10.1.

8: Common Drafting Miscues

If the GPGP is, for one reason or another, contributing real cash, there is a chance that its "carried
interest" and its interest on account of its cash investment will become confused. Thus, assume the limited
partners are putting up $99 million and the GPGP $1 million and the profits are split 80% to the limited
partners and 20% to the GPGP. In such a case, the carried-that is, free-interest to the GPGP is 19%,
rather than 20%. That is fair enough, perhaps, but often not what the organizers had in mind. If the
instrument states that the GPGP has a carried 20% interest in profits and 80% is allocated among the
partners (not only the limited partners) in accordance with respective capital contributions or capital
accounts,
[1]
then the GPGP enjoys a pure 20% carry.

Another frequently encountered drafting error arises when the instrument purports to subordinate the
GPGP's carried interest to some form of preferential payment to the cash investors.
[2]
Assume a scheme,
for example, whereby the investors are allocated 99% of the profits until they have recouped their
investment and then an 80/20 split obtains. The way this provision is usually meant to operate is that: (1)
almost all the profits are allocated to the investors until the recoupment date; then, (2) almost all the
profits are allocated to the GPGP until its allocation equals 20% of the investors' allocation; then, (3) the
allocation is 80/20. The idea is that, at the end of the day, when all hits, runs, and errors have been
totaled, the aggregate allocation should be 80% for the LPs and 20% for the GPs.
[3]
In fact, well-drafted
agreements so provide; they contain an adjustment provision operative as of the date of dissolution and
winding up, which provides that the distributions in liquidation will be so skewed as to achieve the 80/20
outcome overall.
[4]
If, however, the agreement says, as some do, 99/1 until recoupment and then 80/20,
at the end of the day the GPGP will have a lot less than 20% of accumulated profits. The way to bring the
numbers into line with expectations is to provide for profits to be split 99/1 in favor of the investors until
recoupment and then 99/1 to the GPGP until an 80/20 balance is achieved, and then 80/20 thereafter.
Yet another problem is encountered when the draftsmen confuse distributions versus allocations and/or
capital contributions versus capital accounts. Thus, as a variation on the foregoing theme, some
agreements require that distributions to the GPGP be postponed until the limited partners have achieved
some targeted amount of distributions, usually equal to their contributed capital. Indeed, holding the
GPGP's share of allocated profits within the partnership is a handy way of assuring that there is cash
available in case the GPGP is called on to "cough up" prior allocations of profits (see below) in order to
make the entire process come out right. However, if profits are allocated in part to the partners (not just
the limited partners) in accordance with the balances in their capital accounts (versus their capital
contributions), a disproportionate retention of profits in the GPGP's account can result in an unwitting
increase in the GPGP's share of profits.
A third drafting error occurs when the agreement simply provides an 80/20 split of profits and a 99/1 split
of losses, allocated annually. My point is relatively obvious. If the GPGP is allocated 20% of a huge profit in
year one and there then ensues nine years of losses followed by liquidation, the GPGP will have more in its
pocket at the end of the day than was intended. A provision called a "cough-up" or a "look-back" requires
Page 1 of 3 10.1.8: Common Drafting Miscues - Encyclopedia - Library - VC Exp...
a corrective recall from the GPGP of prior distributions in the year of liquidation to correct unintended
results. Alternatively, the agreement may provide that profits and losses are allocated at the end of each
period so that they cancel out prior opposing allocations and then, starting from zero as it were, profits
and losses are allocated in the agreed-upon percentages. Thus, if a large gain is experienced in year one,
followed by a large loss in year two, the loss is so allocated as to neutralize the gain and, when and as the
correction has been applied, the process goes on its way as originally intended. The result is to create a
netting effect with respect to interim gains and losses so that, on liquidation, the timing of gains and losses
is immaterial and only the cumulative effect counts.
[5]
To make this system work properly, either the
partnership must hold back some or all of the GPGP's allocated profits in its capital account or the
agreement make provision for a cough-up upon liquidation.
There is a moral to the story. The organizers of an investment fund should take the first draft of the
allocation and distribution sections and sit down with their counsel and accountants. Various profit 'and
loss scenarios should then be run over the hypothetical life of the partnership and the results compared.
The question is whether the allocation and distribution sections consistently deliver the intended result-so
much to the general partners and so much to the limited partners at the end of the day. This is a very
important recommendation. In the author's experience, there are significant hidden differences between a
number of partnerships that look alike, differences that may ensue to everyone's surprise when the
partnership is liquidated.
[1]
The norm is to peg the allocation formula to capital contributions versus capital accounts. While the
results are likely to be the same in most instances, the proportion arising out of the fixed nature of capital
contribution is more representative of what the investors believe they are buying-i.e., a specific percentage
interest in profits, versus one that may change.
[2]
The subordination notion, which is tied to priority allocations and/or distributions pending recoupment,
should be contrasted to the rate of return "bogey" concept (See discussion), wherein the measuring stick is
a targeted current or cumulative return on investment. The underlying principle is conceptually the same,
i.e., only superior performance rewarded.
[3]
A preferential return, in the eyes of some practitioners, can introduce biases-i.e., an incentive to
concentrate on near-term payoffs or to postpone distributing in kind especially promising portfolio
positions until all the value has been squeezed out. Dauchy & Harmon, Structuring Venture Capital Limited
Partnerships, 3 Computer Law. I (1986).
[4]
The preferential distribution to the investors may include an interest component-all their money back
plus a compounded X% return. Variations in this area revolve around the time value of money and
whether the interest component is calculated on committed capital or capital actually contributed to the
partnership.
[5]
Another way to accomplish this result is to provide that gains and losses are to be Another way to
accomplish this result is to provide that gains and losses are to be allocated in each period so that the
cumulative net effect is 20% of gains to the GPGP and 80% to the limited partners in each period so that
the cumulative net effect is 20% of gains to the GPGP and 80% to the limited partners.
Page 2 of 3 10.1.8: Common Drafting Miscues - Encyclopedia - Library - VC Exp...
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