This piece is part of an ongoing series about how to break into early-stage startup investing, and laying the groundwork to launching a venture fund. Start from the beginning by reading the first foundation article here.
If you’re getting started as an early-stage investor in your own local startup ecosystem, consider becoming a Founder Institute program leader.
A business's operations determine how smoothly it runs, and like most new businesses, setting up an investment fund has many intricate moving parts. Besides the core business of making bets on the right companies to deliver big returns, there are the necessary reporting duties and legal disclosures, as well as the checks and balances put in place to ensure protection for entrepreneurs and fiduciary obligations to investors. Establishing the strong operational foundation for a new fund will yield a company that builds credibility with all those involved, draws the attention of credible investors, and covers all of its basic obligations.
It officially starts with a name.
Credibility and trust are among two of the most important components for a newly launched venture fund, but both are hard to establish. The name of your fund won't ultimately be the thing that makes or breaks you, but you should give some careful consideration to the name: with respect to your overall investment thesis, the keyword strength and website domain availability of prospective names, and how you want to be perceived by both investors and startup founders in the market.
As a newly launching venture fund, a good jumping-off point for naming will be to look at the naming conventions of today's successfully running funds. While Andreessen Horowitz is a tounge twister to anyone who's never heard of it, the Sequoia and Benchmark Capitals of the world show how even a simple noun can confer real meaning in a name.
With a name in place, it’s time to start building out your basic branding based on your already built strategy. This would include who your fund is designed to support, why you are launching it, and the long-term vision you have over the next decade. Once you are branded, from here you must launch a basic website, get some letterhead, a custom email domain, and you’re in business online. Next, and quite possibly the most important initial operational challenge, will be to define the team and everyone’s responsibilities.
Defining Operational Roles & Responsibilities
On paper, determining who does what and who will sit on necessary boards is a simple task. This process is akin to the same level of simplicity you find when having to build out a table seating arrangement. At the top, many VC funds have one or two partners. The decision making stems down from here, can be collaborated on by a board, and is disseminated downward until a task is executed and reported on.
The following is a basic list of the initial roles necessary for a fund’s operations, some of which can be multitasked:
- Build a board of directors
- Build a board of advisors
- Select who is in charge of compliance
- Select who is in charge of operations
- Select a law firm, or bring in a lawyer
- Select an outside accounting firm, or bring in an accountant/CFO
Once these roles are determined, it’s time to ensure that everyone knows what they own. There may be aspects of your fund that dictate how much involvement occurs by which partners, directors, or advisors. For example, some funds are relatively hands-on with LPs, and others are more hands-off. If you develop a board of advisors, at times it makes sense to offer support to the entrepreneurs that the fund invests in. These elements don’t have to be laid out on paper - but eventually, it will be a discussion point when startups seek out your financing.
Do not allow a chokepoint to occur on reviewing pitches and proposals. As a fund, there will be near countless pitches, and the more accessible you make the process, the more you’ll receive. Build a simple process where others can get into the mix and share their thoughts, attend pitching and networking events, and coffee meetings are all but expected.
Understand the Overhead
Once the operations roles have been clearly laid out, you need determine how much it will cost to really get this work done. Even if the fund starts off as a part-time role, physical space is important. This is especially true if offering a more hands-on advisory role to entrepreneurs, or having some form of incubation or short program to kick off the relationship. You will likely need to:
- Identify office space
- Early expenditures covered by the closed fund
- Cost of any initial new hires
- Management fees for the fund
- Costs of website, marketing, PR, industry events, etc.
With projected operations in check, the next step is to legalize. For some additional funding considerations like payouts, carried interest, and management fees, just the final section, "Establishing Payouts & Operational Payments."
Legalizing the Fund
Before any real legal work begins, you need to find appropriate legal support. This can come in the form of a law firm, an independent lawyer, or hiring general council. As a newly launched fund, it’s far less common to have general council on staff, as the overhead can be an unnecessary added cost, and the amount of legal work needed rarely be justifies a full-time employee initially. While finding outside council is common, it is also critically important that your legal representation have the relevant startup and venture fund experience.
A lawyer or law firm should have some of the following:
- They have worked with startups
- They have M&A experience
- They can connect you to entrepreneurs
- They can connect you to investors
- Bonus points if they will differ their fee until the initial fund closes
If a lawyer can connect you with the right people, that in itself nearly repays their associated overhead cost. At a minimum, though, they do need prior experience working with other startups as well as investors.
Legal Paperwork & Documentation
Not all legal paperwork needs a lawyer, but having one look everything over is always highly advisable. To legalize the fund, it usually needs to be formed as a limited partnership (LP) or as a limited liability partnership (LLP). The differences between an LP and LLP are focused on how much involvement your investors will have within the management of the fund.
A limited partnership (LP) typically leads to a hands-off approach for investors, leaving the general partners to manage the fund. A limited liability partnership allows all investors to also be general partners, which grants them the ability to be hands-on in the operations and management of the fund. Lastly, an LLP typically requires the support of a lawyer, where as an LP can be a bit more DIY if desired.
With the legal foundation set, now is the time to work with a lawyer to ensure you have all the necessary legal paperwork available. This can be anything from the articles of association to the limited partnership agreement, through to the private placement memorandum.
A private placement memorandum, often referred to as an offering memo or simply as the "PPM", is the specific legal documentation needed for prospective investors to push capital into the fund. This is different from a Summary Prospectus, (often delivered at the time of sale of a mutual fund), but shares similar goals.
A PPM will cover:
- Investment risks
- Terms of the investment
- Details about the fund
- Nature and character of the fund
Both documents must meet the anti-fraud provisions of federal securities law.
Lastly, a law firm will be able to also reduce risk to the fund by ensuring it meets necessary compliance requirements. This can be anything from ensuring there is a financial system in place to track investments and incoming cash flow, an employee handbook and policy, and other risk mitigation solutions. When there is a lot of money on the line, especially for your investors, having these kinds of legal documents on-hand when requested can add enormous credibility to the fund.
Establishing Payouts & Operations Payments
The vision and the mission of a venture capital fund are important, but at the end of the day, the biggest goal is bringing positive returns to the fund's investors. When building out the operational overhead, it’s important to bring in a lawyer to draft up documents that plainly layout bonuses, benefits, and payouts. For starters, you should determine, what, if any, the management fee will be.
It’s common for funds to take around two percent of the fund's total amount as a management fee. In other cases, some budding VC funds have even opted to withhold taking any management fee, as a way to get the fund off the ground and for initial investors to buy in. In addition to the 2%, there is also a withholding of between 20% and 30% of the profits, known as the carried interest. The larger percent typically comes from funds with highly specialized backgrounds, where the higher management fees can correlate to relatively higher-risk portfolios.
Beyond the management fee, working with a lawyer to solidify bonuses, benefits, and other payouts is also very important. This should define what the payouts would look like if there are more than one founder, how employees get paid and receive bonuses, and any other contractor agreements. An experienced lawyer will also be able to help you determine what documents are needed between operations and payouts for investors.
If you’re getting started as an early-stage investor in your own local startup ecosystem, visit fi.co/lead to learn more about becoming a Founder Institute program leader.
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