Zombie VCs: The Undead of Venture Capital 🧟

The VC world is seeing a rise in zombie VCs—venture firms unlikely to raise new capital/back new startups

The Great Reset:
• 1.3K new VC funds emerged
• Unique investors in startups cut 50%
• 25% of VCs made 1 investment since '23 Characteristics of Zombie VCs

A venture capital firm that:
• Still collects management fees ✅
• Manages but does not liquidate portfolio ✅
• Unable to raise new funds ❌
• Seeks new opportunities but stops investing* ❌

Over each of the past 2 years, just 𝟱% of the total VC market value has been distributed to LPs—leaving a massive gap in liquidity. What can GPs do?

𝗘𝗻𝘁𝗲𝗿 𝗖𝗼𝗻𝘁𝗶𝗻𝘂𝗮𝘁𝗶𝗼𝗻 𝗙𝘂𝗻𝗱𝘀 💡

• LPs are restless for liquidity. While recent fund vintages don't have DPI to give, more mature venture funds are stretching well beyond their original 10-year timelines. 1-to-2 year extensions are manageable, but after 12+ years (with fees piling up), LPs understandably want their money back.

•  Continuation funds have become a go-to strategy in PE to fix this problem. LPs can either cash out or roll over their interests into a new vehicle. This provides liquidity for LPs who want to cash out while allowing long-term investors to stay invested & maintain exposure to the portfolio.

According to a 𝗨𝗻𝗶𝘃𝗲𝗿𝘀𝗶𝘁𝘆 𝗼𝗳 𝗖𝗵𝗶𝗰𝗮𝗴𝗼 𝗕𝗼𝗼𝘁𝗵 paper:

🔹 +𝟳𝟱𝟬% 𝗶𝗻𝗰𝗿𝗲𝗮𝘀𝗲 in deal value over 5 years, hitting $68 billion in 2021.

🔹 𝟴𝟬-𝟵𝟬% 𝗼𝗳 𝗟𝗣𝘀 in legacy funds opt to cash out rather than roll over.

🔹𝟰𝟰-𝟱𝟬% of total secondary market volume came from GP-led secondaries between 2020-2023—that is, $102-126 billion annually.

However, there are challenges, particularly in venture capital:

🔹 𝗤𝗦𝗕𝗦 𝗘𝗹𝗶𝗴𝗶𝗯𝗶𝗹𝗶𝘁𝘆: When a continuation fund buys assets from the original fund, LPs might lose their QSBS eligibility. QSBS typically requires the stock to be held directly by the taxpayer or through a pass-through entity (like a VC fund) for at least 5 years. Careful tax structuring around this is possible, but it adds complexity.

🔹 𝗖𝗼𝗻𝗳𝗹𝗶𝗰𝘁𝘀 𝗼𝗳 𝗜𝗻𝘁𝗲𝗿𝗲𝘀𝘁: GPs may collect more fees and carry without full performance alignment, creating tensions between LPs & new LPs. Also LPs often lack sufficient data for informed decisions.

🔹 𝗡𝗼𝘁 𝗮𝗹𝗹 𝗟𝗣𝘀 𝘄𝗮𝗻𝘁 𝗼𝘂𝘁: Some LPs may prefer to stay invested—there's no "status quo" option; LPs forced to cash out or accept new terms.

🔹 𝗖𝗼𝗺𝗽𝗹𝗲𝘅𝗶𝘁𝘆 𝗮𝗻𝗱 𝗥𝗮𝗿𝗶𝘁𝘆: While this strategy is relatively common in PE, it's uncommon in VC, at least from my experience. Would be interested to hear how costs and time play a role in this strategy.

—Cooley has offered some alternative strategies for creating liquidity while managing ongoing investments in a VC fund (link in comments).

—Articles have promoted the "rise of continuation funds" but I haven't seen it yet in my practice (admittedly, for early stage/emerging funds, this is probably not a thing).

𝗕𝗼𝘁𝘁𝗼𝗺 𝗹𝗶𝗻𝗲: Continuation funds are an option to provide liquidity to LPs without forcing GPs into bad exits. But GPs need to provide full disclosure of all potential conflict of interest and have full alignment with a majority in interest of their LPs.

Links in comments. Chart: PitchBook diagram of VC cashflows showing massive gap in liquidity.

@danprimack reports there is a record high "pay-to-play" provisions in Series A venture deals—here's what you need to know:

• VCs are including these clauses in term sheets at the highest levels ever—8.7% of all deals in Q2 2024, the most since 2017 (5.2% for the year).

