A venture capital fund structured as a Delaware limited partnership is an entity in which a general partner is liable for all debts and obligations, while one or more limited partners have liability limited only to their committed capital commitments. Almost all US venture capital funds utilize this form because Delaware case law regarding limited partnerships is more than a century old, and because the Delaware limited partnership statute lets the fund manager write almost any terms they wish into the fund’s limited partnership agreement, from carried interest waterfalls to removal rights for LPs.
Why Delaware, and Why a Limited Partnership
Almost all US VC funds are Delaware limited partnerships because they are a well-known, well-accepted legal and tax vehicle that allows GPs to use nearly any economic arrangement and structure. Most importantly, Delaware law allows the partnership agreement to contract around almost all default rules, giving GPs and their counsel substantial ability to shape fund economics and governance. There is no Delaware state income tax for income earned outside of Delaware, which is important for funds whose investments are spread across the country. Delaware has filed more than 1.8 million entities, and the Delaware Court of Chancery, a business court that does not have jury trials, is known for its rapid resolution of partnership disputes relative to other courts of general jurisdiction. Institutional investors who are allocating to emerging managers have familiarity with a Delaware LP and trust that their GP is following terms they understand.
One of the primary reasons the limited partnership form is chosen is because it isolates liability for limited partners. If a person has contributed funds to a pooled investment fund and has otherwise remained passive in the operation of the fund, their liability for the debts and obligations of the fund will be limited to their committed capital commitment. General partners who manage the fund, however, are liable for all debts and obligations of the fund, which is why VC funds almost always choose the general partner to be a separate limited liability company owned by the managers of the fund. This is the standard VC fund structure of an LLC limited partnership general partner LLC and you should think about that structure when you start your fund formation.
Another reason VC funds are Delaware LPs is because of the pass-through tax treatment that is applied. The fund entity itself is not subject to US federal income tax and instead income, expenses, credits, gains and losses of the fund pass through to its partners pro rata, and each partner receives a Schedule K-1 reporting their share. This allows each partner to report their share of income on their own tax return. This allows tax-exempt limited partners such as a university endowment to avoid the issue of unrelated business taxable income which would arise if the fund was a corporation.
There are a number of steps to follow in forming a Delaware LP venture capital fund. A Delaware limited partnership is formed by filing a Certificate of Limited Partnership with the Delaware Division of Corporations, and entering into a Limited Partnership Agreement. This document sets forth the material terms and conditions of the fund, and is the core formation document. The formation period should take between 4 and 8 weeks to complete, but this depends on having a good Delaware corporate formation law firm who can get documents done quickly. Most of the time, this period is determined by negotiation with your anchor LPs to get their signatures on the Limited Partnership Agreement.
Formation: The Core Documents and Timeline
The Certificate of Limited Partnership is a very brief filing with the state of Delaware (usually just a couple pages long). It establishes the fund legal name, the name and contact address of the Delaware registered agent, and identifies the General Partner. It costs $200 for a standard filing. The Certificate of Limited Partnership doesn’t mention the names of the LPs, fund size or economic terms, and that is exactly how you want it. Delaware doesn’t care about the details; you will find them in the LPA.
What matters, really, is the LPA itself. A standard LPA for a first institutional fund will be 80 to 120 pages and will include, at the very least: management fee rate and offsets, carried interest % and vesting, preferred return hurdle, distribution waterfall, investment period and fund term, LP advisory committee composition and consent rights, key persons, remove and no-fault divorce, excuse and exclusion, most favoured nation, and reporting. All these terms are subject to negotiation, and anchor LPs will be marking the LPA up.
We have seen first-time managers over and over again under-estimate how long it will take to negotiate an LPA with an institutional LP. It could take two weeks for one family office to mark up the LPA, and it may take a state pension’s quarterly investment committee time to provide sign-off. Plan for at least 8 to 12 weeks in the first close timeline for the LPA.
In addition to the LPA, the fund will enter into a subscription agreement (which allows each LP to sign up to the fund), a side letter structure (to provide LP-specific carve outs and exceptions) and a GP LLC operating agreement. The GP LLC Operating Agreement will govern the carry split, which is far less discussed in the early stages before partnership disputes occur.
The proper Delaware LP venture fund structure involves at least two legal entities: The fund LP and the GP LLC that serves as the fund’s general partner. The management company, that employs the fund’s team and receives the management fee, is typically a separate legal entity, usually a separate LLC that is owned by the same principals.
The General Partner and Management Company Structure
This multi-entity structure (Fund LP, GP LLC and Management Company LLC) is not excessive or unnecessarily complex. It serves distinct purposes. The GP LLC holds the carried interest and has responsibility as the general partner of the fund. The management company is the legal entity that will contract with the fund to provide investment management in exchange for the management fee (which constitutes ordinary income). By separating these, the principals can separate liabilities and separate carry and fee income, as well as bring employees or working partners into the management company without diluting GP economics.
The carried interest, typically 20% of profits above a preferred return, accrues to the GP LLC. Under current US tax law, carried interest held for more than three years qualifies for long-term capital gains treatment under IRC Section 1061, which imposes a three-year holding period requirement. This treatment is a significant economic benefit and a primary reason the LP structure has resisted legislative change despite recurring congressional attention.
A side note from our work with the fund admin: One emerging manager we have worked with formed the fund before defining the carry splits between three founding partners (and wanted to do so post first-close). When the problem came up (triggered by a portfolio company acquisition 18 months later) it took legal help, an amendment, and LP Advisory committee notice to unwind the GP LLC. Write the carry split into the GP LLC operating agreement before the first closing of the fund period, period.
