Document 45880

Formation and Operation
of Venture Capital/
Private Equity Funds
Kenneth W. Muller
Cooley Godward LLP
February 14, 2004
Typical Fund Structure
Fund Managers
Assign Management Fee
Co., L.L.C.
Back-Office Services
Venture Firm Name
Office Equipment/Lease
Payroll System
Staff Relationships
L.L.C. = Limited Liability Company
LP = Limited Partner
L.P. = Limited Partnership
MM/MD = Managing Member or Managing Director
ROI = Return on Invested Capital
Investors (LP)
General Partner, L.L.C.
Management Fee
Fund, L.P.
Typical Fund Structure
Fund – Limited Partnership Agreement (LPA)
General Partner (GP) – LLC Operating Agreement
LPA memorializes division of capital gains/losses among partners,
management fees paid to GP, investment limitations, and major
governance issues
Operating Agreement memorializes division of carried interest, vesting
of carry among individual fund managers (VCs), and major governance
Management Company – LLC Operating Agreement
Operating agreement memorializes division of management fees, major
governance issues and license of name and mark.
Management company enters into lease, bank account, insurance,
employment agreement with all employees (including VCs), etc.
Elements of Fund Offering
• Private Placement Memorandum
• Communicates team’s track record
• Summarizes business deal
• Subscription Agreement
• Contractual capital commitment
• Securities law exemptions
• Limited Partnership Agreement
• Allocations of profit and loss
• Timing of interim distributions
Fund Offering Process
• VCs clear conflicts with companies/prior funds
• Deliver PPM, meet with prospective LPs
• Follow-up with qualified prospective LPs.
• Provide detailed due diligence materials.
• Test terms of offering.
• Identify lead anchor LPs and pre-negotiate final terms.
• Reach conceptual agreement with most LPs on terms.
• Set closing date.
• Circulate final documentation among prospective LPs.
• Maintain private placement status of offering.
Fund Offering Process
• Private Placement Memorandum
• Securities Disclosure
• Marketing/Track Record
• Risk Factors
• Tax/Regulatory Disclosure
• Term Sheet
Securities Disclosure
• Securities Act of 1933 (’33 Act)
• Regulation D (accredited investors)
• No “general solicitation”
• Integration of separate offerings under Reg. D
• 6 months
• Different plan, class of securities, general
purpose, investors, business terms, scope,
• Regulation S (offshore investors)
Securities Disclosure
• Investment Company Act of 1940 (’40 Act)
• 3(c)(1) Fund (< 100 accredited investors)
• Net worth of at least $1,000,000
• Income of $200,000
• Joint income of $300,000
• 3(c)(7) Fund (qualified purchasers, typically < 500)
• Securities Exchange Act of 1934 (’34 Act) §12(g)
• Investments of at least $5,000,000 (individual)
• Own/invest at least $25,000,000 (certain entities)
• Parallel 3(c)(1) and 3(c)(7) funds
Securities Disclosure
• ’34 Act
• Rule 10b-5 (track records)
• Misrepresentation of material fact made with
scienter and relied upon by purchaser
• Broker/dealer (unregistered finders)
• Investment Advisers Act of 1940 (IAA)
• Rule 206 (advertising track records)
• 15-client rule (parallel funds)
• Sale to “qualified clients”
• Net worth in excess of $1,500,000
Securities Disclosure
• Examples of securities law claims include
material misrepresentations regarding:
Fund investment focus
Underlying investments
Debt or liabilities to be assumed by GP
Reports to be made to LPs
Commissions paid to brokers
Reliability of performance projections
GPs investment experience or net worth
Commingling of assets or “cross-investing”
between funds
Securities Disclosure
• Examples of securities law claims include
material omissions regarding:
• Risks associated with investment
• Prior or pending claims against GP for breach
of fiduciary duties or mismanagement of
• Initial closing procedures deviated from
procedures specified in PPM (e.g., minimum
closing threshold)
• Certain material rights granted to some
partners to detriment of other partners
Marketing/Confidential Information
• Confidentiality Legends
• Rule 10b-5 (confidential data)
• Insider trading “tipper”
• Confidentiality obligations as controlling shareholder
• Regulation FD (selective disclosure of public co. info.)
• Fiduciary duties
• Contractual (NDAs, SPAs, and IRAs)
• Directors and controlling shareholders
• Uniform Trade Secrets Act
• Trade secrets protectible if secrecy maintained
• Freedom of Information Act
• Public entities may be required to disclose confidential
information by court order
• Exclude “trade secrets” and “privileged” information
Marketing/Track Records
Team’s background, experience and training
Proprietary deal sourcing/access to opportunities
Future investment strategies
Cohesiveness of investment team
Prior investment performance
• Past performance does not guarantee future results
• Portfolio company valuations
• Standards?