• Pay-to-Play provisions (or "cramdowns") force investors to join future rounds to maintain their ownership or face penalties (not to be confused with pay-to-play rules or laws on government investment restrictions).

Examples of Pay-to-Play provisions:

—Automatic Conversion Penalty: Non-participants may see their preferred stock converted to common stock

—Loss of Protections: Not participating in next round could mean forfeiting anti-dilution or veto rights.

—Carrot vs. Stick: Participating investors might get bonus shares or other incentives like warrants/discounts.

• Typically seen in later-stage deals, the surge in Series A rounds (from 4.0% in Q3 2022 to 13.7% in Q2 2024) is interesting. Quarterly fluctuations aside, the trend is clear—up and to the right.

Hat tip to @CooleyLLP via CooleyGo for open-source data Here's the trendlines for showing the year-over-year TOTAL deal percentage. Up and to the right.📈

Over 98% of US VC funds now follow European-style distribution waterfall in their LPAs. 🇺🇸🇪🇺

hat tip: @getaumni Step 1: Return Capital to LPs

• 100% of distributions go to LPs until GP has returned LP capital contributions

Step 2: Split the profits 80/20% among LPs/GP

• 80% of the remaining fund returns distributions go to LPs and 20% goes to GP (on a typical 80/20 carry split)

May 2024 Topics on My Professional Research Project for Law of VC 🚢
• Death of SAFE: Long live SAFE Preferred Stock!
• VC Deal Terms Are Changing
• Top 25 Key Issues & Docs in NVCA Deals
• Legal Costs for Series Seed with NVCA Terms
• Detailed NVCA VC Deal Terms
• 6 Law Firms Represent 60% of Startups
• Overview of Relevant Fund Documents
• Crypto Secured More LP Commitments in Q1 2024 then all 2023
• 5 Factors That Apply to Cashless Contributions
• History & Impact of NVCA's Model Docs
• Decline in Series B & C Deal Volume but Surprise!
• Key Takeaways on Liquidation Preferences
• Integration Doctrine for VC Advisers
• Transfer Provisions for RIAs W\O Consent
• Accredited Investor Rules & Pay-to-Play
• Common Stock vs. Preferred Stock
• Summary of Q1 2024 VC Results
• Emerging Manager Fund Formation Timeline
• Q1 2024 Valuations & Median Time b\w Rounds
• Instructions on Where to File 83(b) Notices Law of VC Database: roamresearch.com/#/app/Funds/pa…

⬛ What does a structured term sheet look like? Anything that deviates from these market terms.

Some years ago, an associate at a law firm told me that Pay-to-play provisions were "very common" at Series A—as in, a Pay-to-play provision was inserted in almost all venture deals they did. 👀

This was before law firms like @CooleyLLP and data aggregators like @getaumni @cartainc & @PitchBook published their data freely & consistently. Today we know better.

Everyone in a venture deal wins when they know what's important. Leave the rest to the market.

This is for early-stage financings but there are often shared terms at later stages.

Key Legend:

• Liquidation Preference: Ensures investors get their investment back before other equity holders in the event of an exit or liquidation (1x = dollar for dollar, non-participating = no double dip)

• Dividends: These are distributions of profits to shareholders, and non-cumulative means that if they are not paid out in one year, they do not accumulate to be owed in subsequent years. Startups generally don't issue dividends, but CUMULATIVE dividends are a sneaky way of seeking higher liquidation premiums.

• Anti-Dilution: This provision protects investors from dilution if later shares are sold at a lower price than what they paid, with the broad-based weighted average being a method to fairly adjust the price based on the new & existing shares.

• Pro-rata rights: These rights give "major investors" (lead VCs) the option to participate in future funding rounds to maintain their ownership percentage.

• Board Seat: Right of a venture capital lead investor to have one representative on the company's board of directors (Median # board seats for Seed is 3, Series A is 5)

• Right of First Refusal (ROFR): This grants the investor the right to match any offer the company receives for its shares before the company can sell to another party.

• Redemption: This term, rarely used in early-stage deals, would allow investors to force the company to buy back their shares under certain conditions.

• Pay-to-play: A rarely included provision that requires investors to participate in future financings to benefit from certain protections like anti-dilution or even holding preferred stock.

• Protective provisions: These are veto rights or supermajority vote requirements for major decisions, aligned with the NVCA (National Venture Capital Association) default standards. 1) Liquidation Preferences

A paradox with venture funds right now:
• VC funds are at a 9-year low (-65% in $ Q4 2022)
• Billions still being raised & closed in new funds (GGV–$2.5B, Bain Capital–$2.4B, SignalFire–$900m)

What's the key issue?

