USA Law and Practice Contributed by: D. Scott Bennett, Nicholas A. Dorsey, Virginia M. Anderson and Ellen H. Park, Cravath, Swaine & Moore LLP
Carried Interest The main method of profit sharing in venture capital funds is the allocation of carried interest to the sponsor. With increasing sophistication and size over time, venture capital fund docu - ments have experienced some convergence with the broader private equity funds market, including its distribution-based carried interest structure. As a result, the precise structure of venture capital fund carried interest deals also varies widely – although there are some com - monalities. This is particularly the case with regard to the idea of a carried interest “waterfall” . Under the carried interest “waterfall” , gains are allocated according to a specified order of priority as between the GP and each LP, with investors typically receiving a return of invested capital and a preferred return (or hurdle return) before the sponsor receives any share of the profits. Owing to the risk-return profile of ven - ture capital funds, carried interest rates tend to be higher than in the private equity industry more broadly, ranging anywhere from 20–30%. Higher rates tend to correspond with more LP-favour - able preferred return or hurdle structures before sponsors can earn their full carry rate. Venture capital funds tend to make distributions only once the entire portfolio is fully realised or once allocated gain has reached a certain threshold, and it is very common practice for distribution timing to be entirely at the spon - sor’s discretion. However, an increasing num - ber of venture capital funds are starting to fol - low the private equity distribution-based model and return capital as and when investments are realised. Investor Protections Venture capital fund investors are typically locked up for a long duration with no role in the
sponsor maturity, negotiating leverage, invest - ment strategy and fund structure. Capital Mechanics Venture capital funds generally employ a com - mitment/drawdown structure. Investors make capital commitments to the fund, which may be called or “drawn down” (as a capital contribu - tion) in one or more instalments over time. The permitted uses for contributed capital typically include new investments, fees and expenses, follow-on investments, and reserves, with the bulk of capital drawn down during the three-to- five-year investment period for new investments and reserves. Venture capital funds also com - monly have generous recycling and reinvest - ment provisions to redeploy capital from invest - ments realised during the life of the fund. Fees Management fees are asset-based fees charged throughout the life of a fund. Structures vary widely – although a common model consists of an annual fee (usually 1–3%), charged quarter - ly, on the basis of capital commitments during the fund’s investment period and on the basis of invested/contributed capital thereafter. Fees are typically more important earlier in the life of the fund, as investments are being made and no profits are being realised, and allow the spon - sor to cover expenses (including salaries) and maintain operations. In recent years, manage - ment fees have become an important source of additional revenue supporting increasing man - ager enterprise value. The sponsor and its principals may also receive certain portfolio company remuneration and transaction fees (eg, directors’ fees) directly, which are commonly – but not always – offset against management fees.
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