To understand the typical equity structure of an advisor to a venture capital firm, it is important to understand the structure and role of the advisor. A basic venture capital fund is generally organized as a limited partnership. It is made up of two primary business entities – a general partner and a limited partner. The general partner is the management company organized as a limited liability company. The management company serves as advisor to the investors of the venture fund. The limited partner is a business entity made up of all of the fund investors.
Equity Structure of the Management Company
The management company is an LLC. Read the LawTrades blog to learn more about entity structures. The individuals organizing the management company and the investment fund, typically referred to as “venture capitalists” hold all of the ownership interest in the management company LLC. As previously stated, these managers are advisors to the investment fund. These managers will generally invest between 5-20% of the total capital in the VC fund. This shows third-party investors in the fund that the fund managers have a vested interest in the success of the firm’s portfolio companies. As investor in the fund, these owners will generally receive a commensurate distribution of fund profits or losses.
The management company LLC serves as manager and advisor to the venture capital fund. This means that they advise on the process of operating the fund and manage the assets of the fund, source deals, conduct due diligence, and invest funds. The traditional management company LLC receives a management fee that is typically between 1.5% – 2.5% of the total amount of money committed to the fund. The fees are used to finance the operations of VC fund, including salaries for investing partners and their staff. There are, however, numerous variations on the management fees. Sometimes, the management fee is structured over the life of the fund. The fees may be higher during the active investing periods and lower during the maintenance period. Similarly, the fees may be higher in the beginning and tier down over the life of the fund. Alternatively, some managers take a fixed management fee up front to last for life of the fund. In some cases the management company might have no fixed management fee and will charge actual fund expenses. All of these variations seek to achieve the same purpose – adequately compensate those responsible for providing professional services as advisors and managers to the venture fund.
In addition to owning an interest in the venture fund and receiving management fees from the fund, the management company participates in distributions from the sale of the company. That is, the management company manages the funds of the investors in hopes of making a return when the portfolio companies are later sold. Generally, the first distribution of proceeds from sale go to the limited partners. All limited partners must recover their investment before any distribution of profits is made. Also, it is a common provision that the investors must earn an 8% internal rate of return on their investment before any further distribution of profits is made. Once the LPs receive a return of their invested capital (and the 8% if applicable), the remainder of the funds (the profits) are split between the management company and the investors. The split is generally 80/20. Approximately 80% of the profits go to the investors. Individual investors receive a share of these profits based upon their ownership interests. Approximately 20% of the profits go to the management company LLC. This percentage of profits distributed to the management company is known as “carried interest” or carry. It is worthy noting that most venture capitalists get 20% carry. Some extremely successful venture capital funds may receive as much as 25–30% carry. The carried interest of the management company can be a carried interest in the entire fund or deal specific compensation or carry.
Setting up the structure correctly matters
Setting up the structure for equity compensation of advisors to the VC firm is paramount. Don’t try it alone. Work with the skilled professionals at LawTrades.