There are many kinds of venture capital firms. Some are narrowly focused and only invest in particularly industries or geographies. Most of them prefer to invest in start-ups at different stages of their development, which brings with it different degrees of risk and, consequently, rewards. The most notable VC firms have invested in powerhouses including Google, Amazon and Airbnb. While different, VC firms are generally structured in a similar fashion.
How are venture capital firms structured?
The legal structure that underpins a VC firm may appear complex, but when broken down into its elemental components it is relatively easy to understand.
Firms are typically incorporated as limited liability companies, or LLCs. LLCs limit the liability of owners, by creating separation between the owners and the business. LLCs are also “pass through” entities—meaning that all profits pass through the company to the owners. Owners pay personal income tax on those profits. But the company does not pay corporate income tax.
When the VC firm sets out to raise capital from institutional investors like pensions, endowments, foundations and family offices, the money is invested into a fund called a partnership fund. That is structured as a limited partnership. Like LLCs, limited partnerships are pass-through entities.
The institutional investors become limited partners, or LPs, in the partnership fund, which is usually one of several that the VC firm launches over time. By tradition, they are identified by Roman numerals—I, II, III, IV, or V, for example—which serves to differentiate them from one another and also helps to identify the year in which they are launched. The LPs, it’s important to note, are entirely passive and have no say in which startups the fund invests in or how the fund is managed.
A General Partner, or GP, manages the fund and serves to protect the VC firm, which may otherwise be on the hook for the liability of the debt that the limited partnership may incur through its investment. The role of GP is usually distributed among venture capital firm executives.
How limited partnerships work for VCs
The limited partnership agreement, or LPA, is the key document for any VC partnership. It spells out exactly what rights and obligations the LPs and GPs have within the limited partnership.
Specifically, the LPA will lay out exactly how much of the partnership is owned by the GP and the LPs—usually a function of how much capital they each contributed. It will also specify how either a GP or LP can be removed from the partnership. An LPA also details how the partnership’s profits are distributed and the procedures for voting.
Perhaps the most important aspect of an LPA is just having one. That’s because in the absence of such agreement, rules and regulations of state laws would kick in, to the detriment of one or more parties. The LPA can be and often is modified due to shifting circumstances typically, but not always, with agreement of most parties.
Venture capital firm roles and compensation
There are a variety of positions at a VC firm. Some crunch numbers, some research industries, and others drum up capital from investors or search for investment opportunities. And, of course, there are those who decide and execute on deals. No two organizations are the same, but in general positions and responsibilities tend to be similar.
- General Partner/Managing Director. These are the top positions at a VC firm. They spearhead raising funds from institutions, selecting investments and making the major personnel and other decisions at the firm. They are also the most highly compensated executives at the firm.
- Venture Partner. Such partners typically have part-time or temporary positions at the firm. They serve on the boards of portfolio companies and provide experience or specialized expertise. Often, they are either retired former General Partners/Managing Directors or on their way to becoming one.
- Principals. Working under General Partners/Managing Directors, principals effectively serve as middle management for the firm. They may not be making big investment choices or management decisions but they may certainly be in a position to influence those who do.
- Associates. This is in many ways a behind-the-scenes role. Associates perform the analysis that leads to investment decisions and frequently identify opportunities that get sent up the management chain for their superiors to assess. When principals or managing directors identify opportunities, associates are the ones who perform due diligence.
- Analysts. These are usually recent college graduates who do much of the labor intensive number-crunching that underpins decision-making at the firm.
How VC compensation works
Venture capital can be credited with generating phenomenal amounts of wealth—not least for the VC firms themselves. That’s because of the compensation structure that defines the business.
The GP typically contributes just 1% of the capital to a partnership fund. It reaps 20% of the profits. This is known as a performance or incentive fee or, in VC-speak, “carried interest.”
The carried interest is in addition to a typical annual management fee of 2 percent that is supposed to pay for the hunt for prospects, research, and to pay GP executives and staff until the partnership can exit its investments and wind down.
The bottom line
The interaction of capital from pensions, endowments, foundations and other institutions, with the asset allocation expertise of VC firms has generated enormous amounts of wealth. Over the years, the investment activities of VC firms have served to embed names like Sequoia, Silver Lake, and Kleiner Perkins in the history of American capitalism. With their impressive track records, these firms in many ways epitomize the risk-embracing ethos that has come to define the venture capital industry.