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Let's say you want to launch a venture fund with a friend. One of the first things you'll likely do is establish a management company to operate the fund.
As the fund managers (often referred to as the general partners, or “GPs”), you have many options for structuring this new entity. Choose wisely, as this will affect how you manage your fund. Incorrect handling can result in costly disagreements and time-consuming amendments.
This guide provides an overview of best practices for emerging fund managers who want to structure and operate a management company. But first, let's explore why GPs set up management companies at all.
A management company is a business entity—typically an LLC—that manages the operational business functions associated with running a venture fund or group of funds. Management company responsibilities include:
Partners often want ownership in the management company because it provides them with fund management fees collected from LPs (assuming those fees aren’t reinvested back into the fund or used to pay operating expenses). Partners divvy up management fees based on the terms of the management company’s operating agreement. Note that these management fees are different from the carried interest that partners can earn from successful investments.
The founding partners of a firm typically set up and own the management company. As the firm grows and adds new partners, ownership of the management company may expand.
Large venture capital firms may not include junior partners in the management company. Some firms require junior partners to reach a milestone—such as closing a minimum number of deals—before bringing them into the management company.
When a firm is trying to hire a new partner, they may offer them ownership in the management company as an added incentive.
GPs use one of two management company structures: a single-member management company or a multi-member management company. Let’s look at both.
Single-member management companies give one partner full ownership of the management company. Many new GPs prefer the single-membership route because it can simplify the formation process and keep expenses low. Furthermore, it's relatively easy to change to a multi-member management company later on. Partners may do this when the fund's committed capital grows and the GPs bring on more partners.
In this sense, creating a single-member management company acts as a stopgap until the firm has matured to where a multi-member management company may make sense.
Some partners prefer to create multi-member management companies from the start. Often this happens with large funds—such as a fund where the partners are raising more than $10M (the amount at which the SEC requires a reduction in the number of accredited investors in a venture fund from 250 to 100).
When creating a multi-member management company, the partners must agree on specific terms such as who gets compensated on future funds and who can make certain decisions on behalf of the fund. If partners aren’t aligned, this process runs the risk of creating deadlocks and disagreements as the firm grows.
Partners also might go the multi-member route when they have a close working relationship and are committed to running a fund together full-time for the foreseeable future. Creating a multi-member management company is vital if the partners hope to build a long-lasting brand, as the management company—not the individual partners—will own the trademark and fund track record.
Single-member management companies offer GPs flexibility and have a lower setup cost. Multi-member management companies require partners to clearly define the terms of their arrangement from the outset, which may prevent difficult conversations in the future but often comes with a higher price tag and more time spent upfront.
Emerging managers should base their management company structure on what the partners expect to do. If they’re raising just one fund, with no plans for another, it may not make sense to invest significant time and money setting up a multi-member management company. However, if this is not the partners’ first fund, or if they want to build a long-term brand, it’s often worth putting forth the effort upfront to consider how to divide up responsibilities.
If you have questions about which structure is best in your situation, consult with a lawyer or other professional.
Setting up a management company is one thing; running it is another. Here are some common questions GPs ask about running a management company:
Single-member management companies can pay partners without formally admitting them to the management company via a supplemental side letter agreement. Partners or members can also set up employment agreements between the fund managers or arrange distributions under the firm’s operating agreement.
Fees collected by the management company get allocated to the owners per the management services agreement. The management services agreement dictates the relationship between the management company and the fund.
Management companies may also hire managers as employees and pay out salaries.
Management company operating costs vary greatly. Partners should budget for professional services—including legal, accounting, and tax preparation—as well as taxes and fees for office leases, banking, liability insurance, etc.
Refer to Taylor Davidson’s article on the AngelList blog for an example of how to create a budget for operating your management company.
Generally, setting up a management company requires a certificate of formation, operating agreement, business registration, and management services agreement.
Operating a management company also requires a business bank account. Additionally, some LPs will want to see a code of ethics. Depending on the ownership structure you choose, there may be other formal requirements—consult a legal professional if you have any questions about your specific structure.
The tax implications of owning a management company can vary widely based on the type of entity and the number and residency of its owners. The following is a non-comprehensive list of tax consequences. Please consult a tax advisor for more information.
There are other tax considerations beyond just tax compliance. Management fees collected by the management company are taxed as ordinary income, meaning they don’t benefit from the favorable rate capital gains currently receive. Additionally, if the management company hires employees, it’s also subject to various payroll taxes.
Management companies play a necessary—albeit opaque—role in operating a venture fund. For GPs, they’re foundational to how their fund(s) will operate today and in the future.