The principal reason for the low incidence of serious defaults is that typical venture capital fund agreements impose very onerous default remedies against the defaulting investor, including up to full forfeiture of the capital account value associated with the interest, inclusive of paid-in capital and any gains.  Once material capital has been contributed to the fund, there is considerable impetus to make further contributions timely.  If I’ve paid in $1 million of my $5 million commitment, am I really willing to walk away from that $1 million and any attendant gains?  Even if I’m seriously distressed financially, there’s a high incentive not to simply abandon my capital account value.  In short, paying in contributions timely is something that investors are well advised to try to remain on the right side of, and most often, they do. 

With that said, occasionally cases of serious default arise, and fund managers are put in the position of acting on the default remedies found in their fund agreements.  This article explores typical options available to venture capital fund managers when defaults reach a serious level demanding action.

Do I Have to Act?  When?

The preliminary question we usually get is: do I have to act and when?  We are often contacted at a point when a contribution is several months past due, the manager may have had some initial conversations with the investor, and the investor isn’t taking, or seeming likely to take, timely remedial action. 

From a manager’s perspective, defaults are not ideal.  They disrupt budgets for future investments and follow-on activity and potentially cause shortages of cash for quite immediate investment activity, which can then require unplanned additional capital calls from other investors.  If you raised a $500 million fund, you want to end up with $500 million to invest, not $450 million.  Furthermore, defaults will eventually work their way into audited financials if there are not direct contractual notification provisions in the fund agreement or side letters in the first place.  Other investors will eventually learn of the situation, which may raise questions.  Managers typically prefer to avoid this for reputational reasons.

With the above in mind, our first advice is to try to work with the investor to rectify the situation.  Perhaps the investor is not aware of the possible onerous consequences and/or is trying to manage many different capital demands.  A stern letter reminding them of their obligation and the potential outcome can often lead to a reprioritizing of payment to the fund.  Take the case of a distressed corporate investor that has money to pay some but not all obligations.  On reminder, it is often a result that the payment to the fund is moved to the front of the payment queue after awareness is focused on the impending downside.  In our experience, stern letters of explanation may cure something like 25-40% of serious default situations.

Another potential early conversation is to encourage a secondary sale, in which the purchaser will catch-up on missed contributions and take over the interest going forward.  In the preceding example, even if the distressed investor ends up with 70-80% of FMV in a secondary (i.e., $700,000 to $800,000), the result is much more favorable than forfeiting the $1 million of value under the fund agreement’s default clauses.  Where a seller just simply does not have cash, and there is capital account value, this path almost always makes sense and a distressed investor that is rational will pursue it.  They may do that largely on their own once prompted (say by approaching typical secondary buyers), or in some cases the fund manager may wish to get more involved, for example to “steer” the interest to a friendly existing or prospective LP that is or may be a long term investor in the manager’s other funds (i.e., usually not a secondary buyer, unless they have a fulsome primary investment platform).

As to the question of whether a manager is required to do anything, and if so when, fund agreements we work with generally provide that the choice of a manager to enact or not enact default remedies, and the timing thereof, is at the manager’s discretion.  Even on this typical drafting, there may be an ultimate fiduciary duty at law to take action in good faith for the benefit of the fund and its partners as a whole.  We are not often distressed by this concept because typical contracts make it clear enough that ample time is to be permitted for rectification of the situation, and give the manager a lot of discretion on how to handle each case in particular.  Regardless, interest is frequently aligned as the manager has its own capital at stake, has the reputational concern of keeping the books and records free of evidence of serious default and more than anything, has an interest in preserving originally targeted capital to ensure budgeting for follow-ons isn’t disrupted.  In practice most managers we work with might give a long standing, credible investor suffering temporary distress some leeway to rectify, but not likely in excess of say 6 months at the outer edge.  Less known, newer investors, or those as to which there is specific doubt as to creditworthiness, would typically get less leeway, with formal default provisions enacted sooner.

That Didn’t Solve It – What Do I Do Now?

In a few cases, no matter how sensible it may be on that part of the defaulting investor to cooperate, the above methods won’t yield successful results.  So what then?

First, make sure to follow any technical “notice and cure” periods in the fund agreement, if not already done by this time.  Usually there is a requirement for a formal notice of default letter, and 10 or 20 days cure time.  There may be multiple notices and cure periods in some cases.  Given the serious nature of the situation, and notwithstanding notice procedures in the relevant fund agreement, we recommend dispatch by both trackable courier and email.  Once this box is checked, the manager is free to pursue remedies under the default provisions of the fund agreement.  Typically, the choice of which remedy or remedies to pursue is at the discretion of the fund manager, and not mutually exclusive.  Among the typical remedies we would expect to see in a typical fund agreement are the following:

1. Sue for Damages and/or Performance:  This is ordinarily provided for, including the right to collect interest on the defaulted contribution(s) at an interest rate significantly in excess of the prime rate (say 12-18%).  It is not often, however, relied upon because by the time an investor is in serious default there are likely to be collection issues on any judgment, and proceeding along this route takes time and money.  Furthermore, there is reputational risk (fund managers generally don’t want to be seen suing their investors) as well as the potential for the lodging of counterclaims, such as breach of fiduciary duty or other “complaints”.  Even where meritless, the simple potential risk of the filing of a counterclaim can deter the initiation of legal proceedings by the fund manager.  In any event, the typically found remedies listed below are stronger, faster and easier to implement. 

2.  Enact a Transfer:  Under this approach, the fund manager may designate one or more parties (which usually may be existing limited partners or third parties) to be transferees who will receive the defaulting investor’s interest (or parts of it if there are more than one transferee) in exchange for agreeing to contribute capital toward the outstanding capital calls and make good on future capital calls.  This approach usually will not involve payment of any purchase price to the defaulting investor (i.e. the “seller”), other than assumption of these liabilities.  So this approach involves a forfeiture by the defaulting investor of 100% of the existing capital account balance.  Notice that this approach results in aggregate commitments being unchanged, and therefore this is commonly a preferred method by managers.  It is also simpler to deploy (less parties to transact with) and in a sense more “private” (in terms of not “outing” the situation with each and every investor) than #3 below, and thus tends to be more frequently considered.

3.  Enact a Sales Waterfall:  Under this sort of provision, the non-defaulting investors are offered, essentially in a “ROFR” type offering, their proportionate pieces of the defaulting investor’s capital account balance in exchange for proportionate contribution of then-unfunded and future calls.  If not all investors make the election, commonly a second tranche may occur where investors initially electing can get “more”.  Ultimately if the whole interest is not spoken for, third parties may be invited to participate.  In some sense this is not vastly different from #2 above: the defaulting investor suffers a 100% forfeiture, and the fund manager (assuming a successful process) ends up with an undisturbed amount of aggregate commitments.  However, this remedy requires undertaking a significant formal process from a logistical standpoint, and furthermore involves effectively notifying all investors of the situation.  So why would a manager choose this?  Sometimes, there is a view that the most equitable result since some party stands to get a windfall is to share that windfall proportionately with the entirety of the investor base. 

4.   Run To Zero Rights:  This type of provision calls for declaring that the defaulting investor is no longer a limited partner, has no right to vote on any fund matters, and is held back from income/gain allocations into its capital account (and usually distributions as well, discussed further below); however, expenses including management fee may be debited against the capital account (and in doing so “full scheduled management fees” may be collected at the fund level) until such time as the capital account reaches zero.  If that does not occur by liquidation, the remaining balance is often forfeited and allocated proportionately to the other partners.  While this provision protects the fee base, it does not maintain the full aggregate commitments, and as such, is seen as an inferior approach to methods #2 and #3 above.  However, this type of provision is commonly present in most fund agreements in the venture space and can play a role in certain situations where macroeconomic or other events beyond the specific limited partner limit participation in amelioration efforts by other sources of capital.

5.  Pure Forfeiture Provisions:  The most punitive commonly available remedy is the provision allowing the enactment of a simple, pure forfeiture, either of the capital account balance, the right to future profit allocations, or both.  These will commonly cause the forfeited amounts to be redistributed proportionately amongst the other partners, creating a windfall for them to the extent of any capital account balance being shifted.  As is the case with #4 above, this causes aggregate commitments to decrease, and as such, is not usually a preferred method.

