A venture capital fund (VC fund) is a form of investment fund that makes investments in early-stage start-ups with high return potential but significant risk. In a venture capital firm, entrepreneurs fetch funds from high-net-worth individuals and institutional investors. After combining their financial resources, the venture capital company and investors sign a limited partnership agreement (LPA), which creates a limited partnership (LP). In a limited partnership (LP), there are two different types of shareholders. They are Limited partners and General partners. In this article, we will cover How an LPA works in a VC fund.
LPA and VC fund
A VC fund is created and governed by a limited partnership agreement (LPA). It lays forth the guidelines for interactions between the limited partners, who serve as investors, and the general partners, who manage portfolio investments. The general partners are the venture capitalists and they possess infinite power and responsibility. Whereas the limited partners are those partners whose authority and obligations are constrained.
Who is a Limited Partner?
A limited partner is a partner who provides funds for the VC. This Partner aims to gain from the partnership by making money from the fund invested. They don’t manage or participate in the venture fund daily. There is no restriction on the number of partners contributing to these funds. A VC fund may have 10 or even 100 limited partners. Depending on the size of the fund and the amount of money needed to be raised, the average is between 10 and 20 LPs. The maximum amount of liability of this partner is restricted to their investment in the company.
Who can become a limited partner?
Limited partners are individuals who are ready to invest in a fund without having any say in how the money is used. Additionally, their liability is capped at the sum of the investment. High net-worth individuals, affluent families, pension funds, and sovereign wealth funds are the major categories of limited partners in most cases. In other words, a partner, who purchases shares in a partnership, as an investment without involving in the day-to-day affairs of the firm becomes the limited partner of that firm. Also, these partners cannot incur any obligation on behalf of the firm.
Work of limited partners
The limited partners provide capital (either money or resources physically) to the limited partnership in exchange for an ownership interest. They are passive owners of the firm who don’t participate in the management. They act as silent partners and their primary duty is to provide funds to the business and get a return on their investment. Also, they cannot exercise any control over the manner of utilization of the funds invested. Though the limited partners are restricted from receipt dividends, they enjoy direct access to the flow of net income in a firm. In some cases, a limited partner may be asked to provide suggestions regarding funds as an experienced investor.
Benefits of limited partners
The benefits of becoming a limited partner are as follows
- A limited partner may invest money in the company in exchange for a share of the partnership’s earnings.
- They cannot incur partnership debts or responsibilities above the amount of capital invested in the business.
- This partner is not required to attend management meetings or the company’s daily activities.
- A limited partner may be considered a general partner if they put in more than 500 hours of labor in a single year. For a partner who wants to have more influence over the expansion and development of the company, this may be advantageous.
Types of limited partnership
The types of partnerships in a business are enumerated as follows:
- General Partnership – It is owned by two or more general partners, who are jointly and severally liable for all liabilities. Even without an explicit verbal or written agreement, a general partnership can be formed as soon as partners decide to work together. The revenue from the partnership must be reported and taxed regularly by the partnership and its partners. The partners pay the taxes, not the partnership. There aren’t many legal formalities unique to this kind of partnership, except for registering a firm name. The ongoing demands of the government are consequently constrained. For instance, it is not necessary to hold an annual general meeting like a corporation or other corporate entity.
- Limited Partnership – A limited partnership (LP) is a type of partnership that restricts some participants’ legal liability for commitments and debts. At least one limited partner makes passive financial and material contributions. It allows participants to invest without the risk of legal repercussions. To establish this kind of collaboration, a written agreement is necessary. There is at least one general partner who is completely liable in the business. The general partner oversees and administers the company. When establishing or ending this partnership, the LP is required to register and submit reports to the local government. It is more costly and difficult than creating a general partnership.
- Limited Liability Partnership – A general partnership that limits the legal liability of all partners is known as a limited liability partnership (LLP). General partners in this kind of partnership are shielded from the wrongdoings of the other partners, such as neglect, misconduct, and other improper behavior. Local authorities may limit the structure to qualified enterprises in knowledge-based sectors, such as accountants and attorneys. Before partners can form an LLP, authorities may seek documentation of approval from the professional regulatory organization. An LLP must first notify the local government of the identity and number of partners of the limited liability partnership. An LLP often files a document known as a “Statement of Dissolution” or “Statement of Cancellation” to dissolve. When establishing this kind of collaboration, a formal agreement is a requirement.
LLC (Limited Liability Company)
In the United States, a limited liability company (LLC) is a type of corporate structure that shields its owners from being held personally liable for the obligations of the firm. They are hybrid legal entities with traits shared by corporations, partnerships, and sole proprietorships. The provision of flow-through taxes to the members of an LLC is a feature of a partnership rather than an LLC, even though the limited liability aspect is similar to that of a corporation. LLCs do not immediately pay taxes on their profits. Members record their share of their profits and losses on their tax returns after they are passed through to them.
