Legal Fund Formation (Part 2): Limited Partnership Agreements — LPAs

Photo by Patrick Tomasso

In this continued three-part series on legal fund formation, we will offer a thorough overview of the crucial legal paperwork necessary to establish your firm, with insights from the experienced professionals at Wilson Sonsini Goodrich & Rosati.

In this second segment, we will (A) highlight which sections of Limited Partner Agreement (“LPA”) are often negotiated, (B) outline the key terms covered in the LPA, and © share sample LPA documentation for reference. Please note that this information is specifically for emerging managers in venture capital, most lawyers prefer to use their own forms, Growth Vista Ventures is a fictional entity for purposes of this post, and the following information assumes venture capital fund formation of a Delaware fund and Delaware General Partner.

Frequently Negotiated LPA Terms

Among the many clauses and provisions in an LPA, the following five are often the most negotiated:

• General Partner Capital Commitment — While there is no legal requirement that the General Partner (“GP”) have any capital commitment, the General Partner Capital Commitment (“GP Commit”) is often negotiated in a fund’s LPA. It is customary for the GP to commit at least 1% of the aggregate capital commitments of the fund, which can be cash, cashless, or promissory notes. If the members of the GP are wealthy, the GP Commit can be 5–10%. If the GP Commit is not a high enough percentage where Limited Partners (“LPs”) feel that GPs have enough skin in the game, LPs may ask for more or require that it not be cashless. Many LPAs are written in a way that the GP Commit does not have to come through the GP entity; it may be called a “sponsor commitment” and may come through close GPs or members of team, e.g., sometimes the GP wants to count a spouse or spouse’s trust as part of their capital commitment.
• Investment Period — The Investment Period indicates the time period in which investments are made into new portfolio companies. This period is typically 4–6 years from one of three triggers: 1) initial closing, 2) final closing, or 3) initial call of capital.
• Limitations on Authority of General Partner — The Limitations on Authority of GP matter is actively negotiated. The GP can enter into a conflict transaction, however it cannot cause a related fund to buy securities from the fund or sell securities to a related fund. While the group of conflicts are generally not negotiated, there are specific ones that are negotiated, such as recycling capital, the percentage of the fund allocated into any one single investment, crypto investing, investments outside the US, pooled investment vehicles, and publicly traded securities.
• Management Fee — In terms of economics, the Management Fee is often a negotiated point. Even though standard rates are 2%, fluctuation such as 2.5% even decreasing over time may draw comments and requests to reduce. This one of the more material terms and is often negotiated.
• Fund Expenses — The Fund Expenses section is important, long, and often negotiated. Frequently, LPs prefer a cap on organizational expenses that the fund has to bear. Because it is not clear, from the SEC perspective, what the GP can charge to the fund, these sections become longer and longer. For example, the registration expenses of an investment advisor must now be a GP expense, although it was previously a fund expense. Expenses frequently commented on include investment advisor expense, travel, advertising, organizational expenses, etc.

Less-Contested LPA Terms

There are several other terms that can be minorly contentious based on the specific details:

• Admission of Partner — Admission of Partner refers to an open window period, typically 12-months, when investors may be admitted retroactively as if they came in to the initial closing; there is sometimes a minimum amount of capital that may be contributed and often a maximum amount of capital (in aggregate, not per individual), which is negotiable.
• Defaulting Limited Partner Positions — Defaulting Limited Partner Positions is a draconian term that details what happens to LPs who do not meet capital commitment, thereby defaulting on their LP position. While this is not often negotiated, it is typically at the discretion of the GP(s) which default penalties to use, including removing the LP, wiping out the LP’s interest, transferring the unfunded LP capital commitment, or suing the LP.
• Other Activities — The Other Activities section addresses potential conflicts of interest that might arise between the GP and LPs, including disclosure of other activities, potential conflicts of interest, and mechanisms to address conflicts. This section is typically not negotiated by experienced investors who understand that the GP(s) can pretty much do what they want to do. It is sometimes a sticking point if a GP wants to moonlight.
• Distributions — The Distributions section outlines how, when, and in what order profits from the fund’s investments are distributed to the LPs and GP. Most VC funds are using European waterfall where 100% of investors’ contributed capital must be returned before the GP can receive distribution of carried interest. With American waterfall, carry can be received on a deal by deal basis, even if capital has not been returned, which introduces clawback risks and other issues and complications, so not used often. Hurdles can be built into distributions, e.g. hard hurdles of 8% or soft hurdles. This section may be negotiated but is rarely implemented.
• Time Commitment & Key Person Events — This item details the level of commitment and involvement of significant or critical individuals (often senior members) of the GP team in managing the fund and the consequences of any changes to their involvement.
• Removal of General Partner — Similar to termination of the fund, the GP can be removed with cause and sometimes without cause with a lower percentage of LP agreement, eg 60% or 67%; this is negotiated in terms of whether there is cause and if no cause removal.
• Successor Fund — This section describes when the GP or its affiliates may form a successor fund, typically when the existing fund is “fully invested,” meaning capital has been allocated to all new deals, paying for and reserving for expenses, reserving for follow-on investments that collectively is at least 70%, usually 65%-80%. It exists because LPs want to make sure that if deal flow is coming in, it comes to the current fund in which they are invested and not elsewhere.
• Removal of Limited Partner & Withdraw Rights of Limited Partner — The Removal of LP & Withdraw Rights of LP section addresses the conditions and procedures under which LPs can be removed from the fund or can withdraw their commitment from the fund. This section ensures that there are defined mechanisms to address situations when an LP wishes to exit the fund or when their participation becomes untenable. While limited, the GP has a right to knock an LP out if needed for reputational reasons and began during the #MeToo movement.

