For General Partners (GPs) at venture firms, it’s easy for the excitement of identifying companies and building relationships with investors to eclipse the less thrilling aspects of the field, like the nuances of a fund’s governing documents and fund administration. Building a portfolio around your thesis is understandably more rewarding than reviewing distribution clauses.
If you're avoiding that kind of bureaucratic work, we don’t blame you — as a GP, you probably shouldn't waste time managing the minutiae. Still, you can't completely ignore the structure and operations of your firm. The best option is often to outsource those duties to specialized third-parties, such as law firms or fund administrators.
In late June, we sat down with two such third-party partners as part of our ongoing Roundtable event series. Scott Kitchens, a Partner at the law firm Cole-Frieman & Mallon, and Nick Pasco, a Managing Partner at HC Global Fund Services, joined us to discuss the kinds of legal and administrative considerations that GPs, in their focus on building companies, might overlook. Their advice is especially important today, as the market pivots in a new direction.
In good times, the granular details of what to do if things go south between a GP and an LP might not seem so important. LPs are funding capital calls, GPs are distributing money back to investors, and the waters are still. But, as the past few months have made clear, good times don't last forever. And when they end, the protocol for how to respond needs to be transparently documented.
Here’s an example: many boilerplate agreements allow a GP to enforce “any legal remedy under applicable law” against an LP if the LP defaults on a capital call, but include little specificity about what those legal remedies encompass. If the GP attempts to enforce what it believes is a legal remedy against the LP, "The first thing the LP will almost universally say is, 'This is not a legal remedy, you can't do this under applicable law,'" says Kitchens. “Now instead of being focused on how to resolve the default, you're arguing about whether the GP is attempting to enforce a valid legal remedy. That’s not a good use of a GP's time, or its legal fees — it's just not where you want to be."
Instead, the agreement should explicitly detail the remedies a GP has at its disposal and preempt any disagreements about how a GP can address an LP default . "Clients ask me, 'Why do I need this [long LP agreement]? I just need to charge a management fee, I need to invest in startup companies, and I need to earn a carry. Why do we need 70 pages of documents to do that?’” says Kitchens. "The devil is in the details; we want to make sure everyone is in agreement - not just in the good times, but in the bad times."
In buoyant markets, LPs are less likely to ask for special favors, like skipping this quarter's capital call or backing out of their commitment altogether. In down markets, this relationship can be a bit more complex, and GPs need to understand how to manage LPs that can't, or won't, make good on their obligations.
In your fund’s early stages — when your investor base consists of your uncle and some old college friends — working informally with LPs can occasionally work out. But as your fund becomes more established, the rules must be straightforward and consistent for all involved.
"Treat all LPs fairly and don't favor certain LPs favors at the expense of other LPs," says Kitchens. Legally speaking, this means enforcing every LP agreement with equal measure. Such equitable treatment is the golden rule of fund management. Not following it — or not carving out exceptions in a legal way — can get managers into trouble.
For example: If, in the middle of your fund's life, a college friend who was one of your first investors can't make their contribution, your social obligation to your friend is, unfortunately, trumped by your legal obligations to other investors. Now, this doesn't mean you have to bankrupt your friend. There are palatable ways to navigate such circumstances, such as allowing another investor to buy out your friend's share - just as long as you offer the same opportunity to every other LP. Such an approach would let your friend out of their commitment without disadvantaging other investors.
Side letters - which contain special conditions for certain investors - make for an important exception to this golden rule. However, fund managers should be wary of Most-Favored Nation (MFN) clauses, which grant certain investors the right to review and “opt-in” to terms granted to others in their side letters. Granting MFNs to more than a handful of investors can snowball into a huge headache to administer.
For startups, bear markets come with the distinct possibility - even probability - of tanking valuations. In such times, valuations are more heavily scrutinized by investors and auditors. And when that happens, back-of-the-napkin math won't cut it. Instead, as with crafting LP agreements, your firm's valuation policy and documentation needs to be crystal clear and applied consistently across all portfolio companies, whether those companies risk losing 9% of their valuation or 90%.
Additionally, when valuations go down, GPs should generally resist the temptation to cash-in early through in-kind distributions before revaluing the fund’s portfolio. As with the golden rule to treat LPs equally and fairly, GPs must also remember that their own interests are secondary to their investors’, and that this subservience is baked into the fabric of the LP-GP relationship. A good rule of thumb is to always ask, “Is this action or idea in the best interests of my LPs or in my (the GP’s) best interest?” If it isn’t (or is even questionable), you would be wise as a GP to reconsider.
Failing to delineate all of your legal remedies against an LP, doling out favors to certain LPs, taking a distribution early before marking down the fund’s portfolio — these issues arise with surprising frequency, specifically when a GP tries to wear every hat. Instead, it’s usually in a GP’s best interest to delegate such tasks to specialists who think about them day in, day out.
One straightforward reason for this is basic math: Hiring a third-party fund admin, for example, can be written off as an expense to the fund, rather than being charged against the GP’s management fee.
Hiring a third-party admin also brings a new degree of credibility to your firm, says Pasco. Such credibility-by-association is especially important early on, when a firm's reputation is still in development. Perhaps most importantly, letting others take over the grunt work of fund administration and legal oversight lets GPs do more of what they enjoy and what investors have entrusted them to do with their capital: Invest in amazing companies.