• It's not first–time FUNDS. It's first time FUND MANAGERS.

https://twitter.com/scienceisstrat1/status/1627661003449147393

2/ In 2021, VCs closed a record-setting 270 first-time funds raising an aggregate of $16.8B

• However, only 141 first-time VC fund managers closed a fund in 2022, -59% from 2021 & a 9-year low

• LPs invested in 226 VC funds IN TOTAL in Q4 2022 compared to 620 funds in Q4 2021

New Substack: Everything is a Security

This article was a labor of love but it's not a security.

How can you tell when something is a security? Easy! Just ask Gary Gensler, SEC Chair.

1/x There are two ways to approach financial securities.

One is to claim that everything is a security. The other is to cite the Howey test and write a legal treatise explaining why not.

Anyone who claims that securities laws are simple and straightforward is lying to you.

2/x

Crypto funds looking to transition into #RIAs:

• @a16z, @Sequoia & other VCs have gone from ERA to RIA

• Registration is costly & time consuming but not end-all

• If your fund is valued >$150m this year, you must register by March/June next year.

More on this issue 🧵 1/x 2/ Crypto fund formations are often costly because of compliance

• In CA, the 'retail buyer fund' exception requires qualified clients—$2.2m net worth—to charge carry

• Federally, if your funds grow >$150m you must register.

But how does it work?

https://twitter.com/ChrisHarveyEsq/status/1412490535541956609?s=20

What's the secret to max #LPs in a venture fund?

Open parallel funds!

Limits:
• 250 LPs if venture fund <$10m—§3(c)(1)(C)
• 2,000 LPs if all Qualified Purchasers—§3(c)(7)
• ∞ foreign LPs—Reg S.

A legal framework for forming parallel funds.

1/x 🧵 2/ But why are there even limits to raising a fund?

• Three laws makeup 80%+ of venture fund law:
—Securities Act
—Investment Company Act ("ICA")
—Investment Advisers Act

The ICA is one of the three backbones of venture law and the reason a fund has limits.

• 100, 250, or 2k

After 12 years of practicing law each year I learn something new that surprises me—but shouldn't.

2021

• VC fund advisers who file with FINRA qualify as accredited investors, regardless if they themselves are accredited or not.

New Rule: All VC funds = accredited investors.🤯 Now, this is a "new" rule, but it has been on the books since Aug 2020. How did I miss it?

I was researching on a website that hadn't been updated since mid-2020 (Cornell Law).

Eventually someone would have probably called me out.

But how I found out was answering an email.

Law of VC Episode #18 - Simplifying the Safe

• Remove Valuation Caps & Discounts

• Replace with Conversion Percentage

Instead of teaching founders the nuances of discounts, valuation caps and MFNs, why not simplify the Safe and treat it like a cap table with fixed ownership? 2/ After five years of testing pre-money Safes, YC made two major changes to the Original Safe:

1) Pro rata rights removed by default
2) Valuation Cap is now "Post-Money"

What does that mean?

Here's a chart explaining the differences and how to count the other pre-money stuff.

Five Reasons Why Raising a VC Fund is So Difficult:
1. Lack of Transparency & Trad Biases
2. Reliance on Two Types of LPs—FOs and HNWs
3. Risk Aversion
4. Strong Competition
5. Covid-19

Original Source: Samir Kaji (First Republic)
Image Credit: SVB (c) 2020

https://twitter.com/ChrisHarveyEsq/status/1331236377946689538

Market Terms for Emerging Venture Funds:

• Management Fees, Performance Fees, Distributions
• Fund Expenses
• GP Commitments
• Hurdle Rates (Preferred Return)
• Key Person Clauses & GP Removal
• Reporting

https://twitter.com/ChrisHarveyEsq/status/1107998912546308097?s=20

1/ A quick primer on #SPVs

First an #SPV in the VC context simply means an entity setup to provide financing to startups or to acquire secondary shares in pre-IPO companies.

SPV #structures:
-LLC (common)
-LP
-Series LLC: Alumni Ventures Group
-Series LP: Assure/AngelList/etc 2/ Traditionally, #SPVs (special purpose vehicles) were used for structured financing transactions. These entities blew up in the 2009 financial crisis.

Today, it's very common to see SPVs on a Silicon Valley startup cap table. For example, in @Uber's #IPO there were 100+ SPVs.