How a venture fund works

Who does what in a venture fund?

Investors are limited partners (LPs) and supply almost all the money. The manager is the general partner (GP): it picks the companies, sits on boards and sells.

A limited partner's liability is limited to what they've agreed to contribute, and the general partner's is unlimited. The price of that protection is that limited partners must stay passive and can't manage the business.1 ESVCLPs must be limited partnerships, which is why the structure is standard here.2

The limited partnership agreement (LPA) sets the fees, carry, term and default remedies. The information memorandum summarises it, but the LPA is what binds your client. Many funds also have an advisory committee of larger LPs that signs off on conflicts and valuation questions.

Some Australian funds run a unit trust alongside the partnership for investors who don't suit the partnership's rules. ESVCLP, VCLP and unit trusts covers the differences.

What's the difference between a commitment and a capital call?

A commitment is the total your client agrees to put in. A capital call is the manager drawing part of it, when it has an investment to make or fees to pay. Calls are typically spread over three to five years. A fund that calls about 25% a year, for instance, has drawn the whole commitment in roughly four years.

Each call comes with a notice and a due date. ILPA treats ten business days as the standard notice period and encourages managers to give more where they can.3

What happens if a client misses a capital call?

The LPA decides, and the remedies are deliberately harsh. Common ones let the manager charge penalty interest on the unpaid amount, withhold the client's distributions, call the shortfall from the other investors, remove the client's voting rights, and force a sale of the client's interest at a discount (for example 50%) or cut their capital account by 50% to 100%.4

Those last two can wipe out most or all of what the client has already paid in.4 Some LPAs allow a short cure period, but it's safer to treat an uncalled commitment as a debt that's coming and keep liquid money aside for it. How much to allocate covers pacing commitments so calls don't bunch up.

How long is money locked up in a venture fund?

Plan on ten years at least, and often twelve or more, across three overlapping phases.

1. The investment period, usually the first three to five years. The fund backs new companies and calls most of its capital.
2. Follow-on and growth. The fund puts reserved money into the companies that are working, through their next rounds.
3. Harvest. Companies are sold or listed and the fund pays the proceeds out. This is mostly the back half of the fund.

Most funds have a ten-year term with an option to extend, often in one-year steps. The LPA sets how many extensions are allowed and who approves each one: the manager, the investors or an advisory committee. There's no reliable way out early. An investor can sometimes sell its interest to a secondary buyer, usually at a discount and only with the manager's consent.

Why do venture funds look bad in the first few years?

Costs arrive first and gains last. Fees are charged from year one and failures get written down early, while winners take years to sell. Your client's cumulative cash position dips below zero for several years, then climbs: the J-curve.

A paper loss in year three doesn't mean a fund is doing badly, and it's worth telling clients before the first statements arrive. How venture returns work explains why a few winners carry the fund.

How do management fees and carried interest work?

A typical management fee is 2% of committed capital a year, about 20% of the commitment over ten years. Some funds step it down after the investment period. Fees are paid from capital calls, so part of the commitment never reaches a company.

Carry, typically 20% of profits, is usually paid only after investors get their money back plus a hurdle, often 8% a year. Many funds then give the manager most or all of the next slice of profit (the catch-up) until it has 20% of the total. With a full catch-up, the hurdle changes when carry is paid, not how much the manager gets from a good fund.

Two more LPA terms to check. Whole-fund carry (rather than deal by deal) stops early winners paying the manager before losers are counted. A clawback makes the manager hand back carry if later losses mean it was overpaid.

A worked waterfall in dollars

Take a client who commits $250,000 on typical terms. About $50,000 goes on fees over ten years and $200,000 into companies. If the companies return three times that, $600,000 comes back to the client's share of the fund, a $350,000 profit.

Illustrative. Simplified to a single payout at the end. The manager's $70,000 is 20% of the $350,000 profit.

The companies made 3× on the money invested; fees and carry bring your client's result down to 2.12× on the commitment.

At 1× gross your client gets back 80 cents in the dollar, because the fees are gone. Break-even needs about 1.25× on invested money. Low multiples are common in venture, so this is the case to show clients before they commit.

How does money come back to investors?

Mostly as cash after a company is sold or its listed shares are sold, paid through the waterfall. Some LPAs let the fund recycle early proceeds into new investments, which delays cash coming back.

A fund can also hand out shares instead of cash, usually after a portfolio company lists (a distribution in specie). Your client then holds the listed shares directly and decides when to sell. Check whether the LPA allows this and how the shares are valued, and confirm the tax treatment with the client's tax adviser, particularly for an ESVCLP.

Each distribution comes with a notice, and the fund sends an annual tax statement. ESVCLP gains are taxed differently; see The ESVCLP guide and After your client commits.

Which numbers will your client see in fund reports?

DPI (cash paid back divided by money paid in), TVPI (DPI plus the manager's valuation of what's still held) and IRR (the annualised return, allowing for timing).

Early on, DPI is near zero and TVPI is mostly the manager's estimate. Among 2021-vintage funds on Carta, just 9% had paid anything back after three years.5 Reading a fund report covers each measure and how unlisted companies are valued.

Frequently asked questions

Talk to us about Fund III

Tall Order is a Melbourne seed fund. Fund III is a registered ESVCLP for wholesale investors. Justine Lum, our Head of IR, works with advisers and their clients.

Contact Justine Fund III