Fund Structures for Angel Funds and Early Stage/Seed Venture Funds
As the it becomes increasingly obvious that the traditional Venture Capital model is broken, and as more angels start funds, there is a growing interest in the best fund structure for new angel funds and similar early stage/seed funds. This post describes what I believe is the optimum structure for today's early stage equity funds.
There are two common fund structures for equity funds: limited partnerships and open-ended corporate structures (often called evergreen funds). Traditional, institutionally backed Venture Capital funds are virtually all limited partnerships.
In the past few years, most other new equity funds including angel funds, non-institutionally back venture funds, seed and early stage funds and many mutual funds have predominately been open-ended, corporate structures. There are several reasons for the recent increase in popularity of the 'corporate' fund structure.
Traditional Institutionally Backed Venture Funds – Limited Partnerships
Institutionally backed Venture Capital funds operate differently from other funds in several ways. First, the institutions don’t advance all of the capital at once. When you hear that a Venture Capital fund has raised $50 million, their institutional backers have committed $50 million but may have only advanced them $10 million. As the fund manager makes investments, they make ‘capital calls’ or ‘draw downs’ on the institutions to advance more capital. Interestingly, the VCs get to charge their management fee, typically around 2.5%, on the full $50 million, even from the outset.
This fund structure worked well in the past because the institutions used to be reliable in contributing the additional cash when the fund managers were ready to deploy it. The original thinking behind this was to allow the institutions to invest their capital elsewhere, making their overall returns better than if they advanced the entire amount to the venture fund manager who would still have much of it in cash, even several years after the fund was launched.
This fund structure means that the traditional VC only gets to invest the capital once. They make an investment and when there is an exit, they distribute all of the proceeds, less the fund company’s 20% performance fee (or carry) and expenses back to their institutional limited partners. This is a fundamental characteristic of the limited partnership fund structure.
An interesting effect of this mechanism is that venture fund managers cannot really afford to invest in low or medium risk opportunities that might deliver a 3 or 5 times return in three years or so. To succeed, they need to invest in the highest return opportunities, ones that they hope will return 10x or 100x over 7 to 10 years - the moonshots.
Another very important distinction in comparing funds is to remember that virtually all institutions are tax exempt. This makes the limited partnership structure ideal for those fund investors. If the fund structure incurred any tax at all, it would be a negative for most institutions.
VC Funds High Early Costs and Large Early Losses - The J-Curve
One characteristic of the limited partnership fund structure is relatively high up-front losses. Charging 2.5% on a ‘$50 million fund’ that actually only has $10 million in it means that the real, cash on cash, expense ratio is more like five times 2.5% or something around 12.5% per year. Additionally, because the managers are planning for liquidity events in the 7 to 10 year timeframe, these losses can be very significant during the early years before the fund has successful exits.
The types of high-risk high-return investments that the traditional Venture Capital funds have to make also result in significant early capital losses. VC fund managers often say that "lemons ripen faster than plums." This well known effect with equity funds is called the J-curve. The limited partnership structure allows the fund to transfer these high early costs, and large early losses, directly back to the investors.
In summary, because of the ‘use the capital once and return it’ structure, high up-front losses and tax exempt investors, the best fund structure for an institutionally backed venture fund has traditionally been a limited partnership.
Capital Calls Stopped Working During the 2008 Downturn
During the economic downturn of 2008/9, Venture Capital funds had huge problems with their capital calls. More than one fund manager told me that over half of their limited partners (LPs) were unwilling, or unable, to live up to their commitments. There has always been the occasional limited partner who didn't honor their capital calls, but there has never been a time before when half of the LPs wouldn't participate.
This creates a very difficult ethical dilemma for funds. In a challenging economy, funds often need to make capital calls to support their existing portfolio of investments. If a fund can't provide additional funds, or 'pay to play' as it's called in the industry, they are often washed out by the other funds who can provide additional capital, or wiped out when the investee companies run out of runway.
Fund managers now realize that the only fair way to treat LPs who don't honor their capital calls is to wipe them out. If they are treated any less harshly, it's probably unfair to the LPs who do live up to their obligations. Many VC fund managers now realize their structures haven't really been fair to their best investors. It will be interesting to see how this practice in limited partnership fund structures evolves over the next decade or two.
The reduced reliability of capital calls is one of the reasons that new funds are increasingly open-ended structures.
Raising All the Money at the Outset Isn't Workable
The challenges with capital calls led some funds to raise all of the cash at the outset. From the investors’ perspective, that was the worst of all worlds: they were paying high fees for fund managers to manage their cash and those funds did not perform well – at least for the first several years (because they were predominantly in cash).
It was also a significant disadvantage to the fund managers because it has become popular to build in a ‘hurdle rate’ return which has to be achieved before the fund managers can earn any of their carry. For example, a typical management performance incentive, or carry, is 20% of the gains in the fund above an 8% compounded return. If most of the fund's capital is in cash for the first few years, it makes it much more difficult to hit the hurdle return and start to earn 20% of the gains.
The Open Ended Fund Structure Solves All of These Problems
The open ended, corporate fund structure allows the fund managers to manage their non-performing cash balance by raising capital only as they find opportunities to deploy it. This provides the managers a much better opportunity to maximize their returns and earn a share of the gains above the hurdle rate.
