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How Venture Capital Funds Work

Venture capital in a nutshell.

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Venture Capital“Venture Capital.” Sounds exciting, doesn’t it? I think it’s the fact it starts with “V.” There aren’t many words that start with “V,” and those that do tend to be pretty cool words. Think Vans shoes or the word “vroom.” Venture capital just sounds cool.

And it is. Venture capital is an interesting place to be. There are interesting companies, interesting people (though so many are still in their 20s with bank accounts that are multiples of mine that it can be a bit depressing), interesting issues. I’m glad my practice ended up where it did.

When I was in Biglaw, even during my last tour of duty, I didn’t know anything about venture capital funds, so this is meant to be a primer for those who are like I was back then. After reading this column, you’ll at least know the basics.

In short, venture capital funds raise money from investors (usually called “limited partners,” which we’ll discuss below) and use that money to buy shares in private companies (called “portfolio companies”), which they hope to sell at a substantial profit in a few years, dissolve the fund, and then return money and profits to investors while keeping a chunk of it for themselves.

First, let’s discuss the difference between venture capital funds and private equity funds and hedge funds. Venture capital is technically a type of private equity (and both are considered “alternative assets”), though usually they are distinguished based on the fact that venture capital funds tend to make minority investments in relatively new private companies, whereas private equity funds usually buy controlling positions in companies, so they can cut costs, squeeze out more earnings, and then sell (or IPO) the company for a large return. Hedge funds, on the other hand, buy shares of public companies, have complicated trading strategies, and usually do not seek to control a company, though there are certainly some activist hedge funds.

Venture capital funds are structured as either limited partnerships or limited liability companies. The sponsor is the firm (not the law firm — the venture capital firm) behind the fund, and it is usually somewhat in the background, at least as far as the actual contractual documents are concerned. The sponsor will form an entity which will act as either the general partner of the limited partnership or the manager of the limited liability company. The investors are called the “limited partners” if the fund is an LP or the “members” if the fund is an LLC, though even for LLC funds, folks will refer to the investors as LPs just because having funds organized as LLCs is still a relatively new thing.

Any time there is a large pool of money that is being directed (or as we like to say, “deployed,” which is another cool word), then the person doing the directing is going to be considered an investment advisor. In this case, it’s the general partner (or manager, for LLC funds). The general partner is going to get the “carry” we discuss below, and it has to be either a Registered Investment Advisor (RIA) or an Exempt Reporting Adviser (ERA), or the state equivalents, or (quite often) be operating under the umbrella of an entity that is one of the above.

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The “investment period” is the time period — usually five years — during which a fund will make initial investments into portfolio companies. After the investment period, the fund may make “follow-on” (i.e., additional) investments into the better-performing portfolio companies, but cannot add any more portfolio companies, since the firm should be focused on wrapping things up so that the fund can be dissolved by the end of its term, which is usually 10 years.

Venture capital firms get paid through a fee structure known as “two and twenty.” Surprisingly, this does not refer to the ratio of females to males in the venture capital sector, but it instead stands for two percent management fee and twenty percent carried interest. The two percent will generally be on the size of the fund, though this is often calculated differently during and after the investment period. The management fee goes to the investment manager, which is yet another entity affiliated with the sponsor, while the carried interest goes to the general partner.

And now we’ve gotten to what it’s all about. Carried interest. The “carry.” The black gold and Texas tea of Wall Street. Ye gods! The fruit so dear legions of people will rise up and fight at the mere mention of this sweet nectar being taxed at ordinary income. Let’s talk about what exactly carried interest is.

Carried interest is the share of the profits that goes to the general partner. Setting aside the tax aspect, the carried interest concept is a good one. If the fund doesn’t return a profit, then the general partner will get zilch. If the fund returns 105%, then it likely hasn’t cleared the “hurdle,” which is usually 8%, and the general partner will still get zilch. But say the return is 200%. The LPs will get 100% of their investment back, plus an additional 80% return, while the general partner gets its 20% carried interest. Not a bad deal for the investors, in that the only pre-return fee they have to pay is the low management fee, and the general partner is incentivized to make smart successful investments and to exit these investments so that it can claim its carry.

So there you have it — that’s venture capital funds in a nutshell. You don’t know enough now to start pitching to potential VC clients, unless they’re relatively new to the game, but you know enough to formulate a thought on the carried interest tax issue and to follow along when someone complains about a fund not being able to exit its investments in time.

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Gary J. Ross is a partner at Ross & Shulga PLLC, which he co-founded in 2017 after running his own firm for four years and after several years in Biglaw and the federal government. Gary handles corporate and securities law matters for venture capital funds, startups, and other large and small businesses, as well as investors in each. You can reach Gary by email at Gary@RSglobal.law.

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