What Startup Founders Need To Understand About VC Limited Partners

Professional venture capitalists are in the business of investing other people’s money into startups.

They receive money from their investors and, in turn, invest that capital into startups. Through a combination of making good picks (a mix of skill and luck) and stewardship of their portfolio companies, venture capitalists aim to achieve financial returns in excess of the public stock market.

Who are the financial backers of venture capital funds? The short answer is “Limited Partners” (also called LPs by folks in the biz). In this article, we’ll unpack that with more complete answers to a few other questions:

• What is the difference between a limited partner and a general partner?
• What criteria must be met to invest in a venture capital fund?
• What are the main types of individuals and institutions that invest in venture capital funds? What are their motivations?

By answering these questions we hope to give startup founders, employees, and newcomers to the world of startups and VC a better understanding of the “money behind the money,” their incentives, and how LPs help shape the startup landscape.

Before we get into the ins and outs of limited partners, it’s worth a quick revisit of the structure of venture capital investment companies and the distinction between VC firms and VC funds:

• A venture capital firm is the management company (usually an LLC) which manages one or more funds. The firm collects management fees from the fund(s) under its control, and it uses those fees to pay its staff, office rent, back office service providers (e.g. legal and accounting), and basically all of the other costs associated with the business of startup investing.
• A venture capital fund is typically structured as a partnership, with responsibilities divided between “general partners” and “limited partners.” General partners (GPs) are the professional investors who raise and manage the VC fund. (Somewhat confusingly, the General Partner may also refer to the legal entity managing the fund itself, which is in turn managed by individuals who are also called general partners.) By contrast, limited partners may provide the overwhelming majority of the capital a VC fund will invest, but their role in those investment decisions and other matters related to the fund’s management is contractually limited.

Since LPs are not involved in investment decisions or day-to-day operations of the fund, their financial liability is limited to the amount of money they invested in the fund. General partners, on the other hand, may be held financially liable for damages caused by criminal behavior, negligence, or other malfeasance by the fund’s GPs, employees, or its service providers. GPs have unlimited liability, which means that they can be on the hook for more than the value of the fund.

In other words, LPs are “silent partners” in a VC fund who are there to provide the capital VCs deploy into new ventures.

Historically, investing in private investment funds and startup companies has been limited to “accredited investors” and “qualified purchasers.” To be clear, there is no certificate or merit badge for accreditation; investors just need to meet a certain set of criteria (namely, having a lot of money), which we’ll discuss in greater detail below.

Why do accredited investor requirements exist? First, conventional wisdom amongst the regulatory crowd suggests that people and institutions with a lot of money are sufficiently sophisticated to fully understand the risks of investing in somewhat opaque, illiquid assets such as startup equity or stakes in pooled investment funds. Second, high net worth investors and institutions with a lot of assets under management simply have more financial wherewithal. If a risky investment goes sideways, their portfolio can take the hit.

Another post on the Capbase blog goes into more detail about why fund managers and startup founders don’t usually accept money from non-accredited investors. The short answer is that the cost of disclosing and reporting information to non-accredited investors is much higher due to the volume of information that needs to be prepared and disclosed. There are other fundraising exemptions, like Regulation CF offerings, which are designed around the principle of increased disclosure and are available to non-accredited investors.

Venture capital funds can only raise from so many limited partners before they have to register with the Securities and Exchange Commission. Usually, firms registered as investment companies with the SEC are publicly traded mutual funds, but most VC funds are private funds and are exempt from registration through provisions in the Investment Companies Act.

VC funds usually use one of two exemptions outlined in the Investment Companies Act: clauses found in “3(c)(1)” and “3(c)(7)” of the Act. The following sections outline the criteria which prospective limited partners must meet to invest in funds using each exemption.

Depending on the amount of money a venture capital fund seeks to raise under the 3(c)(1) exemption, it can have a maximum of either 100 or 250 investors/”beneficial owners” (which may include the general partners in the fund).

Currently, under the Investment Company Act, a venture capital fund can raise an unlimited amount of money from up to 100 investors. Smaller funds raising less than $10 million are classified as “qualifying venture capital funds” and can raise from up to 250 investors. At time of writing, there is proposed legislation to increase the number of investors and the amount of money that can be raised by a qualifying venture capital fund.

What does it mean to be an accredited investor? As currently defined by rule 501 of the Securities Act of 1933, an accredited investor meets one or more of the following criteria:

• An institutional investor such as a bank or a registered broker or dealer
• Other entities such as family offices, employee benefit plans, charities, and insurance companies with assets in excess of $5 million
• A director, executive officer, or general partner of the company offering the securities, or any director, executive officer, or general partner of a general partner of that firm whose equity owners are all accredited investors.
• A person with a net worth or joint net worth with a spouse or spousal equivalent of $1 million or more, excluding the value of his or her primary residence.
• A person whose income above $200,000 in each of the two most recent calendar years, or whose joint income with a spouse or spousal equivalent exceeded $300,000 in those years, and who has a realistic expectation of the same income level in the current year.
• An individual who holds any one of the following licenses in good standing: general securities representative (Series 7), investment adviser representative (Series 65), or private securities offers representative (Series 82)
• A knowledgeable employee, as defined in rule 3c-5(a)(4) under the Investment Company Act, of the issuer of securities where that issuer is a 3(c)(1) or 3(c)(7) private fund

A more fulsome definition of accredited investors can be found on the SEC website.