In a Delaware LP Venture Fund, LPs don't wire in the capital at closing. LPs commit in dollars, and the GP periodically calls down the capital over a period of time via capital calls. The commitment cycle, from subscription to final distribution, is the core operating area in a fund, and the area where bad processes do the most damage to LP relationships.
Capital Calls, Contributions, and the Commitment Lifecycle
LPs sign the subscription agreements and commit specific amounts in dollars at each closing. The LPAs define a window for drawing down, typically 3-5 business days, to allow LPs to make a payment on a capital call after receipt of a capital call notice. A GP issues capital call notices for a purpose like an investment, management fees, fund expense, reserves. A GP records on the books of the fund each LP's balance of capital committed but not yet called and capital called and paid.
A capital call notice must include, at minimum, an amount of the call, purpose of the call, pro-rata amount due from the LP, wire instructions. Some LPAs require a 10 business day advance period for any call over a certain amount. The LPA defines the cure period in which the LP has after a default, typically 10-15 business days after the date the capital call was due, to fund the capital call. The fund document typically allows a GP to charge interest on the capital call amount, dilute LPs who don't fund or sell out their interests and take away voting rights from LPs who don't fund within a certain cure period.
One of the more complex areas in a fund at an early stage of operation is equalization of subsequent closes. LPs who invest in the fund at a second or third close after the fund has been investing money for a time must pay an equalization amount to the fund, being their pro-rata share of the capital already paid to the fund plus interest usually 8% per year on that capital paid before they joined, so that all LPs participate on an equal economic footing.
A Delaware LP Venture Fund that is an SEC Registered Investment Adviser has ongoing regulatory requirements from the date of formation, which go on through the life of the fund. Exempt reporting advisers (managing under $150 million in regulatory AUM) must file a Form ADV Part 1 and update the Form ADV once a year within 90 days of the end of the fiscal year.
Ongoing Compliance and Reporting Obligations
The SEC updated its Advisers Act marketing rules last year; a requirement that most funds prepare audited financial statements at the end of a calendar year according to US GAAP and deliver those statements to LPs within 120 days after the end of a calendar year. The audit must be conducted by a public accounting firm that is PCAOB registered. For an Emerging Manager fund, the annual audit is the single highest line item in the fund's operating expenses.
The fund files a federal Form 1065 partnership tax return, state tax filings for the states in which the fund has a filing nexus, and the fund must provide K1 tax filings to each LP. K-1s for venture funds typically run very late because the portfolio company tax returns have to be filed first, so a calendar year fund K-1s often won’t make it to LPs until September or October. The LP has to file its annual report and pay the Delaware franchise tax, due June 1 each year, and the minimum franchise tax is $300. Delaware LPs will fall out of good standing if they don’t pay franchise tax, which will preclude other filings and complicate the fund’s life.
A non-US individual or entity can participate in a Delaware LP fund, but the LPA and subscription documents must address US withholding requirements for real property and the risk of effectively connected income, as well as FATCA compliance. Most VC funds allow non-US LP participation by creating a parallel fund to accommodate. Cayman Islands exempted limited partnerships are the most common structure for a parallel fund because most Cayman exempted LP funds do not have tax in Cayman.
What is the key person provision and why is it important to LPs?
Can a non-US LP invest in a Delaware LP fund?
Why do virtually all US venture capital funds use the Delaware LP structure instead of an LLC?
The LP structure separates management authority from passive investment in a way that the LLC form does not accomplish as cleanly under institutional LP expectations. The general partner's formal liability exposure creates accountability that LPs value, and the LP form has decades of settled case law in Delaware's Court of Chancery. Most importantly, institutional LPs have investment policy statements and legal templates built around the Delaware LP structure.
A key person provision is a clause in the LPA that suspends the ability for the GP to make investments if the designated individuals stop devoting a specified percentage of their professional time to the fund. The suspension ends either when the LPs waive the key person event or they terminate the investment period. In a first time fund, all founding partners are generally key persons with 100% time required in the investment period. A key person clause may be waived if LPs are comfortable with a partner leaving or reducing their professional participation in exchange for some other economic concession to the GP.
How does a preferred return affect carried interest?
Carried interest, typically 20% of profits above a preferred return, accrues to the GP LLC. In an American waterfall, preferred return (8% is the standard) is paid to the LP before any carry is received. A GP catch-up is often included in an LPA where once the LP has received their contributed capital and preferred return, all subsequent distributions (100%) go to the GP until such time it reaches a point that the distribution equals a 20% carry.
What is a typical time-line for first-close of a venture capital fund?
First time VC funds are typically 6-12 months. This starts with the selection of a counsel to draft the LPA which takes about 4-6 weeks for the first and last version. This must also file with SEC as a Registered Investment Advisor or as an Exempt Reporting Adviser. LP meetings and due diligence take about 3-6 months, but are done in parallel with the drafting of the LPA. Subscription documents must be executed by LP and fund is closed on the date of first close. Most commonly, the delay is with LPA due to a lead LP requesting material revisions.
The preferred return — commonly 8% per annum — is a minimum return threshold that LPs must receive before the GP participates in profits through carried interest. In a standard American waterfall, the GP receives carry only after LPs have received back their invested capital plus the preferred return. Some LPAs include a GP catch-up provision where 100% of subsequent distributions go to the GP until they reach their full carried interest percentage.
What is the typical timeline from fund formation to first close for an emerging manager?
Most first-time institutional funds require six to twelve months from the decision to launch to first close. The timeline includes counsel selection, LPA drafting (four to six weeks), SEC registration or exempt reporting adviser filing, LP outreach and due diligence (three to six months running concurrently), subscription document execution, and capital call at closing. The most common delay is LPA negotiation with a lead LP who requests material revisions.