Thoughts on best practices from an LP advocate

Defining what it means to be limited-partner-friendly in today’s venture capital and private equity market goes beyond formal legal and economic terms. Rather, it’s a mindset that should drive and inform all activities across a fund.

VCs  love waking up every day to work with founders and to help build amazing companies. But behind this is a duty to the LPs, both family offices and institutions, that have placed their long-term faith, trust and hard-earned capital with their investors.

LPs should be seen as collaborative partners, and with this in mind, GPs must constantly evaluate how they can best develop and manage this relationship.

The nature and philosophy of being an LP-friendly VC fund include the following core principles and practices.

Alignment of economics, practice and culture

Retain top-notch law firms so the terms of the fund are distinguished among your peers, ensuring they will benefit the firm and limited partners in ways that will ultimately improve returns to investors. Align the incentives among your investors, portfolio companies, partners and team members through such terms, including:

  • an agreement not to extend management fees beyond the original fund term, e.g., 10 years, not 11, 12 or more;
  • an agreement to offer co-investment opportunities to suitable investors on a strictly no-fee and no-carry basis;
  • a compensation structure for non-partner employees that provides carried-interest-related profits for 100% of the employees. This way, all staffers, regardless of level or tenure, have skin in the game: They’ll receive material compensation when funds perform well; and,
  • an open-book management practice so limited partners have an opportunity to understand how fees are used to operate the management company, compensate partners, and maintain strong incentives to maximize the return on their investment.

Deal review and sharing; access to the brain trust

The most fruitful relationships among GPs and LPs develop when VCs serve as resource partners to their LPs, providing additional services specific to their investments. These include periodic reports and updates on particular technologies; brainstorming meetings in which the LPs can meet the startups’ executives, and the executives in turn can demonstrate their technologies to the LPs and receive comments and input; and limited-invitation dinners and gatherings during which outside experts can brief the LPs on topics related to their investments.

For many limited partners who have strong interest in making direct investments but understandably have limited due-diligence resources or experience,  GPs would do well to provide a quick but detailed written analysis of their potential investment opportunity. This may benefit VCs by providing a wider sourcing pool for potential investments, and their limited partners will appreciate the advice of an experienced and trusted partner.

Protect and generate returns via portfolio risk reduction

My firm, ff Venture Capital, has an unusually  large and diverse professional staff of more than two dozen full-time in-house employees, enabling us to stay attuned to developments affecting each of our portfolio companies. But venture funds with smaller teams and more limited resources can still take measures to reduce risk in their portfolios by being actively involved with their companies.

Beyond board seats and observer rights, GPs and their teams should focus on two core areas:

  • Clear hurdles, improve outcomes: Allocate as much time as possible to identifying the pain points at your portfolio companies that you or others in your network can directly help to heal. This effort is most needed at the most critical junctures of the startups’ development — like beta testing and new product iterations — and will go far to producing the best possible results; and,
  • Optimize capital allocation: This deeper and consistent interaction with portfolio-company executives will ensure that you are on top of the internal dynamics in your companies’ operations. This in turn will enable you to make more intelligent capital-allocation decisions at each stage of follow-on investing: Should you participate and, if so, to what extent?

These days a record number of funds are in the market, along with new investment structures and platforms that increasingly compete for the attention and capital of limited partners. At ff Venture Capital, we strive to follow these best practices and we welcome additional ideas and feedback from the community.