You don’t need this. You totally know all these terms. ;)
The investing world is full of acronyms and terms that are foreign to those that haven’t been in the game for years. So, we put together a glossary of concepts every fund manager needs to know.
Hopefully this will serve as a useful reference and help you avoid embarrassment when pitching LPs. :)
Shout out to Grant Gittlin, Julia Lipton and Sarah Smith for reviewing.
General Partner (GP)
A GP is a manager of a venture fund. They make decisions on how to invest the capital that LPs provide.
Limited Partner (LP)
An LP is an investor into a venture fund. LPs provide the capital that fund managers invest, and typically have few required obligations outside of providing capital to the fund.
Most funds are limited to 99 LPs, but they don’t have to be. Some funds, including ours at Weekend Fund, have a parallel fund structure with QPs and non-QPs (more on QPs below) enabling them to accept several hundred LPs.
A capital call (sometimes called a “drawdown”) is the process by which a fund manager asks LPs to contribute their portion of their fund commitments. This typically occurs on a schedule set by the GP.
Most funds call additional capital every 6-12 months and set a capital call schedule that aligns with their fund’s deployment period. GPs can call 100% of the capital upfront; however, doing so can negatively affect the fund’s IRR as capital sits in a bank unutilized.
A minimum subscription is the smallest amount of money an LP can commit to a fund in order to be accepted as an investor into the fund.
For Weekend Fund 3’s community raise, we accepted commitments as small as $2K. This is rare. We set a low minimum to make the fund more accessible for well-connected and experienced founders, designers, marketers, engineers, and operators from around the world.
An accredited investor is someone who can legally invest in private companies and funds based on SEC guidelines. To qualify as an accredited investor, individuals must have at least one of the following:
- An individual or joint net worth in excess of $1M (not including the value of their primary residence)
- Individual income in excess of $200K or joint income in excess of $300K for the two most recent years, with a reasonable expectation that they’ll make this in the current year OR
- A Series 7, 62, or 65 license
Most funds are only able to raise from accredited investors.
Under Rule 506(c), funds may engage in general solicitation which allows them to talk about their raise and market the fund in public.
This can make fundraising much easier; however, it also requires LPs that invest after it’s been publicly announced publicly to provide evidence of accreditation. 506(b) funds, which prohibit general solicitation, do not require their LPs to provide evidence of accreditation and instead can accept a verbal acknowledgment.
Qualified Purchaser (QP)
A QP is an individual or entity that owns $5M or more in investments or qualifies with any of the following:
- An individual or entity (for example, a fund manager) that invests at least $25M in private capital, on its own account or on behalf of other QPs
- A trust sponsored and managed by qualified purchasers
- An entity owned entirely by QPs
This is important because SEC’s LP limits are different for QP-only funds.
Qualified Client (QC)
A QC is an individual or entity that meets any of the following criteria:
- Has $1.1M or more of assets under management with the investment adviser after the investment in the fund
- A net worth of $2.2M prior to the investment in the fund (excluding the value of the investor's primary residence)
- Is a “qualified purchaser” (QP)
- Is an officer or director of the fund manager or is an employee who participates in the investment activities of the investment adviser and has been doing so for 12 months
Since the net worth threshold for a qualified client is higher than for an accredited investor, all qualified clients are, by definition, also accredited investors.
The moment when initial funds are collected, enabling the GP to start deploying capital. It’s recommended to celebrate this milestone. :)
Traditional funds typically do a “big bang” fundraise and begin deploying capital after the First Close. Once the fund is officially closed, they’re unable to accept new LPs.
That said, it’s not uncommon for fund managers to leave their fund “open” for several months while deploying and raising additional capital.
Rolling funds, introduced by AngelList in 2020, are structured as a series of quarterly funds. Unlike a Traditional Fund, LPs commit to invest $X/quarter (usually with a 4-8 quarter minimum) almost like a subscription service. This provides fund managers with more flexibility to scale their effective fund size up (or down) and continuously raise and deploy capital from current or new LPs over time.
Limited Partner Advisory Committee (LPAC)
An LPAC is a group of representatives of LPs chosen by the GPs to provide support and advice on specific issues related to the fund such as conflicts of interest and material changes to the fund. LPACs function similarly to a Board of Directors in a company.
