Venture capital funds in the United States are almost always structured as Delaware limited partnerships, with a general partner making the investment decisions and limited partners supplying the capital. A separate management company employs the investment team and handles day-to-day operations under a services agreement with the fund. This three-entity setup, the fund, the general partner, and the management company, exists to solve three problems at once: avoiding a second layer of federal income tax, shielding passive investors from liability beyond what they committed, and fitting within exemptions from the securities laws that would otherwise force the fund to register as an investment company.
Why the Limited Partnership Form
The tax code is the reason. Partnerships are not subject to federal income tax at the entity level.1Office of the Law Revision Counsel. 26 USC 701 – Partners, Not Partnership, Subject to Tax Gains and losses flow through to each partner’s own return, so investors are taxed once rather than twice. In an asset class where a single exit can produce outsized gains, avoiding that second layer meaningfully changes net returns.
The rest of the structure follows from that choice. Most funds form in Delaware, whose partnership statute gives broad effect to whatever the parties negotiate. The Limited Partnership Agreement (LPA) is the controlling document. It sets how capital gets called, when profits are distributed, what the managers can and cannot invest in, and how disputes get resolved. LPA terms are heavily negotiated and vary from fund to fund.
The General Partner and the Limited Partners
The general partner runs the fund. It picks the companies, negotiates terms, takes board seats, and decides when to exit. The tradeoff for that control is unlimited personal liability for the fund’s obligations.2Legal Information Institute (LII). General Partner Nobody wants to hold that exposure personally, so the general partner entity is almost always an LLC rather than an individual. The managers own interests in the LLC, and the LLC serves as GP of the fund, keeping the individuals’ personal assets outside the liability perimeter.
Limited partners are the capital. Pension funds, university endowments, insurance companies, sovereign wealth funds, and wealthy individuals commit specific dollar amounts to the fund. They have no vote on which companies get funded and no role in managing those investments. That passivity is what earns them the liability cap: an LP can lose the capital committed, but creditors of the fund cannot reach the LP’s other assets. Cross the line into active management and courts can strip that protection and treat the investor as a general partner for liability purposes.
Fiduciary Duties, Adjusted by Contract
The general partner owes fiduciary duties to the limited partners, but under Delaware law the LPA can modify, restrict, or even eliminate traditional duties like the duty of care. The duty of loyalty is harder to waive entirely; Delaware courts have reserved the right to refuse enforcement of loyalty waivers in cases of truly egregious misconduct. Most fund agreements narrow these duties significantly while preserving the implied covenant of good faith and fair dealing, which cannot be waived.
Key Person Provisions
LPs invest in a fund largely because of the specific people managing it. Key person clauses name one or more individuals and provide that if any of them dies, departs, or stops devoting substantially all of their business time to the fund, the fund’s authority to make new investments is suspended. The investment period pauses until the key person returns, the LPs vote to approve a replacement, or the fund winds down. This is the main structural check LPs hold without having to participate in day-to-day management.
The Management Company
The fund itself is a lean entity. It holds investments, receives distributions, and allocates profits. The actual business of running a venture firm, employing analysts, leasing office space, paying outside counsel and auditors, sits inside a separate management company, typically an LLC or corporation. That entity enters into a services agreement with the general partner to provide investment advisory and administrative services to the fund, and it receives the management fee described below to pay for all of that.
Splitting the management company off from the fund does two things. It keeps operating expenses from directly eating into the capital earmarked for portfolio companies. And it lets the firm persist across fund generations. A single firm may raise Fund I, Fund II, and Fund III over a decade, each a distinct limited partnership with its own investors and its own lifecycle, while the management company employs the same team across all of them.
How the Managers Get Paid
The economic arrangement is commonly called “two and twenty.” The general partner charges an annual management fee, typically 2% of committed capital during the investment period. This fee flows to the management company and covers salaries, travel, diligence, and overhead. After the investment period ends, many funds reduce the fee basis from committed capital to invested capital, because the fund is no longer deploying new money.
The upside for the GP is carried interest: a share of the fund’s profits, typically 20%. Carry only kicks in after the limited partners get their capital back plus a minimum annualized return, called the hurdle rate or preferred return, usually set at 8%. The full distribution sequence is the waterfall:
- Return of capital. LPs get back every dollar they contributed before anyone takes profit.
- Preferred return. LPs receive an annualized return, typically 8%, on their contributed capital.
- GP catch-up. The GP receives 100% of the next tranche of distributions until it has received 20% of all cumulative profits.
- Final split. Remaining profits are divided 80% to LPs and 20% to the GP.
The catch-up is the piece most people miss. Without it, the GP would only receive 20% of profits above the hurdle, not 20% of total profits. The catch-up ensures the GP’s overall share reaches the full 20% of all gains once the hurdle is cleared.
GP Commitment
To align incentives, the general partner typically commits between 1% and 5% of the fund’s total capital alongside the LPs. Investing their own money next to their investors signals confidence and ensures the managers share in any losses, not just gains.
Carried Interest and the Three-Year Hold
Carried interest has historically been taxed at long-term capital gains rates rather than as ordinary income. Section 1061 of the Internal Revenue Code adds a constraint: for gains allocated through a carried interest to qualify for long-term capital gains treatment, the underlying assets must be held for more than three years rather than the standard one year.3Internal Revenue Service. Section 1061 Reporting Guidance FAQs This directly influences exit timing. Selling a position at two and a half years instead of three can mean a materially higher tax bill on the carry.
