Understanding venture capital carried interest
In the world of venture capital funds, as with private equity funds, carried interest (often referred to as ‘carry’) serves as the primary economic attraction for fund managers to raise, deploy and generate a return on third-party capital. Carry also represents an essential mechanism for fund managers (‘GPs’ or ‘firms’) to attract and retain talent while motivating high performance.
The logic is that a manager wants to hire the best available talent. Usually, these individuals are well educated and are capable of earning large corporate salaries. But because profit is so deferred in fund management, especially in the case of VC funds, the carry serves as the principal pool of (future) funds that will more than compensate a fund management executive for sacrificing large corporate earnings during the years of deployment and asset management.
For this reason, MENA-based venture capital (VC) firms are increasingly recognising the importance of formalising carried interest distribution arrangements among the manager’s senior partners, investment management teams and employees. Understanding the commercial and legal aspects of carried interest plans is crucial for both the firms and their investment teams, as these plans impact fund formation and compensation structures. This article outlines some of the main legal and commercial terms of a carried interest plan.
A well-drafted carried interest plan not only motivates high performance but also attracts third-party capital, making it a critical element of a VC firm’s long-term success.
What’s the plan?
The structure of a carried interest plan is often influenced by several factors, including:
regulatory (eg, regulation of the plan or exemption thereof)
tax (eg, tax treatment of the carried interest, estate planning considerations)
legal (eg, recipients' rights and obligations, employment law issues)
operational (eg, ease of implementation)
cost considerations.
A wide variety of structures and arrangements are possible, such as carried interest tax-transparent vehicles, corporate vehicles with restricted stock units or phantom equity interests, and even bonus schemes.
For many mid-sized VC funds in the MENA region, it’s common to establish a ‘carried interest partner’ or ‘special limited partner’ to participate as a limited partner in the VC fund, which itself is typically a limited partnership. This structure, also prevalent in the United Kingdom, allows the carried interest partner to participate alongside the other investors as a limited partner in the VC fund.
Many of the considerations regarding plan type also apply to selecting the type of legal entity for the carried interest limited partner. Establishing a limited partnership in jurisdictions like the Cayman Islands, Abu Dhabi Global Market (ADGM) or Dubai International Financial Centre (DIFC) is a popular choice. The limited partnership is established as a contractual relationship between the investment professionals and other employees as limited partners, with one general partner typically.
Establishing the partnership by way of an agreement allows for a wide range of commercial provisions, including issuing different classes of interests to different categories of staff, setting out bespoke allocation, vesting and distribution provisions, providing for default provisions and including clawback terms in case of overpayment of carry to the carried interest partner, as discussed below.
Generally, regulators recognise that carried interest plans are employee compensation schemes, so investment fund regulations don’t usually apply to them. Carried interest partners are not normally required to prepare audited accounts. Although the best practice is to appoint an auditor, start-up or smaller VC managers may not be able to afford this additional expense. At a minimum, regular and transparent financial and deal reporting to the participants is required.
Typically, the details of a carried interest plan won’t be visible to investors in the VC fund, but larger investors may request that key persons of the GP or fund manager receive a minimum allocation of the carried interest. Such investors might also ask for information on the vesting terms of the plan to ensure alignment of interests of all parties throughout the fund’s term.
Well-structured carried interest plans can also play a key role in attracting third-party capital into a VC firm. As VC has become an essential subset of the private equity asset class for many of the larger MENA fund managers, VC firms should carefully consider adopting best practices in their plans.
Main terms
Some of the main terms of a carried interest plan are briefly explained below.
Participants
The partners and senior investment professionals of a VC firm will normally be allowed to share in the carried interest of the VC firm. It’s not uncommon for other senior members of the VC firm, such as the general counsel or CFO, to also participate.
Where the carried interest plan is structured as a carried interest partner, participants become limited partners in the carry vehicle. Depending on tax or regulatory considerations, the VC firm may also hold a limited partner interest to facilitate sharing of carried interest (eg, through bonuses) with employees of the VC firm not directly participating as limited partners in the carried interest partner and who do form part of the senior investment team of the VC firm.
Although most participants in a carried interest plan usually have limited rights, founders and senior partners of the VC firm often enjoy more robust rights, including significant management privileges and anti-dilution protections.
Governance
The management of the carried interest vehicle is typically vested in its governing body. For example, the board of directors of the general partner of a carried interest partner will manage the vehicle. However, from a commercial perspective, the carried interest partner is normally managed by the fund manager or its principals. For mid-sized and larger fund managers, best practice is to establish a compensation committee at the VC firm, empowered with a reasonable level of discretion to ensure that carry arrangements function effectively over time.
