Article

Venture Capital Limited Partnership Agreements: Understanding Compensation Arrangements

Kate Litvak

Assistant Professor, University of Texas School of Law

The initial research for this Article was conducted while I was an Olin Fellow in Law and Economics at Columbia Law School. I would like to thank Bernie Black, John Donohue, Merritt Fox, Ron Gilson, Victor Goldberg, Jeff Gordon, Zohar Goshen, Michael Guttentag, Todd Henderson, Michael Jensen, Steven Kaplan, Michael Klausner, Ed Rock, Jeff Strnad, Susan Woodward, the editors of The University of Chicago Law Review, and participants in The Going-private Phenomenon: Causes and Implications, the annual meeting of the American Law and Economics Association, and the Columbia Law School Blue Sky Lunch for comments. I especially thank the venture capitalists, venture capital lawyers, and representatives of institutional investors who were willing to answer my questions and in some cases provide the limited partnership agreements that are the focus of this Article. Those who have given me permission to name them include: Steven Anderson at Kleiner Perkins Caufield & Byers; Alan Austin at Silver Lake Partners; Micah Avni of Jerusalem Global Ventures; Jonathan Axelrad at Wilson Sonsini Goodrich & Rosati; Thomas Beaudoin at Testa, Hurwitz & Thibeault; Bill Campbell at Ater Wynne; Craig Dauchy at Cooley Godward Kronish; Ken DeAngelis at Austin Ventures; Alex Gould at Stanford Law School; Ryan Lester, formerly at O’Melveny & Myers; Andrei Manoliu; J.B. Pritzker; John Quigley at Nassau Capital; and Mark Tanoury at Cooley Godward Kronish. I owe special thanks to Susan Woodward at Sand Hill Econometrics for sharing data on VC performance with me.

This Article uses a hand-collected dataset of venture capital partnership agreements to study venture capitalist (VC) compensation. Several new findings emerge. First, VC compensation consists of three elements, not two (management fee and carried interest), as commonly believed. The third element is the value-of-distribution rules that specify when during the fund’s life VCs receive distributions. These rules often generate an interest-free loan to VCs from limited partners. A shift from the most popular distribution rule to the second-most popular rule can affect VC compensation as much as or more than common variations in management fee (from 2 percent to 2.5 percent of committed capital) or carried interest (from 20 percent to 25 percent of fund profit). Second, VC compensation is often more complex and manipulable than it could have been. However, more complex management-fee provisions predict lower total compensation; thus, complexity is not used to camouflage high pay. Third, common proxies for VC quality predict higher levels of the more transparent forms of VC compensation (carried interest and management fee) but do not predict the levels of opaque compensation (interest-free loan, as determined by distribution rules). Fourth, long-term VC performance predicts fund size (which in turn predicts VC pay, controlling for fund size), but recent performance does not predict changes in fund size. Finally, VC compensation is less performance-based than commonly believed: for vintage years between 1986 and 1997 (most recent years for fully liquidated funds), about half of total VC compensation comes from the nonrisky management fee. On average, a 1 percent increase in fund returns predicts a 0.47 percent increase in total VC compensation; this pay-performance elasticity is similar to that of public company CEOs during the same years.

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