Limited partnership and taxes
A limited partnership is a type of entity that passes through taxes. In their tax filings, the partners disclose the business’s gains and losses. Depending on each partner’s ownership stake, business gains (or losses) are divided among them. For instance, if a business has two partners who each own 30% and 70% of it and earns a profit of $100,000 in a given year, the partners will each receive $30,000 and $70,000 as their share of the profits. The operating agreement of a limited partnership, however, also gives it the option to choose a unique allocation. Its members may concur to split the profits in a different proportion from the ownership stake.
When treated as a return on capital investment, some income portions may even be free from taxes. But it’s important to remember that limited partners only receive passive revenue. Therefore, only other passive income can be used as a deduction for their portion of business losses. A partnership firm is exempt from paying taxes, but it is nevertheless required to submit Form 1065, an informative return that details the earnings and losses as well as the distributions made to each partner during a given year. This return is used by the IRS (Internal Revenue Service) to stop individual partners from evading taxes.
What is a limited partnership agreement?
The general partners and the limited partners sign a limited partnership agreement, which allows the partners to express in writing any specific agreements they have with one another. The general partner is specified in the limited partnership agreement as either a person or another legal organization. Additionally, it includes a list of the general partner’s and limited partners’ ownership interests, profit percentage interests, and any unique rights. The Certificate of Limited Partnership, which establishes the Limited Partnership, also includes the names of the general partners. The names of the Limited Partners are not required to be listed in the Certificate of Limited Partnership.
In contrast to corporations, limited partnerships often do not have bylaws, and their legal requirements are less stringent than those that apply to corporations. Hence a Limited Partnership must have a Limited Partnership Agreement. A “right of first refusal” clause in a limited partnership agreement allows the limited partnership or the other partners to purchase a partnership interest at a predetermined price before it is offered to third parties. For instance, the Limited Partnership Agreement may stipulate that an employee-partner sell his partnership interest back to the Limited Partnership or the other partners if he passes away, is incapacitated, or quits working for the Limited Partnership.
Pros and cons of LPA
The following are LPA’s benefits and drawbacks:
- You gain access to the general partners’ skills and expertise as well as the financial resources of the limited partners.
- Limited partners’ financial liability is capped to the amount of their investment.
- Investors do not influence management’s decision-making.
- Retirement of limited partners has no impact on management.
- Taxation is simpler; there is only one tax.
- General partners are liable for all firm debt indefinitely.
- Limited partners are prohibited from making company decisions.
- General partnerships involve less compliance and paperwork.
- Limited partners may be held responsible for costs incurred as a result of their conduct.
How to form a limited partnership agreement?
A limited partnership agreement in business is a contract that specifies a partnership’s parameters, including what it does, how it functions, and how the partners can collaborate. A crucial element is the partners’ obligations and rights. A comprehensive agreement can be prepared as follows
- Include basic information – Basic information must be included in the LP structure, including the business purpose of the limited partnership, the period of existence, the capital contributions of the partners, the distribution of profits and losses, etc.
- Define roles and responsibilities – The General Partner’s responsibilities and powers, as well as their Limitations, employee hiring and firing, partner compensation, bonus clauses, and clauses requiring the consent of the limited partners, should be included in a limited partnership agreement.
- Mention voting rights – Limited partnership partners determine the voting rights of limited partners. They may limit the limited partners’ ability to vote on some issues or grant them the right to vote on all business-related issues. Additionally, general partners determine how much influence a limited partner’s vote has. The operational agreement of the partnership should specify the conditions of voting rights.
- Split profit and loss – A limited partnership agreement should specify the profit or loss sharing percentages (%) and how they will be distributed among the partners. The methods of calculating profit-sharing ratios at the time of admission of a new partner and retirement of an existing partner should be mentioned in the agreement.
- Withdrawal and termination – The terms and conditions of withdrawal of a partner from the limited partnership and the termination of the firm as a whole should be mentioned in a limited partnership agreement. This would eliminate the dispute between partners at the time of withdrawal and termination.
An important consideration of LPA
The following factors are taken into consideration in the preparation of LPA
- Duration – A fund’s term, or the period from the day it starts operating until it is dissolved, typically lasts between 10 and 12 years. Shorter terms may apply to smaller or more recent funds because they have less capital to invest. To increase the value of the remaining assets at the end of the term, the majority of funds allow the term to be extended by two additional one-year periods. Thus the duration of the firm is a crucial source to be considered while preparing the limited partnership agreement.
- Determine your firm’s alignment – The topic of aligning interests has typically been centered on the performance fee model and the components of a fund’s distribution waterfall, which include the management fee, the preferred return, the carry model, and the carry percentage, for many organizations in the sector. Together, these components aim to align the general partner’s interests with those of its limited partners by rewarding the alpha return and providing incentives for the manager to outperform a predetermined benchmark return. However, other crucial LPA mechanisms aim to assure continued alignment, such as General Partner obligations and non-economic clauses (such as general partner removal).
- Aim for the upside and prepare for the downside – Investors frequently weigh the prospective risks and rewards of a given venture. The possibility that a security’s value may improve is known as upside potential, in contrast to downside risk. The upside risk and the downside risk are not distinguished by conventional performance measurements. Returns that are below a goal rate or a benchmark are used to determine downside risk. While drafting an LPA we should aim for the upside risk and prepare for the downside risk.
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