations of the business.

Question 22

Explain the difference between GPs and LPs as it pertains to VCs…

Answer 22

LPs serve as the primary source of capital into a venture fund, and GPs serve to manage the fund and execute investments with the capital in order to return that capital to the LPs.