One important (but commonly missed) clause for Fund I LPAs
Raising and launching your first VC fund is hard. Including this sentence in your LPA will make it a bit easier.
For emerging VCs, raising a first fund (“Fund I”) is a unique experience, with challenges and quirks that don’t apply to raising and launching later funds. Unfortunately, these uniquely Fund I challenges don’t get much attention, which means they don’t get effectively managed - I’m trying to change that.
This post is about one specific challenge that’s unique to Fund I, but this is really just an illustrative example of a bigger issue. The broader goal of this post is to encourage you to:
Think about Fund I as fundamentally different from later funds; and
Be cautious about blindly applying general fund frameworks and templates to Fund I.
The specific challenge that I’m focusing on here is properly timing and navigating a first close. First time fund managers often wind up holding unusually small first closes, and that can inadvertently trigger a common investment restriction in their funds’ Limited Partnership Agreements - here’s how to avoid that.
But first, please subscribe (if you haven’t already) for more highly practical insights about raising and running your Fund I:
Why many managers hold a small first close for Fund I
Raising a fund can take a long time - sometimes up to 2 years from first pitch to final close. That slow timeline is particularly painful for first-time fund managers for two reasons:
Fleeting deals: When raising Fund I, an emerging VC has lots of deal flow and no capital. Until the fund holds its first close (and has deployable capital) the emerging VC often has to sit on the sidelines and watch many great opportunities slip by. This isn’t the case for Funds II+, because there is usually deployable capital left in the prior fund.
Cashflow pressures: Fundraising is often a full-time job, but emerging VCs who are raising Fund I are not getting paid until the fund holds its first close and starts generating management fees. This isn’t the case for Funds II+, because the manager usually has 1-2 active funds generating management fees.
These two issues drive many Fund I managers to hold a first close as soon as they have enough capital committed for 3-4 pipeline investments.
Small first closes can trigger a common investment restriction
Limited Partnership Agreements usually contain a set of investment restrictions - a list of what the manager of the fund is not allowed to do with the fund’s capital. One common restriction limits the concentration of the portfolio, and often looks something like this:
… no more than ten percent (10%) of the Partnership’s Committed Capital may be invested in the securities of any single Portfolio Company …
Like many investment restrictions, this one includes a threshold that’s quoted as a % of capital commitments. That makes sense when the fund is fully raised, but, as mentioned above, many Fund I managers hold a first close as soon as they have enough capital committed for 3-4 pipeline investments. That means that each investment will represent significantly more than 10% of the committed capital, and will trigger the investment restriction.
Here’s how to fix the problem
Luckily, the solution to this problem is extremely simple and easy to implement - just calculate the investment restriction threshold based on target fund size, rather than committed capital. You can do this through a proviso at the end of the clause containing the restriction - something like:
provided that, for the purposes of this [paragraph x], prior to the Final Close Date, the Partnership’s Committed Capital will be the greater of (i) the Partnership’s actual Committed Capital as of the measurement date, and (ii) the Partnership’s Target Fund Size.
Unfortunately, while this issue is easy to catch and fix, it’s missing in many common LPA versions and templates.
In conclusion
There are many great services, articles, and documents out there for fund managers. But if you’re just starting out on your journey as an emerging VC, it’s important to understand whether those resources are appropriate for Fund I. Whether it’s data on market terms or template LPAs, the resources often miss the fundamentally unique aspects of raising and launching Fund I.
* What’s a first close?
A “close” is a moment in time when you accept LPs into your fund. At a closing, the LPs sign their subscription documents and wire some money into the fund’s account. Most emerging VCs don’t “close” all of their LPs at once. Instead, they hold a “first close” when they’ve raised some minimum amount of capital commitments, and then hold additional closes as they raise the rest of the fund.