6.  Distribution Withholding Provisions:  Recall that the above remedies are not mutually exclusive.  Distribution withholding provisions usually exist and are used in tandem with other default remedies.  These are rights to refrain from distributing cash or securities to an investor in default, and apply proceeds to outstanding calls and expenses, including outstanding interest.  In the case of securities, a well drafted provision will allow the right to sell the securities to generate cash to satisfy such items, which for tax purposes should expressly provided to be a deemed distribution to the investor, followed by sale by them and a deemed recontribution (with a pre-agreed hold harmless in favor of the fund manager).

Anything Else To Consider?

There are a couple of closing thoughts on the issue of investor defaults to keep in mind.  First, a well drafted fund agreement will place the right to act for the defaulting investor squarely in the hands of the fund manager by reference to the power of attorney provisions.  For example if a transfer is to be enacted to rectify the situation, there should be no need to chase down the recalcitrant investor for signatures; the fund manager should be able to act on that directly using a pre-agreed power of attorney.  Ideally, the drafting is very broad, to the effect of the power of attorney being available for any needs arising under the default provisions.

Next, consideration should be given to making sure parallel funds are properly included in the default provisions.  As an example, if a sales waterfall will run to all investors, it will usually (though not always) be appropriate to include parallel fund investors for this purpose.  This should be considered and resolved appropriately in the given context.  Another item to consider is the potential for cross-default provisions, meaning a default by investor X in fund A may be deemed to be a default in additional fund B automatically and lead to the potential for enactment of remedies in both funds A and B.  This is rarely appropriate, but in some cases may be.  For example funds that are literally stapled (say a growth fund with a top up fund for home run deals that has no management fee and lower carry, and everyone is subscribed in a 2:1 ratio; in this case access to the preferred terms fund is “part and parcel” of an investment in the growth fund, and it would not be equitable for an investor to default in the growth fund and keep the preferred piece).

Another concept to keep in mind is credit security.  In venture funds with typical default provisions along the lines discussed above, credit security comes from drawing down cash in order to put value in the capital accounts.  The greatest credit risk exists right after the fund is formed, and until the time capital account balances are sufficient to provide incentive to perform contribution with respect to the remainder of the commitment.  This often deserves special consideration, especially when holding a dry closing in turbulent economic times.  Some fund managers will call a small amount of capital (~5%) in order to create this credit security at the outset of the fund. 

In the case of fund managers that utilize capital call lines or other credit instruments, there will often be borrowing covenants in their loan agreements with respect to defaults by investors in the fund that may require self-reporting or other remedial steps.  Fund managers should review their loan agreement to fully understand the implications of a default on the credit arrangement.

Yet another issues centers around questions about the extent to which a fund manager may itself participate in default remedies.  For example, could the fund manager assign itself to be the transferee of the interest where there is a material capital account balance, taking all the windfall for itself?  There are potentially significant contractual and fiduciary limitations in this area, so consult carefully with counsel before acting in this manner.

Our best closing advice is to get a health check.  Have you reviewed your default provisions with fund counsel lately?  Default provisions have come a long way in the last few market cycles, and if this area of your fund agreement has remained untouched for several vintages, the default provisions probably do not reflect the “latest and greatest” techniques being deployed.  This is an unusual area of the fund agreement inasmuch as investors are generally aligned with the fund manager to provide greater protections and remedies to the fund; unless the investor plans to be the defaulting investor, updating it serves to both help ensure the fund is fully capitalized to make investments, and create stability within the investor group.

Three Year Holding Period for Carried Interest

This blog has previously discussed how to structure a fund manager’s carried interest, meaning the contractual right of a fund manager to receive a percentage of the fund’s profits that is unrelated to any capital commitment. Prior to the enactment of the TCJA, both carried interest holders and capital interest holders were entitled to long-term capital gains rates (for individuals, generally 23.8% at the federal level) on gain from the sale of a portfolio company held longer than one year. However, the TCJA introduced a new three-year holding period requirement solely applicable to carried interest in the fund context. If an investment fund holds stock in a portfolio company for three years or less and sells it at a gain, the fund manager will now be taxed on its share of the gain allocated in respect of its carried interest at short-term capital gains rates (for individuals, as high as 40.8% at the federal level).

In order to mitigate the impact of the new three-year holding period, many fund agreements drafted after the enactment of the TCJA provide fund managers with the option to waive their right to receive carried interest from an investment that does not meet the three-year holding period. In return, fund managers have a right to receive a corresponding increased amount of future appreciation in investments that do meet the three-year holding period requirement. In ideal circumstances, this would permit a fund manager to achieve the same results economically while avoiding the higher tax imposed on short term capital gains. The waiver is typically drafted such that limited partner investors are generally not disadvantaged (e.g., the fund manager generally cannot waive interest or other ordinary income, or gain from the sale of investments held for one year or less).  It should be noted, however, that this strategy involves inherent risks. Catch-up allocations of profits must derive from appreciation in portfolio company equity after the waiver is made, making the catch-up entirely contingent on future upside.  There is no guarantee that the fund’s investments will continue to rise in value (or will rise in value in an amount equal to the waived carry), in which case the fund manager will not have new gains to completely (or partially) recover the waived carry. In addition, this structure has not been blessed by Treasury or the IRS, and may be subject to challenge by the IRS, or may be prohibited by future legislation. Nevertheless, managers we work with are somewhat regularly inserting this architecture in their existing and/or new partnership agreements and will decide whether to utilize the waiver depending on the facts at the time of an exit.

Passive Foreign Investment Companies

U.S. investors in non-U.S. corporations that are classified as passive foreign investment companies (“PFICs”) are subject to special anti-deferral rules under U.S. federal income tax law.

At a high level, a foreign corporation is a PFIC if either 50% or more of the foreign corporation’s assets are passive assets (such as cash, securities, or certain intangible assets) or 75% or more of the foreign corporation’s grossincome is passive income (such as dividends, interest, and certain rents or royalties). Technology companies, life science companies, and other IP-driven companies are often categorized as PFICs because these businesses are less likely to generate any active income during the early stages of their life cycle but can often generate passive interest income.

Typically, a U.S. investor in a PFIC is required to recognize ordinary income instead of capital gain as well as interest charges upon a distribution from the PFIC or a disposition of its stock. These are harsh consequences that can significantly decrease an investor’s profits on an eventual disposition. However, a U.S. investor can avoid these consequences by making a “QEF Election”, which will cause the investor to be currently taxable on the net income of the PFIC (whether or not distributed). Many PFICs have little or no net income, so the practical cost of this election is often minimal. In addition, an investor with leverage may be able to negotiate for distributions from the PFIC in order to pay its tax liability.

When investing in a foreign corporation, it’s important for a U.S. fund to request covenants in the deal documents that require the foreign corporation to cooperate to manage any negative tax consequences to the U.S. fund (or its investors) that could result from the corporation being a PFIC. The foreign corporation should be required to consult with U.S. tax advisors to determine if it is a PFIC on a yearly basis. This can be a complicated analysis that requires detailed information about the corporation and the corporation’s shareholders.  Accordingly, the foreign corporation is in the best position to make this determination. The deal documents should require that, if the foreign corporation determines that it is a PFIC, the foreign corporation will provide its U.S. investors with any information that they need in order to fulfill their tax reporting obligations or make a QEF Election. Taking these steps could help mitigate the negative consequences that otherwise arise from investing in a foreign corporation that is treated as a PFIC.  

Controlled Foreign Corporations (CFCs) and Global Intangible Low-Taxed Income (GILTI)

U.S. investors in foreign corporations should also consider whether those corporations are classified as controlled foreign corporations (“CFCs”). A foreign corporation is a CFC if U.S. shareholders each owning at least 10% of the corporation’s voting power or value (“Significant U.S. Shareholders”) collectively own over 50% of the total combined voting power or value of the corporation’s stock. This determination is made by applying a complex constructive ownership regime, pursuant to which shareholders can be attributed ownership by certain related parties.

