As an entrepreneur, you may be familiar with limited liability companies (LLCs). They allow you to protect your personal assets from potential legal liabilities in your business. Once you try to raise venture capital for your business, you may hear the term limited partnership (LP).
Limited partnerships are often used by private equity and venture capital (VC) investors. Read on to learn how the structure differs from LLCs and why you may want to use it.
Overview: What is a limited partnership agreement?
Limited partnerships structure ownership among limited partners and general partners. Limited partners are shielded from the potential liabilities of the business but must remain passive in the business — that is, they cannot manage the operations.
The general partner manages the business and assumes risk for lawsuits against the business. Typically, general partners will be LLCs to shield the human behind the curtain from the partnership’s liability.
Limited partnership agreements are popular for various kinds of investment pools. Hedge funds, private equity funds, and venture capital funds usually structure each fund in an LP to allow limited partners to make passive investments in the fund while the general partners make investments and earn carried interest.
Limited partnership vs. LLC: What’s the difference?
The owners of an LLC are called members and each is protected from corporate liability by the LLC structure. The limited partnership structure has limited partners and general partners. The limited partners are protected from liability, while the general partners manage the business and are not shielded from liability.
Most everyday businesses should be structured as an LLC, and most investment funds will be structured as an LP so the general partner has full control over management.
Types of partnerships
Businesses can form under three types of partnerships.
1. Limited partnership
In limited partnerships, the limited partners are passive investors in the business and the general partners manage the business. Limited partnerships are generally used for investment pools. They are called limited partnerships because the liability to the personal assets of the limited partners is limited to their investment in the entity.
Some states have begun to allow limited liability limited partnerships where the general partner’s liability is also limited.
2. General partnership
General partnerships are common among smaller businesses with multiple owners. They are easier to set up than LLCs and are effectively a sole proprietorship with multiple owners. General partners have a partnership agreement that dictates how management responsibility is allocated among the partners, and each general partner shares in the liability of the business.
If you are an owner in a general partnership, you can likely still register your business as an LLC, you would just use a partnership agreement for your entity docs and report taxes on the general partnership tax form.
3. Joint venture
Joint ventures are typically set up among multiple businesses to undertake a project. They operate as a general partnership with the businesses as the partners but are dissolved once the project is complete.
Example of a limited partnership
Possibly the most famous limited partnership is Warren Buffett’s original partnership. Buffett raised $105,000 in capital from Omaha investors in 1957 and was managing over $100 million by the time the partnership was dissolved in 1969 after Buffett took control of Berkshire Hathaway.
Buffett acted as the general partner choosing investments for the pool and his investors were limited partners. His fee was 25% of profits after a 6% hurdle rate, that is he didn’t get paid until he returned 6% each year. If investors wanted to withdraw their cash, Buffett would sell shares of the stock owned by the partnership to raise the cash for the investors.
Buffett’s example has spawned a seemingly endless amount of similar investment partnerships. Many value investors have set up their funds with the same structure and pay model, and it still works well for them, more than sixty years later.
Other investment businesses also use an LP agreement to set up a relationship with investors but don’t follow Buffett’s pay structure. Many hedge funds and venture capital funds charge a 2% management fee and then earn 20% of all profits with no hurdle rate. These fees are paid to the general partner, which is often the fund management company.
Many hedge funds and VCs will raise multiple funds, either to invest in different niches or simply to raise more money when other funds are full. The management company is the general partner in each fund and distributes its revenue to employees and owners of the management company.
Finally, in Buffett’s partnership, new investors committed their total investment to Buffett immediately, and Buffett likely invested it as soon as he could find a cheap stock. With VC limited partnership agreements, investors do not have to transfer their investment until the VC finds a deal to invest in.
3 benefits of creating a limited partnership agreement
Here are the benefits of using a limited partnership agreement.
1. Limits liability of limited partners
This structure protects the limited partners’ assets from lawsuits. This is extremely important, especially for passive investors. As passive investors, limited partners can’t control the management of the company and wouldn’t be able to challenge any unlawful acts.
Additionally, the person chosen to manage will often form an LLC they own to act as the general partner. This will protect their personal assets from liability.
2. Allows for passive investment
If you’re starting a hedge fund, you don’t want your investors to have a say in how you choose investments. It’s likely most investors don’t want a say anyway; otherwise, they would be managing their own money.
The same is true for traditional hedge funds, like Warren Buffett’s, and real estate partnerships, venture capital funds, and private equity funds. Limited partners simply don’t have the expertise to analyze the projected financials of a real estate complex or know the business metrics of a startup.
A limited partnership allows you to create a contractual agreement with investors so their involvement in the investment will be passive.
3. Income taxes pass-through to limited partners
Limited partners receive a Schedule K-1 each year to report taxes to the IRS. The taxable income passes through to them and is reported on each individual’s personal tax return. This is superior to the double taxation experienced by C-Corporation investors where income is taxed at the corporate level and then dividends paid out of income are taxed at the personal level.
Don’t start a VC without an LP
If you’re a startup founder, you may never need to form a limited partnership, but if you ever want to manage a venture capital fund or invest in real estate for various contacts, the limited partnership structure is the best way to go. And if you’re negotiating for venture capital financing, it never hurts to understand as much about LPs as you can.
Original source: The blueprint