Important Yet Not Negotiated LPA Terms

The following LPA terms are important but rarely negotiated:

• Capital Contributions — Capital Contributions refers to the timing of when capital is due subsequent to a capital call. The period of time is a minimum 10 calendar days to maximum 15 business days, and this section also specifies when default kicks in, if capital is not contributed in the time period specified in LPA. This matter is rarely negotiated.
• Term — While the term of the fund is something that needs to be represented in the deck, it is almost always the standard of 10-years from a specified date. The specified data is one of three triggers: 1) date of initial closing, 2) date of final closing, or 3) date of initial call of capital. Extensions of 1–3-years may be granted to the GP, then extensions beyond that with consent of LPs. This term is not frequently negotiated if within commonly accepted guidelines. Fund terms can be terminated early for cause, or, in the case of no-fault termination, 90% of LPs may consent to terminate the fund at any time, though it is quite difficult for 90% to agree.
• Allocations of Profits and Losses — The allocation of profit and losses, while a very important term, is not typically negotiated but rather generally accepted at 20%.
• General Partner Right & Authority — This item states that the GP(s) have the right and authority to manage the fund; it is a general statement, its inclusion is important, but it is not negotiated.
• Limited Partner Right & Authority — This item states the LP(s) do not have the right or authority to manage the fund, including no management or consent rights; it is a general statement, its inclusion is important, but it is not negotiated.
• Reporting — The requirement of financial reporting, including providing K1s to LPs, is important, however it is not usually negotiated unless someone requires an audit when not already specified.
• Limited Partner Advisory Committee — The Limited Partner Advisory Committee (“LPAC”) is not often negotiated. The LPAC is not a fiduciary but rather there to act as a monitor, vote on issues of conflict, and so forth. It is standard to have discretionary LPAC, the agreement never says who it is in, rather indicates that the GP has discretion to create an LPAC and invite participants of their choice.
• Limited Partner Transfer Provisions — The LP Transfer Provision is a long section that is not negotiated, and the default rule is that the GP must consent to every transfer.
• General Partner Clawback — The GP Clawback is an important provision that is not typically negotiated, specifying if the GP receives distributions in excess of what they should, the GPs must contribute to make LPs whole.
• Indemnification — Indemnification, while a very important term, is not typically negotiated but rather generally accepted as assets will be used to protect where necessary.

In wrapping up our second segment, we have delved deeply into the intricate landscape of LPAs. From shining a light on the most negotiated sections to offering a comprehensive overview of its pivotal terms, we hope this guide serves as a valuable touchstone. With the inclusion of sample LPA documentation, Link to sample, our aim is to equip you with practical insights and tangible references. As you navigate the complexities of Limited Partner Agreements, may this guide be your compass, ensuring clarity and confidence in every decision.

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More Articles in this Legal Series

• Legal Fund Formation (Part 1): Initial Documentation
• Part 3: Coming soon

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Sincere appreciation to our contributing author Jim Jensen, Partner at Wilson Sonsini Goodrich & Rosati

Thank you to my co-author of The Venture Fund Blueprint, Shea Tate-Di Donna!

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Kaego Ogbechie Rust is CEO at Foresight Advisors — working with foundations, investment firms, non-profits, and for-profit ventures — offering comprehensive support across vision & strategy, investing & financing, and operational planning during critical periods of your growth.

If you’re looking for help, contact kaego@foresightadvisors.co or visit www.foresightadvisors.co.

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