Clawback
Venture returns are lumpy. A fund can produce a big early exit that triggers carry distributions, then absorb write-offs that pull overall performance below the hurdle. Clawback provisions require the GP to return excess carried interest at the end of the fund’s life if final performance doesn’t justify what was already paid. Most clawback calculations are done net of tax, since the GP has already paid income tax on the earlier distributions. Institutional LPs increasingly push for interim clawback testing rather than waiting until final liquidation.
Capital Commitments and the Fund Lifecycle
A venture capital fund typically has a ten-year life, with the option for one or two one-year extensions if the GP needs additional time to exit remaining positions. Investors don’t wire their whole commitment on day one. The GP issues capital calls as deals arise, drawing down a portion of each LP’s commitment each time. LPs keep uncalled capital in their own liquid accounts until it is actually needed.
The first three to five years form the investment period, when the fund is writing checks into new companies. After that, the fund enters a harvest period focused on supporting existing portfolio companies, following on in later rounds where appropriate, and working toward exits through IPO or acquisition. As exits produce cash, the fund distributes proceeds according to the waterfall. Once every investment is sold or written off, the partnership dissolves.
Recycling
Many LPAs let the GP reinvest certain proceeds rather than distributing them immediately. If a fund sells a position early in the investment period, recycling provisions allow the GP to redeploy that money into new deals instead of returning it to LPs and shrinking the investable base. Scope matters. Some agreements allow recycling of only returned capital; others also permit recycling of profits. Aggressive recycling can push the total amount invested above the fund’s stated committed capital, which increases LP risk. Sophisticated investors typically negotiate caps or restrict recycling to returned capital only.
Side Letters and Most Favored Nation Clauses
Not every limited partner invests on the same terms. Large institutional investors often negotiate side letters that modify or supplement the LPA for their particular commitment. Common provisions include reduced management fees, co-investment rights, enhanced reporting, and the right to opt out of investments that conflict with the investor’s own policies or regulatory constraints.
Because those terms are valuable, other LPs want access. Most favored nation (MFN) clauses give an investor the right to elect any benefit the GP granted to another LP by side letter. In practice, the GP circulates the side letters, sometimes redacted, to LPs with MFN rights, and those investors have a window, typically 30 days, to elect the provisions they want. Some funds now embed the MFN mechanic directly in the LPA rather than handling it through a separate side letter.
Securities Laws That Shape the Structure
The structure also has to fit within a set of federal exemptions. Venture funds avoid registering as investment companies by relying on exemptions under the Investment Company Act. The most common is Section 3(c)(1), which exempts an issuer whose securities are held by no more than 100 beneficial owners, provided the fund doesn’t make a public offering. Larger funds that need more investors use Section 3(c)(7), which allows up to 2,000 beneficial owners as long as every investor is a “qualified purchaser,” a higher wealth threshold than the accredited investor standard.4Office of the Law Revision Counsel. 15 USC 80a-3 – Definition of Investment Company
On the offering side, funds typically sell partnership interests under Rule 506(b) of Regulation D, which allows a fund to raise an unlimited amount from accredited investors without SEC registration, provided the fund doesn’t engage in general solicitation.5U.S. Securities and Exchange Commission. Private Placements – Rule 506(b) Rule 506 preempts state-level securities registration, though states can still require notice filings and collect fees under their blue sky laws.
Adviser Registration
Managers who advise only venture capital funds qualify for an exemption from full SEC registration under Section 203(l) of the Investment Advisers Act. They file as “exempt reporting advisers,” which requires limited SEC reporting but avoids the full compliance load of registered advisers. A separate exemption under Section 203(m) covers private fund advisers with less than $150 million in U.S. assets under management, regardless of fund type.6U.S. Securities and Exchange Commission. Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management Managers who exceed $150 million and don’t qualify as venture capital fund advisers generally must register with the SEC.
ERISA and Pension Money
Pension funds are among the largest sources of venture capital, but their money brings its own regulatory constraint. Under the Department of Labor’s plan asset regulation, if 25% or more of any class of equity interests in a fund is held by benefit plan investors, including ERISA pension plans, IRAs, and Keogh plans, the fund’s underlying assets are treated as plan assets.7eCFR. 29 CFR 2510.3-101 – Definition of Plan Assets, Plan Investments That designation would subject every transaction the fund makes to ERISA’s fiduciary and prohibited transaction rules, which would be operationally crippling.
Funds handle this one of two ways. Some cap pension participation below 25%, often targeting the low twenties as a buffer. Most funds that want substantial pension money instead qualify as a venture capital operating company (VCOC). A fund meets that standard if at least 50% of its assets, valued at cost and excluding short-term holdings, are invested in operating companies, and the fund actually exercises management rights in at least one of them during each annual valuation period.7eCFR. 29 CFR 2510.3-101 – Definition of Plan Assets, Plan Investments Management rights include the right to appoint a board member, inspect the company’s books, and consult with management on operations.8U.S. Department of Labor. Advisory Opinion 2002-01A Most venture funds meet these tests naturally, since board seats and information rights are standard terms in startup financings. Maintaining VCOC status requires annual testing, so managers track asset composition and document their exercise of management rights on an ongoing basis.