We are often asked about the prevalent market options for structuring carried interest provisions in venture capital funds. In this post, we’ll speak of mainstream venture capital funds, so to speak. Terms differ in special situations, like co-investment funds, top-up funds, funds that are wholly or partially funds-of-funds, and so forth. Some of these special situations are discussed elsewhere in this blog.
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.