Governance provisions in a carried interest partner limited partnership agreement should typically include a no-removal clause for the general partner, appropriate exculpation and indemnification provisions, tax withholding provisions and defaulting partner provisions for breaches of the carried interest partner’s limited partnership agreement.
Allocations
A carried interest plan should clearly outline the allocation or profit-sharing percentages of the carried interest. Allocations may be made for each fund (as opposed to each deal), incentivising participants based on the fund's overall success rather than individual investment performance. This is often the case for VC funds because of their high volume of investments.
Fund-based allocations normally include the ability for the VC firm to repurchase the interest of a departing participant to avoid the unfair entrenchment effect of an allocation of the carried interest based solely on the VC fund’s performance. Where allocations are made on the individual success of investments, participants will share in the carried interest for their roles in specific deals or contributions to specific investments. Allocations by vintage year are also possible.
The allocation provisions may also address the dilution of existing participants in connection with the admission of new participants, reallocation of unvested carried interest in connection with a departure, and dilution and allocation of carried interest in connection with the sale of a portion of the fund manager to a third party. A VC firm must carefully consider the allocation model that offers the greatest benefits to both the firm and its participants.
Vesting
Vesting allows the continued alignment of interests between the VC firm and the participants in a carried interest plan. The vesting period and the rate at which vesting occurs can differ significantly among VC firms. Vesting is often linked to the investment period of the fund, following a straight-line method or a five-year vesting schedule (20% per annum) with an initial one-year cliff (0% in year one), though variations may exist. Some VC firms prefer to leave 10% of the allocation unvested until the fund is fully liquidated.
Founders of the fund manager may receive preferential treatment through accelerated vesting or fully vested terms. Some employees may negotiate immediate vesting of a larger portion of the allocation grants upon the fund’s closing, in recognition of significant contributions to the fundraising process. It’s important to note that vesting schedules are typically adjusted based on the specific circumstances surrounding the departure of a participant. This brings us to our next provision.
Adjustment events
Adjustment events refer to leavers (eg, termination of employment, death and disability) or cause events (eg, breach of the employment or consulting agreement, gross negligence or other misconduct related to employment or service with the fund manager, criminal conduct or conduct putting the fund manager or the fund in disrepute) concerning a participant that allows the fund manager to adjust the carry allocation.
In the case of a cause event, all vested and unvested carried interest is typically forfeited. Any forfeited carried interest will usually be reallocated to the reserve pool of unallocated carry or, in some cases, allocated to a pool of senior partners of the VC firm. The terms of a carried interest plan may also allow the fund manager of the plan to enter into an agreement with a participant to modify a vesting schedule or other terms relating to the carry allocation upon the occurrence of an adjustment event.
It’s crucial that adjustment events are not drafted in isolation but considered within the broader context of the participant’s employment or consulting arrangements with the VC firm or its affiliates. Post-employment covenants, namely breaches of non-compete and non-solicitation provisions, require enforceability advice from employment law counsel.
Distributions
There are various methods for allocating carry for distributions to the participants in a carry plan, such as distributions based on investments or distributions based on the end of term of the underlying fund. But the chosen method will need to take into account the waterfall clause and carry payment mechanism of the underlying VC fund and the overall allocation and vesting provisions of the plan.
Clawback
If the carried interest partner is required to contribute any amount to the VC fund as a ‘clawback amount’, pursuant to the provisions of the VC fund’s limited partnership agreement, each participant in the carried interest vehicle should be required to contribute to the carried interest vehicle such participant’s pro rata share of such contribution. Participants may also be required to guarantee the carry vehicle’s obligation to pay the ‘clawback amount’ to the VC fund (typically on a several, not joint, basis).
No transfer
As carry plans are mainly designed to recruit and retain senior professionals, interests in such plans are considered personal benefits and, other than estate planning-related transfers, cannot be transferred without the fund manager's explicit approval.
GP removal
The offering documents of a VC fund will normally include provisions for the removal of the GP, both with and without cause, to protect the investor interests and uphold effective governance standards. Any resulting reduction in carried interest payments to the carried interest partner must be addressed and accounted for within the carried interest plan.
Reporting
An increasing number of VC firms recognise that compensation transparency is a key factor in attracting investment professionals. At a minimum, annual reporting should include a description of investments made or disposed of during each financial period, along with participant statements. Furthermore, various organisations offer software solutions that enable more detailed and transparent customised reporting, allowing VC firms to provide participants with statements similar to those offered by banking or investment platforms.