“Venture Capital Fund Formation: Key Structures, Terms, Tax Considerations, and Pitfalls”
Introduction
Forming a venture capital (VC) fund is a significant legal and financial undertaking—one that blends fundraising prowess, deal-making experience, and a precise understanding of entity structuring, tax treatment, and compliance. This blog provides a high-level overview of the fundamental components involved in establishing a VC fund, including key entities, legal documents, tax considerations, distribution waterfalls, and the serious challenges of amending fund terms post-launch.
I. Core Entities Involved in a VC Fund
Limited Partnership (LP Fund Vehicle):
The fund is typically formed as a limited partnership (LP).
The General Partner (GP) manages the fund’s operations and makes investment decisions.
The Limited Partners (LPs) are passive investors (e.g., institutions, family offices, accredited individuals).
General Partner Entity (GP Entity):
Usually an LLC, the GP entity manages the fund and holds the “carry” (carried interest).
This entity may be structured to limit liability and to optimize tax exposure.
Management Company:
Separately formed LLC that employs the investment team and receives the management fee.
Often distinct from the GP to avoid regulatory entanglements and for operational clarity.
II. Key Legal Documents
Forming a VC fund requires the careful drafting and negotiation of a suite of legal documents:
Limited Partnership Agreement (LPA):
The primary governing document detailing fund terms, commitments, fees, distributions, fiduciary duties, and dissolution.
Outlines how profits and losses are shared.
Private Placement Memorandum (PPM):
A disclosure document provided to potential LPs detailing risks, investment strategy, fee structure, and conflicts of interest.
Subscription Agreement:
Sets forth the terms under which investors subscribe to the fund, including representations and warranties (e.g., accredited investor status).
Management Agreement:
Contract between the fund and management company specifying services provided and fees paid.
Side Letters:
Tailored agreements offering preferential terms to specific LPs (e.g., MFN clauses, reporting, co-investment rights).
III. Tax Considerations
A VC fund’s structure is designed to be tax-efficient for all parties:
Pass-Through Taxation:
LPs are taxed individually based on their share of the fund’s income and capital gains (no entity-level tax).
Avoids double taxation inherent in C-corporation structures.
Carried Interest:
Profits allocated to GPs may qualify as long-term capital gains (subject to a 3-year holding period under IRC §1061).
IRS Carried Interest Guidance: IRS – Carried Interest Rules
Unrelated Business Taxable Income (UBTI):
Tax-exempt LPs (e.g., pension funds, endowments) may incur UBTI if the fund uses leverage or invests in pass-throughs with active income.
Read more: IRS – UBTI Guidance
Filing Obligations:
VC funds typically file IRS Form 1065 and issue K-1s to all partners.
IRS Partnership Filing Info
IV. Distribution Waterfall: Profit Allocation Mechanics
VC funds use a structured “distribution waterfall” to allocate proceeds from exits or earnings. A standard waterfall follows these steps:
Return of Capital:
LPs receive 100% of capital contributions before any profit is distributed.
Preferred Return (Hurdle Rate):
LPs may receive a preferred annual return (e.g., 8%) on invested capital.
Catch-Up Provision:
Once the preferred return is met, the GP receives 100% of profits until they’ve caught up to their agreed share (e.g., 20%).
Carried Interest Split:
Thereafter, profits are split (commonly 80/20) between LPs and the GP.
V. Changing Fund Terms Post-Launch: A Legal and Ethical Minefield
Attempting to revise fund terms after capital is committed can lead to serious regulatory, reputational, and contractual consequences:
Breach of Fiduciary Duty: Altering terms post-commitment can breach the GP’s fiduciary duties unless clearly authorized by the LPA.
Consent Requirements: Most LPAs require unanimous or supermajority LP consent to amend material terms (e.g., fees, strategy, term).
Regulatory Scrutiny: The SEC may view post-launch changes, especially those detrimental to LPs, as deceptive or misleading.
See: SEC on Private Fund Advisers
Investor Backlash & Legal Risk: LPs may initiate legal action or refuse future fund participation.
Conclusion
Launching a VC fund is about more than just raising capital—it’s about building a durable, transparent, and tax-efficient investment vehicle that aligns the interests of investors and fund managers. Every structural decision—from legal documentation to tax planning and distribution mechanics—has long-term consequences.
Fund sponsors must tread carefully, especially when considering post-launch changes. Trust, clarity, and compliance form the bedrock of a successful venture capital operation.
Further Resources
IRS – Form 1065 Instructions
IRS – Partner’s Instructions for Schedule K-1 (Form 1065)
SEC – Investment Adviser Guidance