Episode #5 | Venture Fund Terms 201

As a follow-up to Fund81’s previous podcast episode “Venture Fund Terms 101”, this episode tackles some of the more advanced venture fund legal terms. As an emerging venture fund manager, I’ve found that gaining an understanding of fund document terms has been a bit like learning a foreign language. In this episode, my guest, Mark Weakley, helps us navigate some of the more complicated terms.

Mark is a partner at the international law firm, Bryan Cave. Mark leads the firm’s Technology, Entrepreneurial, and Commercial Practice and is the co-leader of the firm’s Private Fund Group. I have worked with Mark for more than six years. He represented me as an angel investor and has been our attorney at MergeLane since the very beginning. Mark and his team have drafted the documents for all of our funds.

For those of you who are new to venture investing, I suggest reading these definitions before listening to the episode.

Enjoy.

General Partner (GP): GPs are the managers of the fund. They raise the fund capital from LPs and serve as the managers  of the funds, conducting due diligence and providing support for each of the fund’s investments.

Limited Partner (LP): LPs are investors in venture capital funds. Common examples of LPs include fund of funds, accredited investors, endowments, and pension funds.

Venture Partners: Venture Partners provide supplemental support to the GPs. They are typically experienced professionals who are engaged to add specific expertise or part-time assistance. Common examples include technology experts, retired CEOs or entrepreneurs, and experienced angel investors (investors who invest as individuals rather than through a fund).   

Carry: Carried Interest, or carry, is a share of the fund’s profit paid to the fund managers if a specific threshold return (hurdle rate) is exceeded. This performance-based compensation is meant to align the Fund Managers with their capital providers (LPs).

*Context: In exchange for investing capital on behalf of the investors and managing the fund, VC firms typically charge management fees and carried interest on a percentage of the profits made on fund investments. This typically takes the form of a 2 and 20 model, meaning the firm will charge 2% of the total fund size per year for management fees (operations, legal, salary) and 20% of the fund carry.

Preferred Return: Preferred return refers to the threshold return that the limited partners of a fund must receive prior to the fund managers receiving their carry.

Vesting: Vesting gives rights to assets over time. For startups, this usually takes the form of earning common stock or access to an employee stock option plan over time. For venture funds, it is typically applied to earning carry over time. Vesting  offers an incentive to perform well and remain within the company.  

Organizational Expenses: Organizational expenses are related to establishing and organizing the fund and its infrastructure. This includes things like accounting, legal, fundraising-related travel, and other expenses.

Fractional Shares: A fractional share is a share of equity that is less than one full share. In the case of a merger or acquisition, the combined new common stock shares often are calculated by using a predetermined ratio. Shareholders will usually receive a fractional share of the new common stock or cash in lieu of the fractional shares.

Reinvestment Cap: A reinvestment cap limits the amount of proceeds from a sale or other disposition of investments a GP may reinvest into the fund during the specified investment period.

Clawback: A clawback provision is an adjustment payment made by a GP to the fund for receiving more than the GP’s pre-agreed share of fund proceeds. This means that the GP is not entitled to keep distributions representing more than a specified percentage of the fund's cumulative profits. Clawbacks are typically utilized when unexpected expenses arise after the GP has received a carry distribution.

Carried Interest Clawback: A carried interest clawback allows LPs to recoup carry paid to GPs during the life of the fund in order to normalize the final carry to the originally agreed upon percentage. The clawback provision protects the LPs if carry paid on one investment does not exceed subsequent investment losses.

Waterfall: The waterfall is a pre-agreed upon economic arrangement that dictates how distributions are prioritized between a fund’s GPs and LPs. Waterfall provisions typically dictate that GPs receive carried interest only once capital contributions (the amount the LPs invest in the fund) and preferred return on realized investments are returned to investors.

ILPA: In the interview, Mark mentions the Institutional Limited Partners Association (ILPA). This organization offers several resources for both GPs and LPs.