If a foreign corporation is a CFC, its Significant U.S. Shareholders will be taxed on their share of certain types of income of the CFC (whether or not distributed). In the past, CFCs were only taxed on certain types of income (known as “Subpart F Income”), which includes dividends, interest, and certain income generated from related party sales and services. However, the TCJA greatly expanded the scope of current taxation to Significant U.S. Shareholders by creating a new, shareholder-level tax based on the CFC’s global intangible low-taxed income (“GILTI”). GILTI generally includes all of the income of a CFC that is not Subpart F Income (other than a deemed modest return on tangible property).

When investing in foreign corporations, investment funds should carefully consider the impact of their choice of investment entity. When determining if a foreign corporation is a CFC, a U.S. partnership is treated as a separate entity and all stock owned by the U.S. partnership is included to determine whether the partnership is a Significant U.S. Shareholder and the foreign corporation is a CFC. In contrast, a foreign partnership is disregarded as a separate entity for CFC testing purposes and each of its partners are treated as owning a proportionate amount of the stock held by the foreign partnership. As a result, an investment by a U.S. partnership is more likely to cause a foreign corporation to become a CFC than an equal investment by a foreign partnership, even if the ultimate beneficial owners of each investment are the same. 

New tax rules now treat domestic partnerships like foreign partnerships for purposes of applying the GILTI rules, meaning the U.S. partners of domestic partnerships can account directly for GILTI and if no U.S. partner is a Significant U.S. Shareholder, no GILTI tax should apply.  Proposed tax rules (which can be applied now under certain circumstances) would extend this treatment to Subpart F determinations, i.e., the proposed rules, like the final GILTI rules, would treat U.S. partnerships like foreign partnerships for purposes of determining if a U.S. partner has taxable Subpart F income under the CFC rules. However, a U.S. partnership would still be treated as a U.S. entity for purposes of testing whether a non-U.S. company has the status of a CFC.  The IRS and Treasury have not yet clarified how the new CFC rules that treat a U.S. partnership like a foreign partnership will impact PFIC reporting and PFIC taxation,

Funds with U.S. investors should require a foreign portfolio company to determine its status as a CFC each year, and to covenant to assist each U.S. investor of the fund to determine if it is a Significant U.S. Shareholder if the foreign portfolio company is a CFC. In addition, the foreign corporation should be required to provide its Significant U.S. Shareholders with the information that they need in order to comply with their tax reporting obligations and determine the amount of any current income inclusions. Funds making significant investments in a portfolio company may be able to require the portfolio company to make tax distributions to cover any tax triggered by the CFC rules, although distributions to cover GILTI tax are not common in our experience.

For any business, one’s good name is one of its most essential assets.   That is especially true in venture capital, where, according to a 2004 study[1], firms with high reputations are much more likely than others to have their startup funding offers accepted.  A VC firm’s name or logo is a symbol of its reputation, and trademark law protects the goodwill those identifiers embody.

As more and more VC firms and other financial services firms come into being, protecting the uniqueness of their names has become increasingly important.  Indeed, as of May 2020, there are over 5,000 applications or registrations with the U.S. Patent and Trademark Office covering venture capital services. 

Having a name that stands out from the crowd and protecting that name by trademark registration can help a VC firm safeguard its valuable reputation and position in the industry.  

Choosing a Unique Distinctive Name

One of the most critical steps in the formation of a new VC firm is choosing a name.  A VC firm should have a memorable name that differentiates itself from others in its field.   Bad things can happen when a firm chooses a name like someone else’s.  If the other business is hit with bad publicity, the similarly named firm’s reputation may suffer from such confusion, or it may have to spend time and effort explaining that it isn’t the guilty party.  If a firm chooses a name like another’s, it could also face an infringement suit costing $1 million or more to defend, which is also very time-consuming and distracting to management’s attention.  

Once a name is chosen, trademark counsel should do a thorough search at the outset to help minimize the risks of confusion and infringement claims.  What is “infringement” is notoriously subjective, and trademark searching is an art. An experienced trademark lawyer won’t just give you a list of trademarks that came up in a search – he or she should give you an assessment of the risk and, where applicable, strategies for reducing it. Using a “low-cost,” cookie-cutter search service is false economy, and often will cost more in the long run.

When a firm is fixated on a particular name – whether because of its meaning, for sentimental reasons, or because a desirable domain name is for sale – that can complicate the selection process and increase expense.  Too often the name that seems “perfect” is unavailable – because someone else thought it was “perfect,” too.  There are workarounds like coexistence agreements, purchases of trademark rights, and licenses, but they always cost money and the firm often ends up with a name that’s far from unique.   

It’s best to avoid names that describe what the firm does, because the law generally doesn’t allow businesses to monopolize descriptive terms as trademarks.  Descriptive names like “Biotech Partners” or “Bay Area Ventures” can’t be protected as trademarks – if at all – unless they have developed enough recognition over time to have “secondary meaning” as brands.  Instead, choose a distinctive name.

What matters most is to select a unique and distinctive name that the firm can own exclusively.  Keep in mind that the meaning of a business name is not the one in the dictionary – it’s the meaning the people who make up the business put into it by developing a strong reputation.

Logos and Tag Lines are Trademarks, Too

Distinctive logos and tag lines also identify a business and its products, and they can be protected just like word trademarks.  Before investing in a logo or tag line, it’s important to do appropriate searching, and applying for registration as with the name to ensure that you are well protected. 

Benefits of Trademark Registration

Once the searching is done and the firm chooses a strong and unique name, it should take advantage of the protection of federal trademark registration.  While trademark rights in the U.S. come from using a mark to identify one’s goods or services, a federal trademark registration enhances those rights with a number of legal benefits.  They include:

• The nationwide right to use the mark for the services listed in the registration, with priority as of the filing date.  Unregistered or “common law” trademark rights only extend as far as the geographic area in which the business trades.
• A legal presumption that the mark is valid and the registrant is its exclusive owner.  This usually makes it easier and cheaper to pursue infringement claims in court.
• A public record of the registrant’s rights, which can discourage others from trying to adopt a similar mark.
• A defense against others’ claims of trademark infringement.  As noted above, infringement cases can cost $1 million or more to defend, and a registration can help a business defeat a claim early or dissuade others from claiming infringement in the first place. 
• Protection against registration of similar marks.  The Patent and Trademark Office will refuse registration of marks that it finds are likely to cause confusion with earlier-filed marks.
• Constructive nationwide notice of the registrant’s rights as of the registration date, which keeps later users from trying to claim that they adopted their marks in good faith. 
• A basis for seeking foreign registration of the mark – important for any business that operates outside the US.
• Enhanced monetary remedies when suing infringers in federal court.
• The right to use the ® symbol, denoting a federal registration. 

While it’s not necessary to have a lawyer file a trademark application, the process is filled with pitfalls and traps for the unwary, so it’s best to have experienced trademark counsel do it.  After an application is filed with the U.S. Patent and Trademark Office, an examining attorney will review it and search for conflicts with earlier-filed marks.  It’s not unusual for examiners to raise issues about the application.  Examiners may flag problems that may not exist in the real world – for example, an examiner may refuse a VC firm’s application because of a similarly named hedge fund or wealth management firm.  Experienced trademark counsel can help anticipate and avoid those issues or address an examiner’s concerns. 

Registrations will protect a mark for defined goods and services.  Because VC firms provide advice to their portfolio companies as well as capital, we typically apply to register their marks for business advisory services as well as venture capital services.  Where firms offer other services, like incubator services, educational seminars in a particular field, blogs, or podcasts, the trademark application should cover those, as well.

Protecting Your Trademarks Abroad

If you plan to conduct business outside the U.S. or license your mark to others, it’s important to protect your trademark by registering it in all foreign jurisdictions in which you plan to operate.  Otherwise you could be at the mercy of trademark squatters, infringers, and unscrupulous local partners.  International trademark protection doesn’t have to break the bank if done according to a well-thought out strategy. 

