Part 3: Navigating EMVC Fund Docs and Unpacking Operating Agreements
In this 3-part series on venture fund formation and legal strategies, we will share an overview of the legal documents required for fund formation and discuss which elements are standard or open for negotiation and customization with answers from the knowledgeable minds at Wilson Sonsini Goodrich & Rosati.
In this third segment, we will 1) highlight which sections of the Operating Agreements are often negotiated, 2) outline the key terms covered in the Operating Agreements, and 3) share sample Operating Agreement 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.
With venture capital fund formation structure, the General Partner (“GP”) and the Management Company (“Management Co”) are inter-related yet serve distinct roles and responsibilities, which necessitates that each have its own operating agreement. Having separate agreements allows each entity to adapt and modify its agreement without unnecessarily impacting the other. These two entities work closely with distinct roles, responsibilities, revenue models, and associated risks warrant separate operating agreements to ensure clarity, flexibility, and risk management.
General Partner Operating Agreement
As the decision-making entity, the GP is responsible for the actual investment activities of the fund and makes decisions about which investments to pursue, manages those investments, and makes decisions about when to exit those investments. It becomes of even greater consequence if there are multiple partners. The GP typically earns a "carried interest" or "promote," which is a share of the fund's profits. There are three types of percentages: 1) capital commitment percentage, GP commit to the fund, 2) carried interest percentage, and 3) other income percentage (can be the same as the carried interest). Here the agreement will detail who gets diluted when a new member is admitted; members are usually diluted equally together, however, sometimes, one person who holds the lion’s share of the carried interest percentage is diluted down first. Most of the time, these terms are not negotiated that hard because the people being admitted do not have a lot of power to change them. Often in GP agreements, there is a section on other people who can get carry other than a GP, e.g., venture partners. A good agreement will build in how these people will affect the economics of a partnership, for example treated as expenses or shown as a partner on a tax return but as an expense in the official legal documentation.
GP Operating Agreement: Link to sample.
Management Company Operating Agreement
The Management Co primarily handles the administrative and operational aspects of the fund, such as hiring employees, administrative tasks, leasing office space, and more and thus does not engage in investment decision-making. It acts as a back office entity, serves as an investment advisor, and earns a management fee for its operational role. A percentage of the Management Co is often harder to access than the GP entity. For emerging managers, there may not be any management fee left over after paying all the salaries and excesses of the firm, however, for a larger firm like a16z or NEA, there is quite a bit of excess capital available to designate at the discretion of the voting partners.
Management Co Operating Agreement: Link to sample.
Pertinent Terms
There are several pertinent terms relevant for both operating agreements:
Admission of Members - Both operating agreements contain a section on admission of members; because these entities are typically formed as LLCs, there must be a detailed mechanism to admit members with economics assigned, voting rights, etc.
Default - There is a section on what happens to a person if they default on their obligations under their agreement, mainly capital contribution obligations. In the GP operating agreement, simply apply all the same defaulting provisions as if an LP in the fund, including removing the LP, wiping out the LP’s interest, transferring the unfunded LP capital commitment, or suing the LP. If a GP defaults, it is a sign that there will probably be a separation, so that is often the eventuality.
Allocations - The allocation section outlines how profits and losses will be allocated amongst the members, which is not controversial and usually not negotiated.
Distributions - This section in an operating agreement describes how cash and property are distributed to members based on specific percentages, with the GP agreement often detailing three distinct "waterfall" methods for this purpose. The GP agreement also includes clawback provisions that outline how members of the GP will share any repayment obligations.
Voting Rights - The section of an operating agreement pertaining to voting rights clarifies management roles, distinguishing between managing and non-managing members. While most decisions are generally governed by standard voting rights, certain significant actions, like selling the GP or Management Co, might necessitate unanimous member approval. Even though one-off approvals are rare, most fund decisions usually follow a majority rule, often determined by the carried interest percentage held by members.
Removal/Withdrawal - While more extensive in a GP operating agreement, there is a section in both agreements on what happens if a member separates, if board seat resignation is required, what happens to a person’s economics if they are removed, how to remove or convert a member from an active member to someone who just has economics. There are also often rules for how to do it if the person has a cause event vs how to do it just as a general rule. These differ for managing member and non-managing member.
Confidentiality - There is a section in both agreements on use of confidential information of the entities, funds, and portfolio companies.
Track Record - The default rule is that the GP entity and/or Management Co own the track records. If someone has an employment agreement, as well as a member of the GP entity and/or the Management Co, the same or similar confidentiality and assignment of inventions provisions might be in an employment agreement and operating agreements. The “success has a thousand fathers, and failure is an orphan” adage applies here. This section is important and often negotiated for multi-partner funds. Both entities must be in alignment here.
Vesting - The vesting section in an operating agreement sheds light on the implications of one's activity level and their stake. In the Management Co, active members maintain their interest, while inactive members might hold no interest in the Management Co, though founders could be exceptions even if inactive. On the GP side, vesting plays a crucial role. Members retain what's vested at separation but forfeit what is not. The nature of the separation, especially under "bad leaver" provisions, such as soliciting employees or joining a rival fund, can lead to significant consequences, potentially losing up to 100% of their carry. While cliffs are less prevalent than in startups, vesting in VC usually spans 10-years, often accelerating during the initial investment period.
Exculpation; Indemnification - This section of both agreements outlines liability of members and indemnification and indemnification of members, similar to fund agreement.
Non-Compete & Non-Solicitation - These provisions aim to prevent members from competing directly or soliciting business, often highlighting the risk of losing all economic benefits and facing legal action. However, it is essential to note that such clauses are not always enforceable in certain jurisdictions, such as California. If an outright prohibition is indicated, the agreement typically covers both aspects, emphasizing the severe repercussions of breach.
Venturing into the intricate realm of venture fund formation, this comprehensive 3-part series has offered a deep dive into the legal facets of the process. Our latest leg traversed the often winding lanes of Operating Agreements—decoding their negotiables, standard terms, presenting sample documentation for your discernment, and underscoring the crucial distinction between the General Partner and Management Company. This dichotomy ensures that while both operate in tandem, their unique roles and obligations are transparently enshrined with separate and distinct operating agreements. From the nitty-gritty of investment decision-making by the GP to the administrative endeavors of the Management Co, we have attempted to encapsulate the vast spectrum of responsibilities these entities shoulder. As you venture forward, armed with this knowledge and the resources provided, remember that understanding these foundational documents is pivotal, not just for compliance, but for the seamless functioning and growth of a venture fund.
More Articles in this Legal Series
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Disclaimer: The information contained herein is based on a fictitious entity and must not be construed as legal advice or a representation of any actual, existing entity, organization, or individual. The providers, companies, examples, products, and services shared represent only a subset of available options and are based solely on internal fund manager conversations. These options are intended to be a general framework, not an exhaustive catalog, and should not be viewed as legal or tax advice, endorsements, recommendations, approvals, or rankings. We encourage you to do additional research into each category to find the resources that best fit your specific needs.
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Sincere appreciation to our contributing author Jim Jensen, Partner at Wilson Sonsini Goodrich & Rosati, along with Shea Tate-Di Donna and Kaego Ogbechie Rust, authors of The Venture Fund Blueprint.
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