How Do Capital Calls Work?

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• A capital call is the process by which a fund manager asks the fund investors to contribute their pro rata portion of their fund commitments.
• Capital calls are legally enforceable and typically follow the rules set out in the fund's limited partnership agreement.
• LPs who default on capital calls risk penalties and legal action.
  

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Picture this: you just invested in your first venture fund on AngelList. 

You agreed to commit $100k to the fund. Right now, you have to pay only a portion of that amount—in this case, perhaps, $25k—as mandated by the fund manager (also known as the general partner or "GP"). You can hold onto the remaining $75k for the time being. At some point in the future, the GP will “call” the remaining capital. This process is known as a capital call.

This guide will review what capital calls are, how they work, and why they're used. 

What Is a Capital Call? 

A capital call is how a GP collects capital from their fund's LPs. GPs make a capital call when the fund needs more money. Capital calls usually happen when a fund plans to make a new investment or needs to pay expenses.

Some common phrases you might hear when a GP does a capital call are “committed capital” and “paid-in capital.”

Committed capital is the total amount that the fund’s investors (also known as limited partners or “LPs”) commit to invest in a fund. If a GP raises a $100M fund, it doesn't mean the fund has $100M sitting in a bank account. That $100M represents the total amount LPs collectively commit to paying over the fund's life. 

LPs put up only a portion of their committed capital at the beginning of the fund’s life. This is called the initial drawdown. There is no set amount for this initial drawdown—it can vary widely depending on GP preferences, fund needs, and deals negotiated with individual LPs.

Paid-in capital is how much money the LPs have put into the fund. The difference between committed capital and paid-in capital is called uncalled capital—the amount that LPs still “owe” the fund. Capital calls are how the GPs convert uncalled capital into paid-in capital.

While there is no standard format for a capital call notice, a typical capital call notice includes:

• The LP’s share of the amount due,
• The portion of all committed capital called,
• Banking details, and
• Payment due date.

Capital calls are legally enforceable and generally follow the rules outlined in the fund's Limited Partnership Agreement (LPA). LPAs typically spell out things like:

• How quickly an LP must pay after receiving a capital call notice (typically 10-20 days).
• The maximum amount GPs can request via capital calls during a specified time period. For example, an LPA might restrict a GP  from calling more than half of all committed capital in a year. 
• The fund’s deployment period, during which the fund will make all its investments (typically the first 2-3 years of the fund’s life). 
• Any limitations on calling capital after the deployment period ends. For instance, an LPA might state that a GP may not call additional capital after the deployment period for investment purposes but can still call uncalled capital for fund expenses. 
• Penalties and remedies if an LP fails to meet a capital call. These are known as "default provisions" (more on this later).

Capital Call Example

Here’s an example of how a capital call works.

Say you commit $100k to a $100M fund. The LPA states that the initial drawdown is 30%—that is, you must contribute $30k to the fund now and hold onto your remaining $70k until it's called. The GP invests the initial $30M drawdown from all LPs in several early-stage companies.

Six months after the initial drawdown, the GP decides to call another $20M. Since that’s 20% of the fund’s committed capital, LPs must send 20% of their initial committed capital within ten days (or whatever time frame the LPA specifies) of the capital call notice. Because you committed $100k, you must send $20k. 

Your uncalled capital now stands at $50k. 

Seven months later, you get another capital call for 30% of all committed capital. And three months after that, you receive a final capital call for the remaining 20%. Once you’ve sent your full $100k, you have fulfilled your commitment to the fund.

When Does a GP Issue a Capital Call?

The simple answer is that GPs call capital whenever they think the fund needs it. However, the GP is likely to take into account additional considerations when timing capital calls. 

In particular, GPs must consider how capital calls will impact their relationships with LPs. A poorly timed capital call can put LPs in a bind by forcing them to part with their money when they may not have been ready. This can put stress on the relationship between the GP and LPs. For this reason, venture capital funds sometimes use "capital call lines." These are short-term credit lines from a financial institution secured against the LPs' uncalled capital. 

GPs use these credit lines to pay fund expenses and make investments upfront. Later, at a more appropriate time, the GPs can issue a capital call and use the proceeds to repay the credit line. Using credit lines can help GPs avoid potential issues around time sensitivity or capital call limits. 

What Are the Benefits of Capital Calls?

The capital call model offers both GPs and LPs several benefits:

For GPs:

• Avoid "cash drag." Less cash on hand means a better Internal Rate of Return (IRR) and Total Value to Paid-in Capital (TVPI)—two key fund performance metrics.
• Help raise money. GPs can promote a low initial drawdown as a way to entice LPs to invest in their fund.

For LPs:

• Hold on to some of their capital. Not having to contribute all their capital upfront gives LPs flexibility to invest the capital elsewhere until it’s called. ‍
• Use distributions to cover future investments/expenses. Some funds pay distributions to LPs before calling all of their committed capital. In this case, LPs can use these distributions to cover part or all of their commitments.

Drawbacks of Capital Calls

The capital call model also has drawbacks. Among them:

• Strained GP–LP relationships. Poorly handled capital calls can sour the GP–LP relationship. For example, a GP might strain their relationship with an LP by calling capital more frequently and earlier than the LP anticipated. ‍
• Delayed deals. Waiting several days to receive called capital could result in missing out on a time-sensitive deal. ‍
• Additional costs. Capital calls have administrative costs. They require the GP to send out capital call notices, handle incoming funds, and deal with defaulting LPs. Additionally, should a GP choose to use a capital call line, they will incur interest plus other fees.‍
• Risk of LP default. LPs may not be able to fulfill their capital commitments when a capital call comes due.

What Happens if an LP Can’t Meet a Capital Call?

An LP who can't meet a capital call is considered in default and is potentially subject to penalties and legal liability. Generally, the fund manager determines which penalties outlined in the LPA, if any, to apply in any particular situation. Some standard default penalties in an LPA are: 

• Canceling the LP’s right to contribute more capital and capping their participation based on current paid-in capital.
• Limiting the LP’s share of future distributions.
• Charging penalty interest on the capital call amount the LP failed to honor.
• Forcing the LP to sell their current interest in the fund to other LPs or third parties under specific terms.
• Seeking legal compensation under common law for damages to the fund resulting from the LP’s failure to meet the capital call.

How Do GPs Manage Risk of an LP Default?

To reduce the risk of LP default, GPs might decide to work primarily with institutional investors or LPs with a track record of filling their commitments. If possible, GPs can try to time capital calls with distributions so that LPs can use these distributions to help cover capital calls.

Capital Call Checklist for GPs

Here are a few questions LPs may ask about capital calls when considering investing in a fund that GPs should have an answer for:

• Are there any capital call limits? If so, what are they?
• Is there a set schedule for when capital will be called and how much will be requested?
• What are the penalties for defaulting on capital calls?
• What are the penalties in the event of a default?

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