Portfolio construction is a combination of variables such as fund size, management fee structure, check sizes, deployment period, and other factors that define the makeup of each fund. This construction is a core part of fund managers’ strategy and something LPs often request to better understand how their capital will be used.
We’ll publish a template on this topic in a future edition of Signature Block – subscribe if you haven’t already. ;)
Reserves are funds venture capitalists set aside for the explicit purpose of follow-on investments into portfolio companies.
Reserves strategy is one of the most debated concepts in VC. Some funds do not set aside any reserves whereas others hold back up to 50% of their fund for follow-ons.
A follow-on is an investment made by the fund manager into a company that they previously invested in. These investments can come out of the fund or through an SPV.
Firms often have different follow-on strategies. Some execute their pro rata in most subsequent rounds. Some evaluate each round independently. Some almost never follow-on. At Weekend Fund we occasionally double down on breakout portfolio companies, taking into account the stage of the company, valuation, and our conviction in the company’s ability to deliver outlier upside.
Management fees are the annual fee that a fund charges investors in exchange for operating the fund. This typically is utilized to cover operating expenses rather than to invest in companies.
The standard management fee for venture funds is 2% annually of the amount of money committed by LPs. However, many don’t realize you can front-load fees to bring operating cash flows earlier in the fund cycle when it’s most needed. This is especially useful for small funds where 2% a year may not be enough to cover one or more peoples’ salaries. For example, in our third fund at Weekend Fund, we front-loaded fees at 3% in the first three years, 2% in the following four years, and 1% in the remaining three years. The effective “cost” to LPs is the same, but this provided more financial stability to hire a team.
Carry (also called “carried interest”) is the percentage of fund profits that GPs, and other members that assist in operating the fund, receive. 20% carry is the market standard for most funds; however, some (typically more well-established) firms charge 25% or more.
Carry percentages can also vary based on performance, increasing in amount once certain performance hurdles are met. For example, a fund might charge 20% carry on the first 3x DPI followed by 25% carry on payouts above that.
A GP commit is the amount of capital that general partners are expected to contribute to a fund. This has historically been 1-2%. It’s important that GPs have skin in the game and aligned incentives with their LPs.
That said, many GPs find it difficult to contribute even 1%. This is especially common among emerging managers who are just starting out and can’t afford to invest $100K (i.e. 1%) in a relatively small $10M fund, for example. Fortunately we’ve seen LPs loosen up on these mandates and recognize that the overall dollar amount isn’t what’s most important but instead the relative commitment to the GP’s financial state.
But for GPs that want to commit 1-2% of their own money into the fund, there are a few creative solutions. They can invest a portion of their management fees called a “cashless contribution”. Some sell part of their GP stake to get early liquidity to invest (although be careful with this as it can be very costly).
Waterfall distributions is the order in which returns are delivered to different sets of investors in a fund. It describes the hierarchy in which profits are returned to different types of investors.
LPs typically get 1x their invested capital before GPs. Once the fund returns 1x DPI, GPs are “in the carry” and start receiving payouts based on their carry structure.
The deployment period is the years in which the fund will make all its investments. Most traditional funds are fully deployed in 18-36 months.
Assets Under Management (AUM)
AUM is the total amount of funds, including the value of investments made, that a venture capital firm possesses. It is calculated across funds managed by a fund manager rather than just focusing on the value of a single fund.
A clawback clause in the LPA allows LPs to “recapture” a portion or all of the GP’s carry if certain conditions are not met. If a GP sees returns on a singular investment but LPs overall aren’t seeing their preferred rate of return, they can recover some of the carried interest the GP earned on the successful deal.
Simple Agreement for Future Equity (SAFE)
A SAFE gives investors the rights to purchase stock in a future equity round, often with a specific cap and/or discount. No specific price per share is determined at the time of the initial investment.
They’re a simple and fast way to get early investments into a company. The SAFE was originally introduced by YC in late 2013, and has become the primary instrument for early-stage investing.
A convertible note is short-term debt that converts into equity. Upon the closing of a later round of financing, the debt typically automatically converts into shares of preferred stock based on the note’s cap or discount. Similar to SAFE agreements, convertible notes decrease the amount of friction involved in legal agreements for early-stage investing.
