If you’re considering engaging in venture capital investments, it’s essential to understand the fundamental concepts that drive the industry. One such concept is “capital call,” a powerful tool employed in this investment realm.
Delve into this informative article to gain insights into the intricacies of capital calls, exploring their purpose, functionality, and the reasons behind their deployment. By unraveling this vital mechanism, you’ll enhance your understanding of the dynamic world of venture capital and private equity.
What Is a Capital Call?
A capital call is also often referred to as a “drawdown” or “capital commitment”. It’s one of the key mechanisms used by venture capital professionals to collect funds from limited partners (LPs) as needed. It serves as a means for LPs to fulfill their capital commitments made in the Limited Partnership Agreement (LPA) with the venture fund.
Instead of requiring investors to contribute their entire commitment at once, capital calls are performed by General Partners (GPs) or lead investors when specific investment opportunities arise or when the fund requires additional financial resources for expenses.
The capital call is initiated when GPs notify the LPs of their intention to make investments and request a percentage of their committed capital. LPs typically receive multiple capital calls over an agreed period of time.
The specifics of capital calls, such as timing and compliance requirements, are detailed in the above mentioned LPA. It should be noted that in some cases the limited partners may have the option to participate in co-investments alongside the venture fund, which requires immediate capital contribution at the time of the investment commitment.
Capital calls ensure flexibility to GPs or fund managers, allowing them to adapt their investments to changes in the market or create the time buffer necessary to spot suitable opportunities. The approach prevents idle capital and optimizes the use of funds. It also enables GPs to employ bridge loans from banks, if necessary, to facilitate the acquisition of assets. The financial resources from subsequent capital calls will be used later to repay the loans.
Capital calls are usually issued once an investment deal has been identified. In most cases, co-investors or Limited Partners have between a week and 10 days to transfer the funds to the fund. This ensures efficient capital utilization while keeping borrowing costs at a minimum. Investors benefit from retaining the funds in favorable investment accounts until the capital is needed, allowing potential appreciation and maximizing returns.
Example of a Capital Call
To illustrate how a capital call operates, consider the following scenario:
Suppose you decide to commit $25,000 to a venture fund with a total size of $25 million. As per the agreement with Limited Partners, the initial drawdown requirement is set at 20%. Therefore, you must contribute $5,000 upfront, while the remaining $20,000 remains uncalled. The general partner then proceeds to invest the initial drawdown amounting to $5 million into selected early-stage startups.
After two business quarters have passed, as agreed in the LPA, the General Partner announces the need for an additional $500,000 and issues a capital call representing 15% of the committed capital. According to the LPA guidelines, investors are expected to transfer their corresponding portion within a specified timeframe. In this case, as your commitment was $25,000, you would need to submit $3,750 more.
As a result, your remaining uncalled capital would stand at $16,250. Subsequently, after three months, you receive another capital call for 25% of the committed capital, followed by a final call three months later for the remaining 40%. Once you have contributed the full $25,000, your commitment to the fund is fulfilled.
When to Use a Capital Call?
Capital calls are a versatile tool that can be implemented in various scenarios within the realm of venture capital. While historically originating from real estate funds, their application has expanded to encompass other investment domains due to the benefits they offer.
One primary circumstance for employing a capital call is when an investment opportunity arises, but the fund does not require immediate access to investors’ funds. By spreading out the investment over a period of time, capital calls allow investors to maximize their returns while waiting for their funds to be requested. This flexibility is particularly attractive to investors seeking financial benefits over the long run.
Additionally, capital calls are valuable for adapting to unexpected changes in the market or when investment projects exceed budgetary expectations. They provide prompt access to additional funds, thus enabling swift and timely responses to unforeseen circumstances. Furthermore, financial institutions may require capital calls to secure financial agreements.
Timing is Crucial for Capital Calls
Capital calls can certainly impact the relationship between general and limited partners. GPs always need to consider the readiness of LPs to contribute funds, ensuring that capital calls are appropriately timed to avoid strain on the GP-LP relationship.