Policing Your Brand

Once you’ve invested time and energy in developing your good name, you’ll want to protect that investment.  If others adopt names like yours, that can cause confusion or harm to your reputation.  Your trademark counsel can subscribe to a watch service that will identify applications for similar trademarks so that your counsel can take appropriate and swift action to defend your marks. 

Your personnel and their contacts are on the front lines of your brand protection, so it’s important that they know what to do when they see a possible infringer.  There should be a point person to whom they can report possible infringements, and who can then alert counsel. 

If someone is infringing your trademark, it’s important to take quick action.  If you delay, and the infringer itself starts to become invested in the mark, it will likely be harder to get it to find a new name.  Also, if two businesses use a similar mark over a sustained period of time without substantial evidence of confusion, a court may decide that the marketplace has sorted out the difference between the two, and decide there’s no infringement.  As a result, the brand loses its uniqueness, and becomes less valuable. 

In Conclusion

Because it embodies the goodwill and reputation that a successful business develops over time, a trademark – whether a word, a logo, or a tag line – is one of a firm’s most important and valuable assets.  Choosing a distinctive trademark, searching to ensure others aren’t using it, and registering it are important steps for every VC firm to take.

[1] D. Hsu, What do Entrepreneurs Pay for Venture Capital Affiliation, The Journal of Finance (Aug. 2004), p. 1085 https://onlinelibrary.wiley.com/doi/pdf/10.1111/j.1540-6261.2004.00680.x (“Offers made by VCs with a high reputation are three times more likely to be accepted, and high-reputation VCs acquire start-up equity at a 10-14% discount.”). 

This might include a regional base of capital (for example, a manager limiting fund raising to high net worth family offices in Southeast Asia might select Singapore); a place of investment focus (for example, a fund that is investing all or most of its capital in India may be bound to set up shop in Mauritius or Singapore for tax treaty reasons); a type of investment structure (funds that deal in royalty income streams may locate in Luxembourg); or so forth. 

In the end, though, a desire to attract global, institutional capital will most often lead to a choice of Delaware versus Cayman.  Prominent institutional investors, almost no matter where located globally, are quite likely to be familiar with (and probably already invested in funds in) both locations.  So, there is usually little to no serious headwind created by a determination to set up in one place or the other, absent some chance of commercial perception issues as discussed below.

With all this in mind, what to do?  A careful analysis should consider all of the commercial, cost, regulatory and tax issues.  Let us take those in turn.

Commercial Issues

While it is hard to generalize for every possible situation, there is a very high chance in our experience that your reputable, institutional investors globally could, if they wanted, subscribe to your fund whether it is Delaware or Cayman based.  There are not likely to be “deal breakers” in terms of the potential for laws, rules or regulation to actually prohibit it, either from the standpoint of the domicile of the investor or from the standpoint of Delaware or Cayman welcoming your selected investors to subscribe.  The word “reputable” above is, though, key to this: investors from blacklist countries or investors from non-blacklist countries that show up on terrorist watch lists or anti-money laundering lists won’t be welcome no matter which location you choose.

However, just because it might be technically feasible from a laws, rules and regulations standpoint, it is not always the case that investors will universally be happy about your choice, and some thought should be given to this.   These degrees of willingness to invest in place X or Y, not being driven by actual laws, rules or regulations, are most often driven by perception, so to speak.

What we mean by that is, some non U.S. investors may think Delaware risks putting them too close to a regulatory system that seems onerous and intrusive to them, and they generally don’t like to make investments in Delaware, accordingly.

Likewise, another investor might attribute a bit of “tax haven” mentality around a choice of Cayman, and prefer not to invest there despite it being legally possible.  We have encountered large corporate investors, German ones in particular, that have internal policies against investing in Cayman funds based solely on the potential for the appearance, in their view, of impropriety.  This has not been particularly helped by the recent “blacklist” situation though that will be resolved quickly and has only marginally impacted this view.  The irony of the perception about Cayman is that ultimately, the AML/KYC vetting and so forth in Cayman is quite stronger at present than what is legally required in Delaware.

But back to the headline: commercially, it is usually the case that a deal could get done in either Delaware or Cayman, as the tax analysis and at some point simply manager preference ultimately dictate.  Really sticky investors the capital of which is needed could ultimately be accommodated through parallel funds or feeders, though it rarely comes to that in our experience.  So we would say, be mindful of perception issues but let regulatory, cost and, particularly, the tax analysis drive the situation.

Administrative and Cost Issues

Forming a fund in the Cayman Islands is usually more expensive.  A good benchmark is to add about 10% of total project costs for a fund formation undertaking if it will be Cayman domiciled compared to Delaware.  There is also a more detailed time and procedure aspect to Cayman funds.  This includes the need for levels of AML/KYC that are above the effort required in Delaware (though still much more user friendly than say Singapore, Mauritius, Hong Kong or most anywhere in the EEA), the requirement to maintain ownership registers, some requirements for greater levels of corporate formalities, and so forth.

Where there are good reasons otherwise to form a venture fund in the Cayman Islands these issues should not be determinative, but it is an aspect worth noting particularly for smaller or first-time funds on limited organizational budgets and/or with modest back office capabilities.

Regulatory Issues

In some cases, regulatory issues may warrant some consideration.  This typically arises where a fund is making certain investments in regulated sectors.  An exemplar case could be a media fund investing in FCC regulated businesses, or similar, often in the U.S. but sometimes outside of the U.S.

Of current particular focus are funds that may invest in U.S. critical technology companies, and thus fall under the watchful eye of CFIUS and the relatively new FIRRMA regulations.  In years past, a group of U.S. venture capitalists taking down global capital and investing globally might have chosen Cayman based on tax reasons (see below).  But today, a potential to do one or more U.S. critical technology deals may warrant stronger consideration of Delaware as a domicile (though the recently issued PPB guidance mitigates this concern in some cases).

The punch line is: if you are going to invest in regulated industries, you should have a more detailed discussion with counsel about structuring and choice of domicile than might otherwise be the case.  Still though, since most venture funds do not make myriad regulated investments, the thinking usually moves quite quickly to the tax analysis.  And that is the basis on which most ultimate decisions about domicile are in fact made.

Tax Issues

When thinking about tax, the conversation then usually covers some or all of the following eight issues, all of which have to be carefully considered together with counsel to determine the extent to which they may be applicable in your own situation.

Issues of Highest Importance

Requirement for Fund to File a U.S. Tax Return

Every partnership formed under the law of a U.S. state, like Delaware, except those that have no income, deductions, or credits for federal income tax purposes, is required to file a U.S. tax return using IRS Form 1065 each year.  As a part of that tax return filing a Schedule K-1 is issued to each and every person or entity that was a partner in the partnership at any point in the year.  In contrast, a partnership formed under non-U.S. law, like the Cayman Islands, is not required to file a U.S. return if that entity does not have “effectively connected income” (think of that as U.S. situs business income) or “U.S. source” gross income.

While not getting too deep in the weeds, there is a difference of opinion among tax practitioners whether a Cayman partnership with U.S. limited partners generates U.S. source income when it sells shares in a portfolio company.  The capital gain allocable to the U.S. limited partners is clearly U.S. source income (with some exceptions we will not discuss) as to the U.S. limited partners but opinions differ as to whether that sourcing at the partner level also applies at the partnership level.  Some Cayman funds file and some do not in this context. For those that do file there is a rule that says Schedule K-1 need only be issued to U.S. taxpayer partners.  Some fund managers are sensitive to issuing U.S. tax forms to non-U.S. taxpayer partners and this latter rule is helpful in that regard.

Withholding Documentation the Fund Must Provide to Third Parties

A Delaware limited partnership is a U.S. entity for withholding purposes and need only provide a properly filled out form W-9 to third parties (e.g. banks, brokers, paying agents, etc.).  A Cayman entity, in contrast, is a pass-through entity for withholding purposes.  Such an entity is supposed to provide a Form W-8IMY to third parties like those listed above.  This W-8IMY is supposed to include the withholding forms (e.g. W-9, W-8BEN, W-8BEN-E, etc.) of the partners in that partnership along with a “withholding statement” disclosing each partner’s share of income.