The open ended fund structure also allows the fund managers to reinvest capital and gains they receive from successful exits. Fund managers can consider investments that might only provide a 2 or 3x return. These can still be excellent investments if the risk is low or the exit horizon is only a couple of years. This is a significant advantage because it provides access to a much wider range of investment opportunities.
In most western countries today, tax integration is fully implemented. This is a very complex area, but the simple explanation is that it means that the overall tax rate on capital gains in either corporate funds or limited partnerships will be almost identical. With full tax integration, the tax rate for either type of fund will be the same as if the investor made the investment individually. In other words, the goal of an integrated tax system is to make the tax the same no matter how you structure the fund or make the investment.
Retirement Savings Plans
The Canadian term for a registered retirement savings plan is an RRSP. Most countries have something similar. Some high net worth investors now have many millions in their retirement funds. In most jurisdictions, it’s a relatively simple matter to invest in a corporate structure from a registered retirement savings plan, but I believe that in many places it’s relatively difficult to get a limited partnership to qualify as an eligible investment. Two ways limited partnerships can qualify is if the units are listed on a stock exchange or if they qualify as a ‘small business investment limited partnership.’
Today's Angel and Seed Funds Have Lower Early Losses
Technology company exits are happening much earlier than in previous decades - often just two or three years from startup. These early exits mean that many new angel funds and early stage funds are not incurring any significant up front losses. If the funds are not expecting to have significant losses, it eliminates one of the biggest potential benefits of the limited partnership structure. This is because there are no significant losses to distribute and because the fund would have taken advantage of the losses pretty quickly as their earlier exits started to be realized.
More Familiar Structure
Many high net worth investors are not familiar with the mechanics of limited partnerships, but almost all are familiar with how corporations work. Regardless of their familiarity, a corporate structure is much simpler for the investors because they won’t have to make an annual tax filing to include the gains or losses every year like they would in with a limited partnership.
Simpler Accounting and Lower Costs
The accounting and tax filings for a corporation are much simpler than for a limited partnership. This keeps direct expenses much lower, but it also significantly reduces the indirect costs of communicating with investors regarding their questions about the annual tax filings associated with a limited partnership.
Some fund managers have tried to raise limited partnership capital in a regular series of funds to match their fund raising with their ability to invest. This often creates a series of funds with names like fund name I, fund name II, fund name III, etc. The challenge with this series of funds structure is that separate accounting has to be done for each of the funds. If the funds are small, or medium sized, the accounting costs and other overheads make this very uneconomical.
Simpler Fund Structure for Management Performance or Carry
A corporate fund structure also provides a simpler way to structure the management performance incentive, or ‘carry’. This participation can be structured as shares in the fund. This mechanism allows the managers to receive a very favorable tax treatment on their share of the gains.
Tax Free Switching Between Funds and Cross Fund Tax Deferral
A big advantage of the corporate fund structure is that managers can set up multiple funds under one corporate structure by using different classes of shares. This allows the investors to switch between funds without triggering a tax payment. A multi-fund structure like this also allows the losses in one fund to shelter the gains in another.
The question of whether a corporate structure or a limited partnership is more efficient from a tax perspective is complicated. It depends significantly on the taxability of the investor.
If the fund really is an equity investor, it should be reasonably easy to ensure the fund is not a ‘trader’ and therefore will enjoy capital gains tax treatment at the fund level.
Taxation of limited partnerships is more complicated than it first appears. Gains can be income, dividends or capital gains depending on a number of factors.
Another advantage of the corporate fund structure is that the fund can be structured so taxable and non-taxable shareholders (for example in RRSPs) can have different classes of shares. This allows the dividends to be 'streamed' to the taxable and non-taxable shareholders differently, producing a significant decrease in overall tax and an enhancement in fund returns for all shareholders.
I've personally spent many tens of hours, and invested many thousands of dollars, with tax accountants and tax lawyers debating the relative tax efficiency of the two popular fund structures. My current understanding is that in Canada, the corporate structure has tax advantage if different classes of shares are used to stream the gains to taxable and non-taxable investors. If only one class of shares is used, the tax efficiency of both fund structures is equal. I've spent less time on the tax question in the US and would be grateful to anyone who'd contribute a comment below based on their understanding.
The Only Challenge with Open Ended Funds - Valuation
The only real disadvantage of the open ended, or evergreen, fund structures is that the entire fund has to be valued periodically. If the fund is evergreen, or perpetual, investors need a mechanism to get their capital back. Most open ended funds do this by providing a redemption function. When an investor wants their money back, the fund redeems them (exchanges the shares for cash) at the 'net asset value' of the fund.
A decade ago, some fund managers would have considered this unworkable due to the inherent challenges of valuing a portfolio of illiquid investments in early stage companies. Fortunately, the national venture capital associations in America and Europe both developed, and published, excellent valuation methodologies in the early 2000s. In America, the FASB (which governs accounting standards) issued FAS157 and the IRS introduced the 409a requirement, both of which required the fair market valuation of private company equity. In the past decade the methodology for valuing private companies has evolved to the point where both investors and fund managers should be comfortable with valuations and share redemptions.
For angel funds and early stage, or seed venture funds, the corporate, or open-ended, fund structure has several advantages. It is simpler, easier to account for, has lower expenses and produces higher returns. The tax advantages depend on the investor and jurisdiction; but the corporate structure will usually be the most tax efficient due to its ability to 'stream' the gains differently to taxable and non-taxable shareholders.