Simple Agreement for Future Tokens (SAFT)
A SAFT is an investment contract issued by companies that have plans to introduce crypto tokens in the future. It has some of the same characteristics as a SAFE in that it simplifies legal negotiations.
A token warrant is a generalized document that guarantees investors' rights to purchase tokens that will (or may) be issued in the future, at a specific price.
Liquidation Preference dictates how much investors will get paid out before any other shareholders get paid in the case of a liquidation event (i.e. company is acquired or IPO). It’s an agreement between a company and an investor.
It is expressed as a multiple of the initial investment. For instance, a 2x liquidation preference means that an investor gets paid back double their original investment before any shareholders lower in the preference stack receive anything. Note that debt typically supersedes equity investors in the preference stack.
It is quite uncommon for early-stage investors to ask for liquidation preference structures.
Ratchets protect early investors from dilution by subsequent fundraisings at lower entry prices.
In the scenario that a subsequent investor into a company invests at a lower price per share, earlier investors with “full ratchet” protection get price adjustment to that lower price.
Pro Forma Cap Table
Pro forma cap table is a version of the cap table that shows the updated company ownership after a financing round closes.
For investors, the pro forma cap table is a key diligence document as gives detail on ownership, dilution, and more, should the round close.
The pre-money valuation is the value of a company excluding their latest round of funding. It refers to how much a company is worth before it receives an investment.
The post-money valuation is the value of a company including the latest round of funding. It refers to how much a company is worth after it receives an investment.
With pro rata, or participation rights, investors have the right to invest in subsequent funding rounds to maintain their ownership percentage in a company. Pro rata agreements can be limited to the next subsequent round (this is the default in YC’s pro rata template).
If exercising pro-rata rights, the investor typically invests at the same valuation as all others in the same round.
The pay-to-play provision requires existing investors to participate in future financing rounds on a pro-rata basis to avoid negatively affecting their position. Investors that do no participate might have their preferred stock converted to common stock, for example.
Pay-to-play is used rarely.
When a startup gets an attractive acquisition offer, drag-along rights give majority shareholder(s) the power to “drag” the minority shareholder(s) along in the acquisition. The earlier the company is, the more likely that founders are majority shareholders.
When a startup gets an attractive acquisition offer, tag-along rights give minority shareholders the right to participate in the sale if they choose. They can “tag along” to the sale if they so choose. It may also be called co-sale rights.
Dilution is the extent to which ownership percentage represented by each share of stock is diluted each time new shares are issued, typically with each round of financing.
Early-stage investors often underestimate the amount of dilution they may encounter before a liquidity event due to consecutive financing events, stock option refreshes (see ESOP), and other factors. Many investors try to secure pro rata rights to secure a right to invest in future rounds to reduce their dilution.
Fully-diluted capitalization is the capitalization of a company assuming that all plans and obligations to issue shares have been fulfilled.
It’s common to see the fully-diluted capitalization expressed as a single number of shares.
Board of Directors
The Board of Directors is a group of key shareholders appointed to make key decisions of a company. Board members have “fiduciary duties,” meaning they have to act to ensure that the company is being managed in the best interest of all stakeholders.
Seed-stage companies rarely have a formal board whereas most Series A companies do.
A board observer is somebody who attends a company’s board meetings but doesn't have a voting rights or fiduciary duties.
Board observers usually hold a minority stake in the company, although sometimes majority stakeholders require board observer seats for additional team members.
Pari passu means “equal footing”. In most cases, ordinary shares are pari passu, which means that they all have an equal rank and no one has more rights to dividends or assets.
Preferred stock receives preferential treatment over other investors in specific situations. In the case that a solvency event lower than the company’s valuation occurs (such as bankruptcy, mergers and acquisitions), preferred stockholders get paid first.
Startup investors typically hold preferred stock, while founders and employees, generally hold common stock.
Compared to preferred stock, founders and employees generally hold common stock. Usually employees receive options to purchase common stock.
Employee Stock Option Pool (ESOP)
An ESOP is the pool of equity specifically allocated for employees. They’re used to help companies hire, motivate, and retain talent. When structured well, they align incentives with everyone in the company.
Runway is the amount of time a company can continue to operate without raising additional funds based on their financial projections.
Most seed-stage startups raise capital to give them 18-24 months of runway. We recommend founders aim to have a runway of 24+ months, especially in turbulent market conditions.