The difference in disclosure required in this context should not be minimized.  Think of the not uncommon situation where a venture fund makes a small investment in another fund, perhaps for access to deal flow or to assist in launching a new manager.  Let’s assume this fund being invested in is a U.S. filer.  If the investing fund is a Delaware entity, then the subscription process will involve solely providing the form W-9.  If the investing fund is a Cayman entity, then the withholding documentation provided will disclose the identity of all limited partners in the fund, information potentially thought of as sensitive business information.  We have seen some Cayman funds refuse to provide this “second layer of information”, but our advice would be to do so only after understanding the risk that the withholding form provided may be viewed as invalid.

Treaty Benefits

Historically many countries (Brazil, Spain and Portugal, for example, among others) have applied a “blacklist” approach to foreign investment in their country, applying higher tax rates to investors from countries viewed as tax havens.  Not surprisingly, the Cayman Islands is often on the blacklist for these countries, subjecting investment gains to higher taxes than would apply if a Delaware entity had invested.  As mentioned above, recently the European Union added the Cayman Islands to its list of non-cooperative jurisdictions (referred to as the EU’s tax haven blacklist).  Though expected to be temporary, this listing has caused consternation especially with some institutional European investors when considering whether to invest in a Cayman Islands fund.  At least at present, this poses an issue for certain investors.

Issues of Lesser Importance

Requirement for the Fund to be a Withholding Agent

As a general rule, a Delaware limited partnership will act as a withholding agent with respect to U.S. source withholdable income (such as interest and dividends) and a Cayman limited partnership will not.  As with most of tax there are exceptions to this general rule, but the general rule does inform most situations arising in practice.  Some fund managers (where the fund expects to have U.S. source withholdable income) are unhappy at the prospect of performing any withholding obligation and on this dimension will prefer a Cayman entity.  As a practical matter, venture capital funds do not earn much in the way of income subject to withholding, so this consideration is not often determinative.

Impact on U.S. Taxation of non-U.S. Limited Partners

The good news here is that the choice of Delaware or Cayman will have no impact on the requirement of a non-U.S. limited partner to file a US tax return.  While a Delaware fund would involve issuing the non-U.S. limited partner a Schedule K-1, the receipt of that piece of paper does not determine tax filing requirements.  The determining factor for tax filing status for the non-U.S. limited partners is the sort of income earned by the fund.  “Effectively connected income” earned by the fund, whether formed as a Delaware or Cayman entity, will trigger a U.S. tax filing requirement for non-U.S. limited partners.  Most venture capital funds with non-U.S. limited partners will have covenants against earning this sort of income.

Issues Involving Passive Foreign Investment Companies (PFICs)

PFICs are a complicated area and this post will not go into any detail regarding these rules – except to say that many non-U.S. formed early stage venture capital funded companies are PFICs for U.S. tax purposes.  In order to avoid adverse tax consequences attendant to owning a PFIC, an election (called the “qualified electing fund” or “QEF election”) must be made.  A Delaware fund, as a U.S. entity, makes the QEF election.  A Cayman fund, as a non-U.S. entity, cannot make the QEF election and, instead, the U.S. partners in the Cayman fund make the election.  So, the difference here is who has the burden of filing the U.S. tax form (Form 8621) to make the QEF election.  As a practical matter, whether by the terms of the limited partnership agreement, a side letter, or business practice, the fund manager will need to make the determination of PFIC status for its non-U.S. portfolio companies (in some financings we will see Investors Rights Agreements containing a requirement that the portfolio company make the determination).  As a result, the Delaware versus Cayman choice then impacts solely whether the fund or the investor makes the QEF election filing.

Issues Involving Controlled Foreign Corporations (CFCs)

The PFIC rules mentioned above and the CFC rules addressed in this paragraph fall into a category of the U.S. tax laws termed “anti-deferral” rules.  Specifically, these anti-deferral rules are designed to prevent U.S. taxpayers from “parking” income or assets offshore and delaying the U.S. taxation on that income. The PFIC rules accomplish anti-deferral by either taxing sales of PFICs as ordinary income (along with a punitive interest charge) or by virtue of the QEF election, which is an agreement to treat the PFIC as a “modified pass-through” entity for U.S. tax purposes.  The CFC rules achieve this anti-deferral by requiring some larger shareholders in non-U.S. companies controlled by U.S. shareholders to include in their income, on an annual basis, their pro rata share of certain types of income earned by the CFC, even if the CFC has not paid a dividend of those earnings.  This “deemed dividend” each year is taxed as ordinary income.

CFC planning is a key difference between Delaware and Cayman funds.  A Delaware fund is a U.S. person for CFC determination purposes, thus if a Delaware fund owns 10% or more of the vote or value of the foreign portfolio company, it will be counted as a “U.S. shareholder” for purposes of determining whether U.S. shareholders as a group own more than 50% of the foreign corporation, triggering CFC status.

A Cayman entity is not a U.S. person and the determination of U.S. shareholder status would occur at the partner level.  As a result, unless the Cayman fund holds a large position in the portfolio company and a U.S. limited partner holds a large portion of the fund, it is unlikely that a Cayman based investor will contribute towards a foreign portfolio company being a CFC.

Historically, many firms with Delaware main funds have formed Cayman alternative vehicles to invest in non-U.S. portfolio companies for just this purpose (if not entirely shifted domicile to Cayman to avoid the need to do so).

The efficacy and necessity of this planning has changed given recent changes in U.S. tax law.  At a high level, the 2017 Tax Cuts and Jobs Act changed some hyper-technical “attribution of ownership” rules that now cause many more non-U.S. entities to be CFCs.  Fortunately, the U.S. Treasury has issued some proposed and final rules in this area, which, at their heart, seek to remove this “Cayman versus Delaware” distinction when determining who actually is affected by CFC status.  These new rules (from last summer) retain the Cayman versus Delaware distinction in determining which entities are CFCs but they seek to remove the distinction between Cayman and Delaware when determining who is taxed on certain types of income earned by the CFC.   CFCs may deserve a longer discussion, but, for purposes of this post, the take-away point is that the Cayman versus Delaware distinction previously applicable is less impactful.

FATCA and AEOI Issues

The venture capital community has been living with FATCA for the past 10 years now, so we will not delve into details here.  One obvious point to make, though, is that a Delaware entity is not foreign and therefore is not a foreign financial institution (FFI) required to register with the IRS and perform FATCA due diligence and reporting on its investors.  A Delaware fund’s sole interaction with FATCA is as a withholding agent when required.  A Cayman fund is an FFI and is required to obtain a Global Intermediary Identification Number (GIIN), register with the Cayman Islands Tax Information Authority and perform annual reporting to that body.  There are also similar Cayman requirements as to non-U.S. jurisdictions (AEOI).  Thus, the FATCA/AEOI compliance costs for a Cayman fund generally will be higher than those incurred by a Delaware fund.

Conclusion

As can be gleaned from the above, the choice of jurisdiction for a venture capital fund depends on a number of factors. The above discussion is limited to certain matters that most frequently come into play when sitting down to make this determination.  The importance and weighting of each factor will differ manager-to-manager.  After considering the above, and mapping out the attributes of your proposed fund, a careful structuring discussion with counsel is warranted as a first step in your fund raising effort.

With that in mind, at a high level, there are three things to consider generally when structuring management fees: first, what is the amount of those fees; second, when in time do those fees start and end; and third, will the amount of fees reduce (i.e., “step down”) at some point in time reflective of perhaps a lesser level of work later in a fund’s lifecycle.