A venture capital fund seeking to raise under the 3(c)(7) exemption can raise an unlimited amount of capital from up to 2,000 “qualified purchasers” (including the general partner).

What’s a qualified purchaser, you ask? Under the Investment Company Act of 1940, an investor may be classified as a “qualified purchaser” if they are any one of the following:

• An individual or couple who owns more than $5 million in investments, or a company or trust held by that individual or couple.
• An entity or individual which invests on a discretionary basis and which has at least $25 million in investments
• An individual who is deemed to be a knowledgeable employee of a qualified purchaser.

A more expansive definition of qualified purchasers can be found in 15 USC § 80a-2(a)(51).

It’s worth noting that investing in venture capital funds is not only for the ultra-wealthy.

Changes to SEC rules allow venture capitalists to raise small amounts of money from non-accredited investors through crowdfunding platforms. The amount of money non-accredited investors can invest depends on an individual investor’s income and net worth.

Here’s how that breaks down, according to the SEC:

• If either your annual income or your net worth is less than $107,000, you may invest up to the greater of $2,200 or 5 percent of the greater of your annual income or net worth during any 12-month period.
• If both your annual income and net worth are equal to or greater than $107,000, you may invest up to 10 percent of annual income or net worth, whichever is greater, but not more than $107,000 in any 12-month period.

Accredited investors are not subject to these limits.

There is an important difference between investing in a venture capital fund via crowdfunding versus investing as a traditional LP. Money raised via crowdfunding doesn’t go into the pool of capital that gets invested into startups; rather, the investor is purchasing ownership interests—via a Crowd Interest Purchase Agreement (“Crowd IPA”)—in the management company (usually an LLC) that manages one or more funds. The Crowd IPA entitles the investor to a share of the profits generated by the management company.

So far, crowdfunding remains a niche market for venture capital funds, but several firms have taken advantage of the new rules. Backstage Capital raised just over $4.71 million from 6,749 investors on the crowdfunding platform Republic, and Calm Company Fund raised just under $1.3 million from 746 investors via WeFunder in July 2021.

Note: Founders can raise directly on Republic, and Capbase customers get a discount on Republic’s fees.

Now that we’ve gone over the rules and regulations determining who can invest in venture capital funds, let’s take a look at the different categories of investors who become limited partners.

• Pension Funds. Corporate and public pension funds need to grow and maintain an asset base to meet their current and future financial obligations to pensioners. Examples of pension funds that invest in VC include CalPERS (California) and the Ontario Teachers Pension Plan (Canada).
• Endowment Funds. Nonprofit organizations and universities invest their endowment funds in order to ensure the long-term financial sustainability of their organizations. Endowment funds, like the Yale University Investments Office, typically allocate a larger share of their portfolios to VC and private equity than pension funds.
• Sovereign Wealth Funds. Many countries maintain their own investment funds to help finance infrastructure, social benefits, and other public goods for their citizens. Sovereign wealth funds such as Norges Bank Investment Management (Norway), Mubadala (Abu Dhabi), Temasek (Singapore), and others make direct investments in startups and take limited partner interests in venture capital funds.
• Fund-Of-Funds. As the name implies, there are pooled investment funds which specialize in allocating capital to other capital allocators. Examples of fund-of-funds specializing in venture capital include Darwin Ventures, Northgate, Level Ventures, and others.
• Corporations. Corporate venture capital (CVC) is kind of its own separate thing, and many large corporations operate venture capital arms to identify and back startups that could prove strategically advantageous for the corporation. Some corporations also passively invest in VC as limited partners.
• (Ultra-) High Net Worth Individuals. Much like angel investing in startups, some people invest a portion of their assets directly into venture capital funds. This is the most common type of limited partner in first-time and other “emerging” venture capital fund managers.
• Family Offices. Family offices are investment companies tasked with growing and maintaining the wealth of a single family. Family offices may become LPs in VC funds as part of their growth investing strategy.

In most cases, who invests in your investors doesn’t really matter to your startup. Many VCs are unable to disclose the identity of their limited partners, but that’s starting to change in response to demands for more transparency.

If your investors are hesitant to discuss their LP base, that’s not necessarily a red flag, and VCs are generally willing to answer broad questions like “Do you have investors from outside the country?” (The answer to which could matter if your company touches on areas of defense, national security, and strategically important technology.)

There are some other things to keep in mind:

1. For most LPs, venture capital is a side bet. Except for fund-of-funds, venture capital is a minor component of most institutional limited partners' investment strategy. As a "alternative asset class," venture capital is considered a high-risk, high-reward investment. Most institutional LP portfolios contain less than one-third alternative assets.
2. Institutional limited partners are known as "patient capital." VC funds typically operate on a 10-15 year cycle, and it can sometimes take even longer to obtain liquidity on their stakes in privately held companies.
3. Your VC's limited partners have little direct control over individual investment decisions in general (with the exception of corporate venture capital). They may contribute to the overall investment strategy, but they are unlikely to be appointed to the investment committee.

If you looked at this article and got intimidated by all the details, here’s the long and short of it:

• Traditionally, investing in VC funds has been out of reach for all but wealthy individuals and institutional investors. That may be changing, slowly, as the SEC opens up routes for non-accredited investors to get some skin in the game.
• Investors in venture capital funds are known as limited partners. Apart from providing the capital for VCs to invest, LPs don’t have much say in the specific companies a VC fund invests in.
• LPs understand that venture capital is a risky asset class, and that it could take as long as 10 years (or more) to see a return on their investment.