Burn rate is the rate at which a company is spending their cash, and is typically quoted in terms of cash spent per month. It is calculated by (original cash balance) - (remaining cash balance) on a monthly basis.
Total Value to Paid-In Capital (TVPI)
TVPI is a measure of both the realized and unrealized value of a fund as a proportion of the total paid-in, or contributed, capital. It is calculated by (total value) / (paid-in capital) where total value is (distributions + net asset value). A TVPI over 1.00x means an investment’s value has grown while one less than 1.00x means it has contracted.
For example, a 1.5x TVPI means that the fund has generated 50 cents in value (on paper) for every dollar contributed. This typically is used to assess a fund performance
Per Pitchbook, in the 2010 - 2020 vintage years, the median TVPI for top decile VCs globally was 3.84x, but varies widely based on vintage year between from 1.96x to 5.87x.
Multiple on Invested Capital (MOIC)
MOIC is calculated by a portfolio’s (total value) / (initial Investment). While this looks similar to TVPI, the difference is in the denominator. In this case, the denominator is the total dollar amount of capital invested by the fund rather than the amount of money paid in to the fund. “Paid-in” includes management fees.
Distributions to Paid-In Capital (DPI)
DPI is a measure of the capital that has been distributed back to LPs as a proportion of the total paid-in, or contributed, capital. Where TVPI is a leading indicator of performance, what really matters, in the end, is DPI.
It is calculated by (distributions) / (paid-in capital) and used to measure the realized, or cash-on-cash, return on investment.
Per Pitchbook, in the 2010 - 2020 vintage years, the median DPI for top decile VCs globally was 1.67x, but varies widely based on vintage year between 0.10x to 3.17x.
Distributions occur due to a liquidity event, typically a company going public or being sold. In some cases, GPs may decide to sell their holdings in a subsequent round of funding to new investors which also would trigger a distribution.
DPI is also known as the cash-on-cash multiple or the realization multiple.
Internal Rate of Return (IRR)
IRR is the rate of return that sets a portfolio's net present value to zero. It represents the annual growth that your portfolio is expected to generate.
While IRR has a more complex definition than the above performance metrics, the IRR is simply the annual rate of growth that an investment is expected to generate over a time horizon. This is useful because IRR takes into account the importance of time when it comes to investments.
Per Pitchbook, in the 2010 - 2020 vintage years, the median IRR for top decile VCs globally was 43.97%, but varies widely based on vintage year between 34.47% to 96.23%.
Early in a fund’s lifecycle, IRRs can be particularly volatile and may not be an accurate representation of performance in the first few years.
A markup occurs when the valuation and perceived market price of an investment increases relative to the last time it was evaluated and/or at the time of the investment.
Early-stage investors often see portfolio companies raise additional capital on a SAFE or note at a higher cap than their original investment. True markups are based on priced rounds, calculated using the new price per share. You can include details of these SAFE or note rounds in LP communications but don’t misrepresent them as markups.
Cash-on-cash return (also referred to as money-on-money return) is the (annual net cash flow of an investment) / (initial investment). This is another metric that helps assess the cash an investment generates relative to the amount of initial investment.
A Schedule K-1 is a tax document that helps investors in venture funds calculate their tax obligation for the year. A VC fund – typically their legal counsel or back office – sends K-1s to LPs and GPs annually to help them calculate their tax liability when filing taxes.
Form 1065 (also known as a “partnership tax return”) is issued by IRS to help them understand a company’s financial status progresses until the end of the tax year. In Form 1065, the partnership will need to report total net income and all other relevant financial information for the partnership.
Limited Partnership Agreement (LPA)
An LPA is the document between LPs and GPs that defines the structure and governing principles of the fund. An LPA outlines important characteristics regarding the fund including, but not limited to, fund size, management fees, returns distribution, and term of the fund. The LPA is the primary governing document for the fund.
If you’re a new fund manager, thinking of starting a fund, or just curious, subscribe to Signature Block if you haven’t already. If you think this might be useful for emerging managers, share on Twitter.
Lastly, let us know what topic you’d like us to cover in the next edition.
Until next time!
Ryan and Vedika from Weekend Fund :)
Subscribe to Signature Block
Should I start a fund?
Everybody is starting a fund. Is it the right decision for you?