As to amount, management fees are typically based on an agreed percentage rate applied to an agreed capital base, and are usually described annually in the legal agreements (though in terms of cash payment they are most often divided up and paid quarterly or semi-annually).  In actively managed venture capital funds, the market rate is 2.5% of aggregate committed capital in the first part of a fund’s life.  This is contrary to say the buyout side of private equity where you often hear “2/20”, i.e. where the fee rate is often 2% instead of 2.5%.  Rates in venture capital funds are quite regularly 2.5% reflective of the fact that whereas a buyout fund may have a very large committed capital base and do 5-10 investments over its lifespan, a venture capital fund usually has a smaller capital base, often much smaller, and over time can make a quantity of investments on the magnitude of 2-3x that of a private equity fund.  In short, there is a lot to do, and where the capital base is more modest, management fees are not typically a source of a high degree of residual profitability over fixed expenses, if any.  With that said, in some very large venture capital funds (say $750 million and north), fees can sometimes drop to 2.25% or 2%, though depending on the size and nature of the organization, even these larger funds may often have a fee rate of 2.5%.  The preceding is widely applicable in the United States and Asia venture capital markets (as to USD-denominated funds); in Europe there may be more tendency for fees in venture capital funds to be in the 2% range, possibly reflective of a much smaller overall industry and an accordingly less degree of market term separation from private equity.

As to the start time for the payment of fees, they are often assessed from the initial closing (including retroactively for later admitted investors) though sometimes they are assessed beginning later, such as from the time of first capital draw or first investment.  This is somewhat dependent on the strategy in raising the fund and the expected time at which the team will start looking to place opportunities therein.  If the predecessor fund is out of dry powder and therefore necessarily the fund being raised will be the place where the next new opportunity is taken down, then there is significant justification for fees from the initial closing.  The team is after all “working” for the new fund already, in the sense they are out there sourcing deals for it; as such, the justification for payment of fees is clear.  In other situations, an existing fund may have remaining available capital for a couple of new deals, and there is an intent to put identified opportunities into the existing fund accordingly.  In this situation, the new fund is being effectively raised but put on the shelf, so as to be ready when capital is needed without any chance for a period of time without capital for new deals.  Where this is the case, a later inception of fees in the new fund may be warranted.

One also needs to consider when fees end.  This is a point that has been undergoing some change in the last 5-10 years, and may be subject to some negotiation.  There are three ending times that are most common: at the end of the natural term (say, 10 years in); at the end of any extensions to the term (say, 12 years in); or at the final liquidation of the fund (say, 13 years in).  In the last couple of years, we have seen increasing instances in which fees are paid all the way to final liquidation, albeit often at much lower rates than initially (see below, regarding fee step downs).  The theory here is that there is work to be done, someone needs to do it; and that is not free to provide, nor should it go unpaid for.  We see a number of venture capital funds with whom we work collecting fee to final liquidation on this basis, more in number than was the case some years ago.

Finally, there is the issue of the potential for fees to reduce (i.e., “step down”) at some point in time.  This is usually at the time that investments in new portfolio companies ceases, and the venture fund enters a period where it is doing solely follow-on investing and harvesting.  The theory in reducing the amount of management fee at that time is primarily that there is less work to be done, and secondarily, as a corollary thereto, that there is likely to be a successor fund providing a “full” fee base and therefore it is not necessary to collect high fees in the fund that has reached this level of maturity.  One way or another, most venture capital funds do have some “step down” concept.

A connected issue is, where fees reduce, how is that done exactly?  There are three ways the reduction in fees can be accomplished: the percentage rate can be reduced and the capital base can be left unchanged (a “rate step down”); the percentage rate can be left unchanged and the capital base can reduce (a “base step down”), or both the percentage rate and capital base can be reduced (a “double step down”).  In the years immediately following the reduction, say years 5-10 or 5-12, double reductions are quite uncommon and usually reflect quite a bit of lack of negotiating leverage on the part of the fund manager.  This is versus reductions during liquidation, where a double reduction is more common.

So, again focusing on what happens at or around year 5, in almost all cases it will be one or the other of a rate step down or a base step down.  Most venture capital managers will prefer a rate step down.  The reason is that this leads to a situation where one can state with specificity (at least from the time of final closing when the capital base amount is known) the exact amount, in dollars, of management fees in later years.  Since management fees are meant to be used for fixed expenses (think rent, equipment, hiring staff) and are usually consumed fully in furtherance of those expense requirements as opposed to leading to retained earnings, not knowing the dollar amount fees you will get in say year 6 (as would be the case where those fees are some percentage of a capital base not known until that time) is an extremely hard position for a manager.

With that said, while savvy investors understand this and will work to support the needs of the managers they invest in, they often prefer a base step down.  Their point of view is that no matter how low a percentage rate drops, it may be inappropriate to apply any rate to the full committed capital base later in the lifecycle when there are few remaining investments.  With that said, especially in smaller venture capital funds (say, $500 million and south), usually the method of rate step down prevails.  Sometimes, a compromise may be agreeing to a double reduction in the liquidation period to address the foregoing concern very late in the fund’s life.

It is important to get these concepts right.  We have found that getting them wrong can amount to “penny wise, pound foolish”, in extreme cases, hampering a manager’s chance of success.  What we mean by that is, investors put fund managers in business.  They pay a lot in fees to do that, no matter how negotiations on the above issues work out.  Fees are needed to compete for talent in the marketplace.  It is a shame to see negotiations to reduce fees result in a situation where the fund manager can’t hire and retain the “A” team from a compensatory standpoint.  Careful attention to market norms can assure the manager avoiding a competitive disadvantage, yet doing so in a way that is respectful of the investors’ perspectives on these matters.

The answer lies in a set of provisions that reside in the fund’s partnership agreement.  We generally refer to these as “LP governance rights”.  The common theme is that these LP governance rights represent ways in which LPs can take action if, in fact, they do become deeply concerned about the fund’s prospects or the conduct of the manager.

LP governance rights are best thought of as a suite of options.  Not all of them will exist in every fund agreement, but usually some of them will.  They can differ based on the duration of engagement between investors and the fund manager and the adherent level of trust that has developed over time amongst the parties, or for other reasons (including business leverage and precedence of prior funds).  It is safe to say that where investors are very demanding of attaching unusually strong LP governance rights to a deal, they probably have a heightened level of concern about issues of team stability, trust or just generally a lack of familiarity with the manager.  Certain investors may, internally and in light of their nature, be prone to requesting stronger than middle-market LP governance rights; for example managers of public pension or sovereign wealth assets may have strong legal or fiduciary reasons for such requests compared to private sources of capital.

So, what encompasses this suite of options comprising LP governance rights?  At a high level, there are three broad categories to be aware of: (1) provisions which can lead to the fund’s investment period ending prior to its scheduled time; (2) provisions which can lead to the fund’s entire term culminating early and the fund being completely shut down; and (3) provisions which leave both the investment period and overall term of the fund intact but cause the existing fund manager to be replaced with a new fund manager of the investors’ choosing.  Let’s examine each of these in turn.

Termination of the Investment Period

In a typical venture capital fund, an investment period will apply.  This is the period of time after closing, usually four to six years in duration, that the fund may make investments in brand new portfolio companies.  Beyond this time, only follow-on investments will be permitted.  The goal is to ensure that the fund can liquidate reasonably on-time, say after ten to twelve years.  That won’t be possible if investments in brand new portfolio companies, especially early stage ones, are made late in the fund’s lifecycle.  The investment period duration regulates this.

An investment period may end early if a fund becomes fully invested ahead of schedule, but from an LP governance perspective, there are two ways it might end even earlier.

The first is in association with a key person event, in which a certain number or particular persons of a select group of the fund’s investment personnel are no longer meeting their time devotion to the fund (usually substantially all business time) or are no longer managers of the fund.  For example, perhaps a fund is targeting 30 investments, and has five professionals expected to identify and nurture, on average, six deals each.  It might be the case that investors would tolerate some level of departures and still be comfortable with the team’s ability to fulfill the investment mission, but what if a supermajority of the five investment professionals has left and replacements have not been found and approved?  It may no longer be feasible to invest in 30 deals if these departures happen a couple of years into the investing cycle.  In many agreements, this happenstance, called a “key person event,” may call for the suspension of the investment period either automatically or by LP / Advisory Committee vote.  During this suspension period, the manager seeks to find replacement talent or otherwise formulate and propose some go-forward plan.   After exhausting efforts to find suitable substitute talent over a period of time, the fund’s investment period will terminate under the fund’s governing documents.  In this case, the remaining team will stay in place to guide the fund’s investments that have been made to fruition, but the investment period will terminate and opportunities in new portfolio companies cannot be pursued.