• IAA (Rule 206)
• IRR’s calculated net of carry, management fees, organization and
syndication costs, other expenses
• Selected transactions
Risk Factors
• Detailed and clear disclosure of actual risks
• Tailored to specific offering
• Shifts “total mix of information”
• Rule 10b-5 / “bespeaks caution” doctrine
• Common risk factors
• Private company investments
• Emerging technology/life science
• Illiquidity
• Competition
• Reliance on individual VCs
• Conflicts of interest
• Side letter agreements
Tax Disclosure
• Tax opinion
• Fund classified as partnership
• Each LP required to report allocable share of income,
gain, loss, expense and deduction
• “Investment partnership” (I.R.C. § 731(c))
• In-kind distributions of marketable securities
• Federal long-term capital gains rates reduced to 15%
• Qualified Small Business Stock
• Rollover gains
• 50% gain exclusion (effective max. rate of 14%)
• Avoid “trade or business” (ECI) for offshore investors
• Avoid UBTI for tax-exempt investors
Term Sheet/LPA
• Fund
• Purpose/scope
• Delaware vs. California
• Fine-tune fiduciary duties
• Fund Size (maximum)
• Open window period (6 – 12 months)
• Minimum capital per partner
• 3(c)(1) limitations
• Maintenance of private offering
• Term (10 years)
• Extensions to liquidate “living dead” in portfolio
Term Sheet/LPA
• LP Capital Commitments
• ERISA venture capital operating company (VCOC) compliance
• GP Capital Commitment
• Lesser of 1% or $500,000
• Rev. Proc. 89-12, 95-10
• Promissory notes in excess of first $500,000
• [_]% of Fund size
• Cashless capital contributions
• Prior management fee waiver
• Special allocation of profits equal to fee waiver amount
Term Sheet/LPA
• Capital Accounts
• Safe Harbor Capital Accounts I.R.C. § 704(b)
• realized items
• Fair Value or Mark-to-Market Capital Accounts
• Realized and unrealized items
• Carried Interest allocations
• 20%, 25% or 30% of net capital gain
• Contingent carried interest (e.g., 20% to 25%)
• IRR hurdles
• Return of [_]X capital
• Net of management fees/expenses
Term Sheet/LPA
• Distributions
• Tax Distributions
• Discretionary Distributions
• Net asset value (NAV) or “cushion method”
• Carry distributions made [80/20] if portfolio net asset
value equals at least [___]% of cost basis, postdistribution.
• Bifurcation method
• Distributions made on security-by-security basis (x) cost
basis distributed according to capital commitments, and
(y) profits distributed [80/20].
• Return of capital
• Amount equal to capital contributions returned before GP
takes [80/20] carried interest distribution.
• Hurdle rates
Term Sheet/LPA
• Clawback
• Carried interest distributions followed by losses may cause
the GP to receive excess distributions
• Several or joint and several obligation
• Separate personal guarantees
• Division of obligation among members
• GP escrow
• Impact of vesting provisions at GP level
• Extent of tax carve-out
• Actual tax distributions
• “Deemed” tax liability associated with in-kind
Term Sheet/LPA
• Management fees
• 2.5% of aggregate capital commitments
• Reduction or “tail-down” after 5 to 6 years
• Reduced % of aggregate capital commitments
• % of cost basis of securities held by Fund
• Management fee offset (MFO)
• Commitment, break-up, directors, officers, advisory
and management fees paid by a portfolio company
• Fee conversion techniques
• Prior management fee waiver
• Special distribution or loan
• Priority allocation of profit
Term Sheet/LPA
• GP expenses
• Normal GP operating expenses (including
employee salaries, rent, and communications)
• Placement agent fees (offset management fees)
• Fund expenses
• Organization and syndication costs (cap)
• Management fees
• Expenses associated with deal
• due diligence
• Fees for annual and quarterly reports
• Valuation expenses
• Costs of insurance/indemnification
Term Sheet/LPA
• Investment Limitations
Limited borrowing (leverage)
No unrelated business taxable income (UBTI)
Diversification among portfolio companies
Domestic investments
Real estate investments
Investments in other funds/flow-through vehicles
Limited public company investments
• Exclude PIPEs
• Limited recycling of profits
• Up to [120]% of aggregate capital commitments
Term Sheet/LPA
• Exculpation and Indemnification
• Except gross negligence, willful misconduct, fraud or felony
• LP default on capital commitment obligation
Sue for specific performance, interest, expenses
Eliminate future profit allocations (not losses)
Cancel unpaid capital commitment
Force sale of interest to other LPs or third parties for nonrecourse note
• Requiring withdrawal of LP
• Delaware will enforce contractual “penalties”
Term Sheet/LPA
• Advisory Committee Oversight
• Investment limitations
• Conflicts of interest
• Interested transactions
