Tough times bring questionable moves by general partners of VC funds

Article content

The general partner of a venture capital fund is essentially a “wannabe” serial entrepreneur. It raises a pool of money from limited partners (LPs), which the general partner (GP) then invests. As soon as that pool is fully invested – and sometimes sooner than that – the GP starts raising a second fund, usually named something creative like Fund II.

The compensation structure for GPs is supposed to align their interests with that of their LPs. GPs commonly take an annual management fee (such as 2 per cent of the committed capital) to “keep the lights on,” plus a significant cut of any gains, such as the 20 per cent (or higher) “carried interest.”

Unfortunately, the serial nature of VC funds means GPs are often incentivized to make decisions harmful to their existing LPs, in the hopes of attracting new investors for a subsequent fund.

An example

Consider this scenario. Acme Inc., an unprofitable tech company that needs money today, faces a very hostile environment: It must raise money at a low valuation (highly dilutive) or starve. This poses a peculiar problem for the GP of a fund (Fund I) that invested in Acme in the heady days of late 2021.

Investing more into Acme via Fund 1 may be the right business decision – especially if Acme needs only a runway extension to make it through a globally difficult period, and the alternative is bankruptcy. Putting new money in protects Fund I (and its LPs) from a total loss on the initial investment.

So far, so good. The GP and LP interests are aligned. The conflict arises when ascertaining Acme’s value for the second investment.

All other things being equal, the valuation of a struggling tech company in late 2022 should be lower than its value during the 2021 boom. Markets are down this year, and tech markets in particular have crashed. Profitable public tech companies are off 30 per cent from late 2021 values. Non-profitable ones are down 50 percent to 70 per cent.

Public tech companies are relatively transparent, and their stock prices are a clear barometer of how the market values them. Private company values are subject to the same forces and – because they are usually smaller – are more vulnerable to economic storms. But being private, their illiquidity means that their values are much less transparent and are subject to “creative interpretation,” if not outright manipulation.

Maybe Fund I should be investing in Acme a second time – but it should be at a reduced valuation (a “down round”), giving Fund I and its LPs more bang for their buck.

Eyes on Fund II

Why, then, would the GP reinvest at the old, higher valuation? In other words, why would a GP let Fund I overpay to invest again?

The answer lies in the fact that a GP’s major goal at the moment isn’t protecting existing investors but raising a proposed Fund II. The GP is no longer focused on Fund I. It is already thinking about how to attract investors to Fund II.

Investors evaluate VC funds on the basis of the GP’s past performance – the results generated for prior funds. Early-stage tech VC funds invest in pre-revenue, pre-profit companies and may need to wait 5 to 10 years to see results (sales of the companies or IPOs). A VC that raised $100 million in 2019 and invested most of it during the 2019-2021 boom won’t know the results of its bets for many years. By then, a GP will have already raised its second – and perhaps third – fund.

And it will be raising Fund II largely on the basis of Fund I’s projected performance.

While Fund I’s LPs would benefit from Fund I investing more into Acme at a lower price (reducing its average cost per share), the down round would have a negative impact on the GP’s ability to raise money for Fund II.

Imagine that in early 2021, Fund I invested $5 million at a $45 million pre-money valuation ($50 million post money valuation). Assume Fund I gets 5 out of 50 shares for its $5 million. Its 10-per-cent stake is worth $5 million. Then the tech market collapses, and in late 2022, Acme’s total valuation is only $20 million. Fund I’s 10-per-cent stake is now only worth $2 million.

Not a good look for the GP trying to raise another fund.

A success story on paper

If Acme needs more money, and Fund I invested an additional $5 million at a pre-money valuation of $20 million, that second $5 million would buy 10 shares. Its $10 million invested would now own 15 of 60 shares (25 per cent) of a company worth $25 million. This averages down the cost per share for Fund I investors, but the $10 million invested is worth only $7.5 million. On the other hand, if Fund I makes the second investment at the old $50 million valuation, the GP can spin that as Acme maintaining its value (and thus the value of Fund I’s investment) in a hard economy.

A failure becomes a paper success story.

The incentive for a GP to cut this kind of a deal increases when there have been intervening rounds at higher valuations. If, after Fund I’s first investment at $50 million in 2021, Acme raised money at $100 million in 2021 before the crash, then even a small subsequent investment by Fund I at $100 million would allow the GP to market a proposed new Fund II with a spectacular winner. But it would be at the expense of Fund I’s LPs.

To add insult to injury, Fund I’s LPs may never know this has happened – at least until it’s too late. The GP can hide it away in an annual report footnote: “Fund I exercised its right to make a follow-on investment into Acme Inc., on the same terms as the prior round.”

This isn’t illegal, and I’m sure a GP could provide a plausible rationale – they could argue that they are heroes for supporting Acme in a time of need, for instance. Or that Fund II could help Fund I deals. But it’s a raw deal for the LPs.

What can be done?

A problem of agency

Game theory calls this kind of conflict of interest an agency problem. It exists when a decision maker is playing with someone else’s money, sharing in the profits but not in the risk of loss.

Limited partnerships are prone to agency problems because of their structure. VC funds originally structure themselves as partnerships because this provides a tax benefit as early year losses can be passed on to LPs, and limited partnerships usually limit LP liability to the amount invested.

However, other limited partnership features primarily benefit the GP at the LPs’ expense.

Unlike a corporation, a limited partnership offers investors few rights, and fewer protections – beyond (usually) capping LP liability to the amount the LP invested. While corporate shareholders are generally statutorily entitled to receive certain information and disclosures, LPs are not. Shareholders are generally entitled to elect and remove directors. Limited partnership agreements may give a supermajority of LPs the right to remove a GP, but even then only in very narrow circumstances.

It gets worse. Theoretically, GPs have fiduciary duties akin to those of a corporate director. They need to act in the fund’s best interest and avoid conflicts of interest. However, unlike a director’s duties, many jurisdictions (including Delaware, home to an outsized number of limited partnerships) allow the GP’s fiduciary duties to be waived by contract. When that happens, the GP is explicitly allowed to act against the investors’ interest, for the GP’s own gain.

Most limited partnership agreements are drafted for GPs to maximize GP gains and minimize GP risk. They provide very little transparency and permit virtually no oversight. During the life of the fund, LPs have few rights and remedies unless specifically negotiated. Most LPs don’t know what to ask for, or believe they lack leverage. Some funds are quickly oversubscribed, but most have to hunt for investors. Prior to investing you have more leverage than you think.

That’s why it is vital to carefully review limited partnership agreements and push for the inclusion of protective terms to provide transparency, and have potential conflicts dealt with by a separate committee representing the investors, rather than the GP itself.

David Latner is a partner at Toronto-based Advocan Law LLP, a boutique law firm focused on assisting family offices and technology companies.

Get the latest stories from Canadian Family Offices in our weekly newsletter. Sign up here. 

More from Canadian Family Offices:

• Why UHNW and family office investors are delving into private debt
• Burden of paperwork growing for family advisory firms
• Five things enterprising families are quietly doing right
• How your business’s transfer pricing set-up can trigger CRA audits

Please visit here to see information about our standards of journalistic excellence.