The second way an investment period may end earlier than scheduled is upon an investor vote.  This term is present in only a minority of deals to begin with, but where it is seen, it will almost always require bad conduct on the part of the fund manager team (“cause”, in industry parlance), usually proven in court, arbitration or a similar tribunal to the stage of final adjudication.  Very infrequently, it may be the case that a supermajority of investors may vote to terminate the investment period without any such cause.  It’s worth careful emphasis to highlight that this is a very uncommon clause, and one that most venture capital managers will not agree to.  The position is usually that such a punitive action should require wrongdoing and not be arbitrary, especially where venture fund managers by their lengthy mandate invest in and contract for long duration assets and obligations (offices leases, etc.) that can be difficult and costly to unwind.

Termination of the Fund

Whereas investment period termination is usually driven by a concern over the ability to make all of the contemplated investments, as reflected in a typical set of key person provisions, if concerns run deeper, the investors may in exceptional circumstances wish to completely terminate the fund.  If this occurs, the fund is liquidated and the securities – marketable and nonmarketable – are simply distributed in kind to the investors in connection with the winding up of the fund.

This remedy is in fact truly exceptional inasmuch as investors typically do not desire to hold private venture-backed securities in their portfolios.  This is what they hire fund managers to do, and they are often ill-prepared to take this on, especially if they are outside the domicile of the investments (like a UK pension fund trying to deal with U.S. portfolio securities).  In addition, the diffused, small positions that each particular investor may receive are not likely to carry the weight of the position as a whole that was previously held by the fund (think of things like the leverage to obtain a board seat or major investor rights); and the act of seeing the positions to fruition through follow-ons or if not disposing of them privately, perhaps in a secondary transaction at a discount, are not terribly appealing either.  So this remedy is reserved, in application, for the most serious situations.  Reputable fund managers need not lose much if any sleep that such a provision will be acted on.

The flip side is, in light of this sort of “natural bias” on the part of investors to call for application of the termination right, it is in fact often able to be exercised without cause.  In comparison to say a right to terminate the investment period or substitute a fund manager for no cause, the strong “downside” of enacting the fund termination serves as a natural check and balance.  The result is that in the industry, a majority of venture deals have no-fault termination rights.  These are usually on supermajority investor votes – perhaps as high as 85% in interest.  Sometimes, the right to terminate the fund in entirety on a lesser vote is seen where there is adjudicated cause and/or after a key person event – perhaps in these cases, on a 66% vote.

Replacement of the Fund Manager

The final type of LP governance right we see in venture capital deals involves an option for investors to replace the fund manager (often referred to as “GP removal”).  Where this happens, the fund will continue, but under the supervision of a new manager they choose.  The former manager is likely to retain some carried interest and possibly some transitional management fees, but won’t be involved in the going-forward management of the fund and ultimately will be likely to cede some economics, perhaps to a significant degree, to the new manager.

Some deals, especially in the case of emerging managers or managers struggling in fund raising, have some sort of removal and replacement right, almost all of which run off adjudicated cause.  In this case, following that sort of final determination in court of a serious bad act, a supermajority vote may lead to the right to remove and replace the fund manager; provided that in some deals where the bad conduct is resulting from a particular team member and that team member is terminated, the removal right may disappear (it being intended that an otherwise well-run organization shouldn’t be punished as a whole for basically “lone wolf” type conduct that isn’t pervasive in the firm).  Investors may ask for no-fault removal and replacement rights on a high supermajority vote – 85% or north, for example.  In reality, this type of provision is highly infrequent; a positive number yet approaching somewhere close to zero percent of deals we see today have this sort of provision.  As with no-fault investment period termination, most managers are simply unwilling to concede that they can be put out of business where there is no adjudicated bad conduct.

In the case of a removal and replacement right, whether for cause or otherwise, the departing manager is almost always afforded carried interest in the prior deals (often up to 100% though in some cases less) and sometimes a transitional amount of management fees permitting the outgoing manager to gracefully wind down operations.  These provisions are meant to be a deterrent to enacting the removal rights, such that those rights are invoked only where circumstances truly warrant it.

A Suite of Rights

In the end, most deals will have some collection of the above rights.  Having no such LP governance rights is rare, as is having everything listed above in any particular deal.  Fund managers and investors are well advised to cooperate to put in place a standard set of provisions encompassing some of the above and as the situational facts dictate.  In deals where provisions are too favorable for LPs, team retention issues may result.  That is to say, an excellent investment professional at the top of her game may not be satisfied to work at a firm where provisions can be enacted, especially on a no-fault basis, to effectively shut the company’s doors.

With that in mind, at a high level, there are four things to consider generally when structuring carried interest.  First, what is the percentage rate of gains that will apply and will that percentage rate be fixed, or will there be the potential for it to change (for example on superior investment returns).  Second, how will the amount of investment gains be calculated when sitting down to apply that percentage rate.  Third, at what point in time will be fund manager be permitted to take cash or securities distributions constituting carried interest.  Fourth, and finally, in the event that cash or securities distributions are in excess of the agreed amount, will there be a return obligation (i.e., a “clawback”).

As to the percentage rate of gains that will apply, it is widely accepted that as a starting point this rate will be 20%.  It is rare for a mainstream venture capital fund to assess a rate lower than 20%, though in some cases the rate may be higher.  Some exceptionally well performing funds with superior investment track records or similar pedigree attributes assess flat, headline rates of 25%, 30% or in just a few outlier cases in the industry something higher.  We call this “flat premium carry”.

Where there is the potential for premium carried interest above 20%, in today’s marketplace this will tend much more frequently to be “earned premium carry” (as opposed to a “flat” model), meaning that it will only apply if investment gains warrant it.

In an earned premium carry model, investment gains are measured, most frequently with reference to cash-on-cash returns (2x, 2.5x, etc.) but in a minority of cases using more complicated models such as IRR-based calculations.  The higher rate of carried interest will either apply solely after meeting the applicable condition (i.e., the manager gets 20% carry for some time then later gets 25% carry), or much more frequently on a retroactive basis using a catch-up to the fund manager (i.e., once the condition is met the manager gets 100% of the next gains until it has received 25% of gains on a from-inception basis).  Sometimes, such a catch-up is effectively slowed down by providing if not 100% of the next gains to the fund manager, some amount over 25% (like a 50/50 share until the fund manager has 25% of total gains from inception).

Sometimes, there may be two tiers of increases, for example a model where the fund manager gets 20% of gains until a 2x cash-on-cash return, then 25% of gains until a 3.5x cash-on-cash return, then 30% of gains beyond that (with catch-ups likely to apply at each tier).  Cash-on-cash measurements are likely to apply to contributed capital, as opposed to committed capital.  This means that as more capital is drawn, a fund manager that had previously met say a 2x condition may no longer be in that position.  Where this is the case, the manager will usually have to cede the collection of carried interest until the applicable condition is met again.

The second general issue in structuring carried interest is to determine the amount of investment gains that will be used when applying the agreed upon percentage rate.  Two general approaches seen in the industry.  In some cases, the percentage rate is applied against the total investment gains in the portfolio net of total investment losses, without taking into account fund expenses.  In other cases, fund expenses in addition to total investment losses are debited against total investment gains in determining the relevant amount against which to assess the carried interest percentage rate.  Each model is associated with numerous funds in the marketplace and neither model is exclusive.

The next issue to consider is the issue of when in time the fund manager can take cash or securities distributions representing its carried interest.  It’s important to note that while the accrual of carried interest on an accounting basis into the fund manager’s capital account will always begin from inception of the fund, the right to take the balance out of that account in the form of a distribution is almost never from inception.  A delay until some condition or another is met is seen in essentially all typical venture capital deals.