• Co-investments by GP
• Cross-investment between funds
• Affiliated service provider transactions
• Valuation methodology
• Private Equity Investment Guidelines Group (PEIGG)
• Safe-Harbor vs. Fair Value capital accounts
Term Sheet/LPA
• Termination Rights
• “Key manager” provision
• X% of VCs become incapacitated
• Termination for “cause”
• Fraud, felony relating to Fund operations, gross
negligence or willful breach of fiduciary duty
arising under the Partnership Agreement
• “No-fault” divorce
• Terminate Fund upon vote of [85]% of LPs
Term Sheet/LPA
• Parallel Funds
• ’40 Act 3(c)(1) and 3(c)(7) funds
• No integration under ’40 Act
• Affiliates Funds
• [10]% of aggregate capital commitments
• Parallel Fund without MFO
• Eliminates U.S. trade or business (ECI) concern for
offshore investors
• Principals Fund
• Segregate liabilities
• Avoid paying management fees to selves
• Improves “Qualified Small Business Stock” rollover
Fund Operations
• ERISA venture capital operating company (VCOC)
• “Significant participation” test
• Employee benefit plan investors (> 25%)
• Qualify as VCOC upon receipt of capital from ERISA
plan that would trigger “substantial participation”
• Receive capital on same day as first investment in which the
Fund has “Management Rights”
• Escrow ERISA plan contribution until first investment in
qualified operating company
• “Management rights” agreements with > 50% of
portfolio companies (measured at cost basis)
Fund Operations
• Management Rights include:
• Board seat; or
• Rights to
• Attend board meetings, participate in director discussions;
• receive and review interim balance sheets, income statements,
cash flows, reports required by law, in accordance with any
outstanding indebtedness or Section 13 or Section 15(d) of the
Exchange Act;
• reasonably request copies of documents, reports, financial data
and other information;
• inspect property and books of account, discuss the affairs,
finances and accounts with officers; and
• consult with and advise management on a frequent basis
regarding all matters relating to operations and business.
Fund Operations
• NASD Rule 2790
(Effective March 23, 2004)
• Fund may be restricted from acquiring “New Issues”
• “Restricted Persons” may not participate in New Issues:
• Portfolio managers (GP and VCs) with authority to buy/sell
securities for investment company
• NASD Members/Broker-Dealers/personnel
• Finders and fiduciaries (attorneys, accountants and financial
consultants) to managing underwriter of New Issues
• Immediate family of the foregoing, etc.
• Restricted Persons benefit < 10% of Fund
• Excludes GP’s initial receipt of carry/fees (but watch for recycling)
• Fund may segregate or carve-out benefit from New Issues to
comply with de minimis test
• Anti-dilution rule
Fund Operations
• Privacy (“FTC Regulations”)
• Consumer Financial Information
• Annual privacy notices describing privacy policies
• Limited disclosure of confidential information
• Anti-Money Laundering (AML) Regulation
Adopt AML controls
Appoint “compliance officer”
Employees participate in AML program
Compliance officer certifies that GP conducted due
diligence and “knows each investor”
Safe Harbor Capital Accounts
• Increased by
• Capital contributions
• Allocated share of realized profits
• Interest income
• Realized gain on sale of portfolio company securities
• Built-in gain for in-kind distributions
• Decreased by
• Distributions (whether in cash or in kind)
• Allocated share of realized losses
• Fund expenses,
• Realized losses on sale of portfolio company securities
• Built-in losses for in-kind distributions
Contingent Carry Hurdle/Fee Waiver
Contingent Carry Hurdle/Fee Waiver
Fund Operations
• Distribution limitations under LPA
• Capital Account balances
• “Marketable Securities”
• Traded on established public market
• Not subject to underwriters’ contractual “lock up”
• Sold by LPs in compliance with ’33 Act
• Non-affiliates may sell within 1 year of Fund’s
acquisition subject to Rule 144(e)(2) volume
• Non-affiliates may sell within 2 years of Fund’s
Fund Operations
• VC may be Rule 144 “affiliate” of issuer if officer,
director or the GP’s Funds control > 10% of
issuer’s outstanding stock
• Stock may be sold subject to Rule 144(e)(2) limits
• Rule 144(e)volume limitations
• Securities sold through broker during 3-month period
must not exceed (i) 1% of issuer’s outstanding shares, or
(ii) average weekly trading volume over 4 week period
preceding sale or filing of Form 144
Fund Operations
• ‘34 Act Reporting Requirements (Section 16)
• Officers, directors and beneficial owners of more than 10% of
any class of issuer’s publicly-traded securities
• 10% threshold aggregates all Funds under common control
• May include warrants and options
• