10 Financial Planning Tips for Future Venture Capital and Private Equity Partners

You have a lot to consider if you're on track to become a partner in a venture capital, or VC, fund or private equity, or PE, fund.

Because VC and PE partners are often required to invest their own capital into the fund, it's worthwhile to begin your journey by assessing your ability to meet capital commitments—and fully understanding your new role's potential impact on your personal financial situation. The following tactics can help you with these endeavors as you navigate your financial future.

1Understand the fund's structure

First, it's essential to fully understand how the fund is structured. It's likely been set up as a limited partnership, where a general partner, or GP, of the fund is a legal entity that takes liability. GPs have three sources of revenue: management fees, carried interest and returns on their investment. The management fees are paid to the management company, which then pays expenses and salaries.

2Know the tax implications

Take the time to familiarize yourself with the tax implications of becoming a partner. Will you be receiving a W-2 or K-1? A W-2 reports annual income and taxes withheld and is typically associated with traditional employment. On the other hand, a K-1 reports an individual's share of the partnership income, deductions and credits.

It's also important to look at capital gains versus qualified small business stock, or QSBS. The tax rates on capital gains depend on the income, asset type and holding period. If any of the partnership distributions qualify as QSBS, a portion of the capital gains taxes may be excluded, but the stock must meet specific criteria. For example, it must be issued by a domestic C corporation with gross assets that don't exceed $50 million before—and immediately after—the stock is issued. As you plan around your distributions, consult a tax professional because carried interest may be treated differently from your direct investment.

These complex tax implications may be compounded by the fact that a VC or PE partner's income is variable. As a result, performing quarterly estimates is crucial to ensure you remain compliant—and avoid penalties, interest and unwanted surprises. Because of the complexity involved, talk with a qualified tax professional to help develop an effective tax strategy.

3Plan for illiquidity

As a VC and PE partner, it's a good idea to plan for illiquidity during the first several years. For instance, you can expect a drawdown period—typically a period of 1 to 4 years when there are capital calls to the fund but no distributions. Distributions of profits typically occur within 3 to 10 years, and new fund raises—the securing of additional capital to deploy into new investments—typically occur within 2 to 3 years.

Given the illiquid nature and uncertain timing of returns, prudent management of your personal cash flow is crucial. Ensure you have sufficient liquidity for your typical monthly expenses and additional funds available for unforeseen needs.

4Create a basic estate plan

To help minimize your estate tax liability and streamline the distribution of assets to your beneficiaries, consider titling your share of the profits—the carried interest—and other assets into a revocable trust. Taking this step now may help protect your growing wealth and build a foundation for advanced estate planning in the future.

5Track the original value of your investment

By tracking the original value of your investments—your basis—from the outset, you'll have a firmer grasp of the various tax implications. The basis can vary over time based on factors such as additional investment contributions, returns of capital, and your share of the VC and PE fund's income, gains, losses and expenses. You may have multiple bases depending on different investment dates, purchase prices and stock splits, so it's a good idea to work with an accountant to understand capital gains and losses before selling any shares.

6Protect your wealth as it grows

Insurance is an important component to add to your wealth plan. While there are a variety of solutions to consider, an umbrella policy may be a strong choice because it's designed to protect your wealth as it grows. Life and disability insurance are also worth considering as ways to provide further protection for you and your beneficiaries.

7Maximize retirement planning

By maximizing pre-tax contributions to any retirement savings plan, you help minimize your tax obligations both now and in the future. One strategy to consider is a backdoor Roth IRA, which allows you to circumvent the income restrictions associated with direct Roth IRA contributions.

The income limit for a Roth IRA is based on your modified adjusted gross income, or MAGI. However, the backdoor Roth IRA approach allows you to make a traditional IRA contribution—which may or may not be tax-deductible depending on your income—then convert it to a Roth IRA.

The tax implications of a Roth conversion can vary based on your individual financial situation. In general, converting traditional IRA funds to a Roth IRA involves paying taxes on the converted amount that hasn't been previously taxed.

8Account for personal life changes

Your professional life might not be the only area with change on the horizon. As your personal life changes, consider how it might impact your overall financial plan. For instance, if your future plans include marriage, aligning your financial goals can be an important first step. A prenuptial agreement, for example, establishes the financial and property rights of each spouse in the event of a divorce. Now might also be a good time to update your estate plan and the names of your beneficiaries.

9Strategize your approach to future mortgages

If you're considering purchasing a home, it's important to understand how your role as a VC or PE partner might impact the mortgage qualification process. The way a potential lender categorizes your interests in the fund can have a significant impact on the mortgage amount you qualify for.

Once you address the mortgage qualification process, you also may want to explore other financially advantageous strategies, such as putting the title of your home into a living trust. A living trust provides greater flexibility and control of your assets and may allow you to avoid probate. Your financial team can help you navigate your options well in advance of your home purchase.

10Diversify your investments

As you gain liquidity over time, diversifying your assets across a range of financial instruments is an effective way to balance your risk. The more you diversify your assets, the greater financial flexibility and security you may experience. For example, taking the time to understand the importance of cash management, the value of a liquid investment portfolio and the need for concentration risk management can provide key financial advantages.

Also look for tax-optimization opportunities across your portfolio with tax loss harvesting, self-directed IRAs and mortgage interest tracing.

The bottom line

If you're considering becoming a partner in a VC or PE fund, set aside time to assess the impact of your new role on your personal financial plan. While these are just some of the things you'll want to consider as a VC or PE partner, they may provide a valuable starting point to address the upcoming change. As always, it's important to connect and collaborate with wealth planning and tax professionals who understand VC and PE partners and their life cycles.