The reason for the delay relates to the potential for overdistribution.  Venture funds will typically do many deals in their whole lifecycle.  Consider a $100 million fund that draws down $5 million for a first investment and sells it relatively quickly for $25 million.  If there is a 20% carried interest rate, there will be $4 million of carry (20% of the $20 million gain) to put in the fund manager’s capital account on an accounting basis.  What if the fund draws down the other $95 million and the results are not as glamorous?  There is no assurance on these facts that this fund will, on a whole lifecycle basis, make money.  Despite the early investment success of that first company, it’s possible that this fund won’t even be able to return the entirety of the $100 million in commitments if later investments don’t perform.

Since carried interest will be assessed on a whole fund basis, investors (and in many cases the fund manager itself) will want to defer taking the $4 million in this example.  Deferring the distribution of this amount in cash until a later time provides more certainty that in fact at the end of the day the $4 million will be able to be kept and not be an overdistribution.  Put another way, by waiting to take the distribution, one can see if there are investment losses which will wipe out, in whole or in part, that $4 million accounting entry in the fund manager’s capital account.

By far the most prevalent method of delay is to require the manager to return contributed capital prior to taking cash or securities carry distributions.  This is called a “European waterfall”.  Consider the above example but say that by the time the $25 million in cash exit proceeds are obtained on that first investment, the fund manager has called down $30 million of capital to make some other investments, and pay fund expenses.  In a European waterfall model, no carried interest distribution is permitted yet, because the $25 million is not sufficient to return the $30 million that has been contributed.

If the fund will not use a European model, it will probably use some form of a deal-by-deal distribution model (called an “American waterfall”) though in the interest of avoiding an overdistribution some form of test will again be quite likely to apply.  There are many permutations of this but a common test will look at the fair market value of the remaining portfolio in determining the eligibility to take carried interest distributions.  For example, such a model might require the fair market value of the remaining portfolio after the proposed distribution to be 125% or greater of such portfolio’s cost basis.  This is in effect a delay mechanism, since it will take some time for the portfolio to mature to this point.  The important point is that the appreciation of the remaining portfolio cushions the potential for an overdistribution, because the fact pattern that leads to such a situation is “early winners, later losers” (think back to the $5 million example in a $100 million fund).  If the remaining portfolio is nicely appreciated, there is much less of a chance of those later losers occurring and accordingly an overdistribution is far less likely.

It is worth noting that in the U.S. and some other similar tax regimes, the fund manager’s team will be taxed not on cash distributions but on the original allocation of carried interest into the capital accounts.  In early years, it is not likely they will be permitted to take carry distributions in light of the above concepts, and so, the issue arises of how they will pay their taxes.  Almost all deals solve for this by creating an exception to the “delay” rules permitting partial distributions sufficient for that purpose, aptly referred to as “tax distributions”.  Tax distributions are always an advance against the future actual distributions that the team will be entitled to once the agreed-upon delay conditions are met.

The final issue to determine is whether a return obligation (called a “clawback”) will exist if there is in fact an overdistribution situation, and at what time.  Most frequently in venture capital deals, there will be a clawback.  It is most frequently assessed one time: upon liquidation.  In a minority of deals, it may be applied earlier as well, though because venture capital funds typically invest in a material quantity of deals, hypothetical overdistribution situations inside of a fund’s lifecycle will usually “self-correct” in the course of allocating gains and taking (or not taking) distributions in later years of the fund’s life.  Especially with a European waterfall, while there is a statistical chance for a clawback situation to exist on liquidation, it is not incredibly likely.  As such, investors are usually comfortable with a clawback applying once, at liquidation, and additional “interim” clawbacks are not seen with much regularity in these deals.

An associated issue is credit security for the payment of the clawback.  If the clawback is in fact a liquidation clawback, there is a need to have the underlying carried interest recipients return money to the general partner (or directly to the fund) in order for the clawback to get paid, because, at this juncture neither the fund nor the general partner, on an entity basis, have material remaining assets.  Some years ago, this may have been handled by an escrow account where those recipients had to store some value for this future situation.  This is very unlikely today.  The credit security issue in most deals is solved by the signature (or sometimes stand-alone guaranty) of those recipients where they make an explicit agreement to return their part of the carried interest.

As is the case with management fees inasmuch as fees are a means to pay salaries, carried interest is a compensatory matter in the venture capital industry, and probably a more vital one in most cases.  Fund managers will do well to pay attention to market norms, so as to avoid a situation where the team is not incentivized to stick around and perform.  This is in the mutual best interest of managers and investors alike, and most sophisticated investors in the space will want a market-based set of carried interest provisions as much as the fund manager itself.

Some years ago, there was considerable concern with respect to a number of states that a fund manager’s information (be that pitch books, PPMs, partnership agreements, quarterly and annual reports or other materials) might be subject to disclosure to the general public upon demand. As it turned out, given how the laws have developed in this area, this has not proven to be a major concern today, as nearly all of the relevant laws have come to expressly provide, or at least have been interpreted by regulation or otherwise to provide, that essentially all of the sorts of highly sensitive information about themselves and their underlying portfolio companies that fund managers would most care about protecting from public disclosure now qualify for protection from such public dissemination (most frequently because such information is considered a “trade secret” in nature, and thus, protected by specific provisions in applicable state laws and regulations).

The type of protected information described above usually includes all portfolio company level information and all information about the strategy and terms of a fund’s offering. A number of states do permit the request by the public and subsequent dissemination of certain fund level (as opposed to portfolio company level) information, and some states go so far as to mandate its public disclosure even without a specific FOIA request from the public. For example, California requires that its public entity investors (CalPERS, CalSTRS, etc.) affirmatively disseminate to the public such fund level information, which is usually done by way of website. Fund level information varies by the location in question, but generally includes items such as name of fund, year of formation, aggregate capital commitments, the dollar amount of capital contributions, the dollar amount of distributions, the fair market value of the interest as of a specific time, the amount of fees (and sometimes carried interest) assessed, and so forth. Note, though, that the preceding is not reported on a portfolio-company basis, as information at the portfolio company level is generally viewed as trade secret.

Funds exist for a long period of time and these laws do change. California, for example, recently broadened the list of information deemed to be “fund level,” and thus, required for public disclosure. Accordingly, fund managers generally rely on two levels of protection to put them in the best position to disclose as little information as possible about their funds and the underlying portfolio companies. First, upon inception of a relationship, they analyze the current conditions of the investor in question with respect to what disclosure risks such investor poses to the fund manager (presently, for example, public investors in certain states are typically viewed as a bit too “leaky” to accept as investors, whereas the other states are viewed as mostly tolerable in our experience). Thus, concentrated planning for FOIA exposure issues during the investor intake phase is important.

Second, fund managers craft partnership agreement provisions which offer ongoing protection through several typical methods: (i) the confidentiality provisions are carefully crafted to provide that only a limited set of “fund level” information may be publicly disclosed by public agency investors or by fund-of-fund investors to their own public agency investors; (ii) the public agency investor is required to notify the fund manager of any FOIA requests and handle, or provide assistance for the fund manager to handle, resisting the request to the extent it is overbroad; (iii) the fund manager is permitted to demand the destruction or return of information from the investor if there is a later determination that there is a material likelihood of the public gaining access to it (this information being information beyond the broad fund-level scope, i.e. the type of information that is expected to remain confidential from public view); (iv) the fund manager, on a prospective basis, can stop providing sensitive information to the public agency (or fund-of-funds) investor if there is a non-permitted disclosure of information or there is a material likelihood or risk of the public gaining access to or being disclosed such information; and (v) in some cases, the fund manager may be able to cause a mandatory withdrawal of a particularly troubling investor.

In practice, a fund manager will need to decide whether it wishes to cross the line of accepting public agency investors or fund-of-funds investors with public agencies in them. Some managers determine that they do not even want fund level information available in the public domain and they elect to refrain, wholesale, from relationships with such investors. Other managers determine that they are fine with fund level information being publicly available, they accept these types of investors, and they rely on the above stated “typical protective provisions” to provide protection over the long life of the fund. No matter what course you may take, you will need to plan adequately for this issue in advance and determine the position your fund will take in respect of these sorts of prospective investors.