To mitigate these concerns, venture capital funds sometimes employ “capital call lines” – short-term credit lines secured against LPs’ uncalled capital. This allows GPs to cover fund expenses and make upfront investments, repaying the credit line later through capital calls. Such credit lines help circumvent issues of time sensitivity and financial limits, enhancing the overall capital call effectiveness.
Capital Call Pros & Cons
Capital calls have both benefits and drawbacks for all parties involved in investment funds. Let’s explore them:
Pros of Capital Calls
- By calling capital only when needed, GPs can minimize the amount of uninvested capital sitting idle, leading to better fund performance metrics such as Internal Rate of Return (IRR) and Total Value to Paid-in Capital (TVPI). Check out our glossary for more clarification on this terminology.
- Fundraising advantage – GPs can entice LPs to invest in their fund by promoting a low initial drawdown, providing an attractive proposition.
- LPs can hold onto their capital and invest it elsewhere until it is called, potentially earning higher returns in the meantime.
- Some funds distribute profits to LPs before calling all committed capital, allowing LPs to use these distributions to cover part or all of their commitments.
Cons of Capital Calls
- As already noted, poorly managed capital calls can negatively affect the relationship between GPs and LPs, especially if the frequency or timing of capital calls differs from what was initially projected.
- Waiting for called capital to be received may cause delays in taking advantage of investment opportunities that are highly time-sensitive.
- Capital calls involve administrative efforts and costs for GPs, including sending notices, handling incoming funds, and dealing with defaulting LPs. Additionally, if a capital call line is used, the GP incurs interest and fees.
- There’s always a possibility that LPs may not be able to fulfill their capital commitments when a capital call is due, posing a risk to the fund’s operations.
It is important for GPs to avoid making premature capital calls without suitable investment opportunities in place, as it can lead to overfunding and inefficiencies. Similarly, relying on capital calls to cover operational costs should be avoided, as the primary purpose of venture funds is to generate value and profit for investors. Capital calls should be used primarily for funding investments and managing temporary market challenges.
What if a Limited Partner Fails to Meet the Capital Call?
When an LP is for whatever reason unable to meet a capital call, it is considered a default situation with potential legal implications and consequences. The specific penalties and liabilities depend on the terms outlined in the agreement and are determined by fund managers.
Some common default penalties include:
- Pursuing legal action to seek compensation for damages caused to the fund
- Requiring the LP to sell their share in the fund to other LPs or third parties
- Restricting the LP’s ability to contribute additional capital
- Limiting their participation based on the current paid-in capital.
- Imposing limitations on the LP’s share of future distributions.
To mitigate the risk of LP defaults, General Partners (GPs) can choose to work primarily with reliable institutional investors or LPs with a proven track record of meeting their commitments. GPs may also consider aligning the timing of capital calls with distributions, allowing LPs to use the received distributions to help cover their capital obligations. These measures may facilitate risk management and thus ensure the smooth functioning of the venture fund.
Unique.vc is a platform that provides GPs or fund managers with a web3 solution for performing capital calls. It allows investment leads to create a blockchain-powered venture fund that includes all the tools for carrying out investments, invite Limited Partners and fundraise in an automated way, with a cap table that gets updated accordingly in real-time.
Venture funds using the platform can set up the frequency, duration, target amounts, allocations, and reserved percentages of capital calls. In case the LP defaults, the GP can allocate the amount from that LP to different LPs. Unique.vc offers great flexibility, as well as milestone-based investing (releasing funds in stages) based on predetermined goals being achieved by the invested startups.
Unique.vc is an example of the platform designed specifically for GPs and fund managers seeking a web3 solution to streamline their capital calls. With its blockchain-powered infrastructure, this platform provides investment leads with a comprehensive suite of tools necessary for efficient VC investment operations, enabling the invitation of Limited Partners and automated fundraising, while ensuring real-time updates to the cap table.
Using Unique.vc, venture funds gain full control over capital call parameters, including frequency, duration, target amounts, allocations, and reserved percentages. In the event of an LP default, the GP can easily allocate the remaining amount to other trusted LPs, ensuring a smooth continuation of the investment strategy. This flexibility is complemented by milestone-based investing, where funds are released in stages based on predetermined goals achieved by the invested startups.