Setting the Market Standards (Part 2)
Joseph W. Bartlett, Founder of VC Experts.com
Part 2 of a 4 Part series.
3 and Part
I have spent a number of years negotiating the terms of
commingled, private equity venture capital and buyout investment
vehicles. Distressingly, a large proportion of my time has been taken
up debating whether a given provision is "market," or "industry
standard," the notion being that the "market term should prevail". The
goal of these debates is for one side to bully the opponent into
admitting that the proponent's experience is more extensive. If the
opponent concedes, the discussion is over.
The problem is that discussions of this nature are often a
dispute without end, as one party contests that a certain term is
"standard", while the other side argues it isn't. Moreover, both sets
of lawyers desperately want to win, regardless of the importance of the
point, because a loss concedes that the other lawyer knows more.
Out of a personal desire to derail discussions of this sort in
the future, I have decided to take the bull by the horns. Since I may
be the oldest living active practitioner in this area, I have decided
to declare my version of the 'market standard' for a list of what I
believe to be the next commonly contested terms in the organizational
documents of venture and buyout funds. The list is
free from bias in the sense that I represent both sponsors and
investors on occasion, but neither side in this exercise. Moreover, the
source material I have used goes beyond the anecdotal, and is culled
from personal experience. While all judgments and accompanying
commentary are my own, the 'market standard' list is the product of:
- The controversial Mercer Report, by
- Other third-party information and data.
The following are, in no particular order, numbers 6-14 of the
29 questions and issues I have most frequently encountered in this
context and my view of the 'market standards'.
QUESTION: What is the initial percentage
of capital that the limited partners (LPs) must put up at the first
MARKET STANDARD: The 'market standard' is 5% of
capital, if anything. However, because many initial closings are "dry
closings," they are able to satisfy the Department of Labor's Plan
Asset Regulation and qualify as a Venture Capital Operating Company. In
these cases, no capital is called until the fund
lines up an investment. These funds have 'just-in-time' closings
because the later the capital is committed and the earlier the
investments are harvested, the greater the investors' IRR.
QUESTION: How long can the GP hold the
fund open for additional investors?
MARKET STANDARD: The 'market standard' is 6-9
months from the initial closing. The 'market standard' dictates that
subsequent investors pay the management fee as if they had been
admitted at the initial closing. This amounts to a late admission
charge. New investors pay interest at 8% on the capital component they
would have earned on investments, had they contributed capital at the
initial closing. Plus, they pay a contribution of sufficient capital to
true-up their capital accounts with those of the initial investors,
vis-à-vis any investment the fund has made in the interim.
The assets are not, however, "booked up" (meaning unrealized profits
and losses allocated to capital accounts) if the last closing occurs
within 6-9 months of the first closing.
QUESTION: What is the frequency and size
of subsequent capital calls?
MARKET STANDARD: The 'market standard' is
'just-in-time,' meaning on 10-30 days notice prior to the making of an
QUESTION: What is the penalty imposed on
the defaulting LP failing to meet capital calls?
MARKET STANDARD: There is no 'market standard'.
Draconian penalties are specified in partnership agreements generally (e.g.,
sacrifice of 50% of one's capital account) but no 'market standard'
exists because those penalties are never imposed. The parties typically
negotiate with a defaulting LP for some way of replacing the LPs
capital, against the background of potentially disastrous consequences
to the defaulter. Because the subject has not been litigated in any
case of consequence, no one has any idea if the proposed penalties
imposed on defaulting LPs would be enforced.
QUESTION: When are capital calls for new
investments no longer authorized? (Note: The capital call refers to the
end of the call or commitment period, during which the GP must use the
committed capital or lose it.)
MARKET STANDARD: The 'market standard' is 5-7
years, with 5-6 becoming increasingly popular.
QUESTION: May funds borrow in
anticipation of capital calls? For example, if there is a 30-day period
when an LP cannot be contacted and the GP has a chance at a
particularly juicy investment?
MARKET STANDARD: The 'market standard' is "Yes",
funds may be borrowed. Temporary borrowings of this sort, repaid as
soon as the capital call is honored, do not appear to create Unrelated
Business Taxable Income. Because of the UBTI issue, the only borrowings
allowed are temporary borrowings, but it is not entirely
clear that temporary borrowings do not create UBTI. Many
experts believe that a short-term borrowing is acceptable if the
borrowing does not produce investment income.
QUESTION: How soon after raising a fund
are the managers allowed to raise the next fund?
MARKET STANDARD: The 'market standard' is as
soon as the existing fund is 70% to 75% "committed". Committed funds
contributed and invested
Funds formally committed for investment
Funds "reserved" in the good faith opinion of the GP for follow on
Funds, if any, reserved for other purposes.
Therefore, once the fund is approximately 50% invested, the GP is often
out raising another fund. This is usually halfway through the
investment period or at the end of the fund's second year.
QUESTION: Regarding the distribution
policy, must the fund always distribute cash from investments as
harvested? Implied in this question is the issue whether the GP can
reinvest some portion of harvested proceeds from the sale of an
MARKET STANDARD: The 'market standard' is that
cash is distributed in sufficient amounts to enable LPs to pay taxes on
partnership income and gains by year end, at the highest federal and
state rates potentially assessable. In addition, the 'market standard'
is that, after a limited period of time and allowing for reserves for
contingencies and other potential liabilities, cash proceeds are to be
distributed promptly. Some experienced practitioners (e.g.,
Jonathan Axelrad at Wilson Sonsini) argue that some portion of
harvested proceeds should be available for reinvestment. The reasoning
is that, given the self-imposed requirement that capital be held back
for follow on investments, the nominal size of the fund is actually
much larger than the actual capital available for investment. The
consequences of not enlarging the capital invested are higher
management fees and larger partnership expenses, since expenses are
fixed and fees are variable based on capital commitments.
The 'market standard' solution, however, is that cash is returned to
the original contributors and they are at liberty then to reinvest in
the sponsors next fund. If so, the decision to reinvest harvested
proceeds is on an LP-by-LP basis rather than lodged in the GP. (Note:
Individual GPs may be strong in favor of reinvesting the proceeds from
harvested investments in view of their ability to postpone tax if the
proceeds are invested within 60 days under Section 1045 of the Internal
QUESTION: Regarding the distribution
policy, must the fund always distribute shares of securities to the
LP's as portfolio companies go public and the shares become liquid?
MARKET STANDARD: The 'market standard' is that a
GP in a venture capital fund will distribute securities once they
become liquid. However, the GP has discretion to hold back the stock
position if it has reasonable cause to believe that as a value added
investor it can further enhance the fortunes of the company. The
'market standard' is that the hold back period is limited to 1-2 years.
Since the stock is usually locked up contractually for 180 days post
the IPO, the hold back is often not of great economic concern to the