How to start a VC fund

The process for starting a venture capital fund is difficult and requires a great deal of effort. Let’s begin by discussing what a venture capital firm is or does.

Types of Venture Capital Fund

A venture capital fund is a business organization that acquires capital from investors to invest directly in a portfolio of private companies. These private companies are growth-oriented businesses who need the investment capital to fund its growth. The VC fund managers actively take part in the high-level management of these companies. The objective of the managers is to make a profit on investor funds by selling or undertaking an initial public offering with the portfolio companies.

The venture fund may vary depending on a number of factors:

• Stage - In what stage of startup will the VC fund invest?

• Sector - In what industries or types of ventures will the VC fund invest?

• Geography - In what geography will the VC fund invest?

• Performance Objectives - What objectives does the fund have for portfolio companies?

What is the Legal Structure of a Venture Capital Fund?

The structure of a VC fund can be quite complicated. It consists of a maze of business entities organized under state law. Generally, all of the entities will be organized under the law of Delaware. Each of these entities must have their own organizational and operational governance documents. A corporation will have articles of incorporation and bylaws. An LLC will have a articles of organization and an operating agreement. Partnerships will have a detailed partnership or limited partnership agreements.

General Partnership - A VC fund is generally structured as a limited partnership. A limited partnership is made up of a general partner and a limited partner.

General Partner - The management company (organized as an LLC) is the general partner. The management company runs the fund and acts as advisor to the portfolio companies. It is normally organized as an LLC with member managers who employ the professionals necessary to raise, manage, and invest the funds. These professionals include analysts, accountants, attorneys, and administrative staff. The management company generally receives between 1.5 - 2% of the total subscribed funds to run the day-to-day operations. The management company also receives a “carried interest” which is a percentage (usually 20%) of the profits generated by the fund.

Limited Partner - The investors organize as an LLC or a corporation, which serves as the limited partner in the partnership. The investors are generally wealthy individuals, family offices, pension funds, hedge funds, mutual funds, endowments, etc. The limited partnership purchases and holds the equity interest in the portfolio companies. The purpose of this structure concerns operational, tax, and legal implications. Further, it allows the management company to work with a single entity holding all of the investment funds.

Investment Capital & Advisors (Multiple LLCs) - The general partnership holds all of the funds pledged by investors and called by the company. The funds are generally allocated into multiple LLCs. This allows for ownership of the portfolio companies to be spread out strategically among those LLCs. Often, the general partnership will also organize one or more separate LLCs to act as managers or advisors to the LLC holding the investment funds.

Process for Raising the Fund

Find Investors - You will need a plan for identifying and pitching to potential investors. You will need to understand the fund characteristics that different types of investors prefer. A typical fund will raise anywhere from $10 million to several hundred million dollars. Some funds employ “placement agents”, but this practice is normally done with larger funds.

Disclosures - The firm will prepare a Purchase Price Memorandum (PPM). This is a detailed business plan disclosing major aspects of the fund, such as: size, team, strategy, risk factors, current portfolio, track record, fees and expenses, co-investment rules, and legal disclaimers.

Subscriptions & Capital Commitments - Investors subscribe or promise to invest in the fund. The general partner will execute subscription agreements with the various investors. A primary concern of this document is to have investors attest that they are accredited under the securities laws.

Investment of Funds - Once the funds are committed, they must be called from the investors. Generally, the fund reaches its investment goal in stages. The stages are marked by “closings” in which the firm closes the investment round and accepts money from investors. Closings should take place at stated milestones of the fund raise. The funds are generally invested into the limited partner and then allocated to the individual LLCs. In return, investors receive an ownership interest in the limited partner (an LLC or corporation).

Sourcing Deals & Maintenance - The general partner will then begin identifying portfolio companies and negotiating investments. The negotiation process includes valuation, deal terms, due diligence, and closing. Once the investment transaction is completed, the general partner will work to maintain the fund and to help the portfolio companies be successful. At any point in the fund life, it will have a designated percentage of funds invested in portfolio companies. Generally, a certain percentage is held back for stages of the fund’s existence that may focus on seed funding, growth, or follow-on financing.

Distribution and Dissolution - It will generally take anywhere from six months to two years to fully raise a fund. A fund will generally last as long as 10-15 years. The company investments may last anywhere from 18 months to 3 years. The firm will make decisions on when and how to make distributions to investors. When the fund exits or sales a portfolio company, it will make a decision on how to allocate the funds received from sale. Most funds will make distributions throughout the life of the fund.

Regulatory Process Behind Founding a VC Fund

A venture capital fund faces a number of regulatory hurdles to formation and compliance.

Investment Advisor’s Act of 2010 (“Advisor’s Act”) - To avoid registration under the Advisor’s Act, a company must meet the requirements for exemption under the “Venture Capital Exemption” or the “Private Fund Exemption”. In either case, the company must still complete and file the initial sections of Form ADV. An exemption qualifies the advisor from most state registrations. There are often separate state-level exemptions for advisors with fewer than five clients.

Investment Company Act of 1940 - Must have less than 100 investors to avoid registering under this act.

Securities Act of 1933 - Regulation D, Rule 506(c) provides the primary exemption from registration of the fund raise as a security offering. This exemption generally applies to state-level regulation of securities. States often have a “de minimis” exemption for issuances of securities to less than 15 accredited investors.

Internal Revenue Code of 1986 - Understand rules concerning pass-through taxation, corporate taxation, and qualified small business stock (Section 1202 of the IRC).

Things to Remember When Forming the Fund

Personal Contribution - The fund managers serving as the general partner will generally put up anywhere from 5-15% of the fund capital. This makes certain the fund managers have a vested interest in the funds success.

Connections - Managers generally raise the majority of funds through personal or professional connections, such as wealth individuals, family offices, fund of funds, and wealth management groups.

Track Record - Fund managers must generally have a strong track record in the industry to attract institutional investors. If you do not have a track record, don’t raise a blind pool. Identify various portfolio companies that are performing well that you can role the ownership over into the fund. First time funds generally have difficulty in attracting institutional investors. As such, first-time funds are generally in the $10-25 million range.

Professional Assistance - Hire a business attorney and tax accountant to help you formulate a plan, discuss financial options, ensure compliance, and assist you with the overall development. The structure and compliance requirements are complicated. Legal costs of setting up a fund can range from $40,000 to $150,000.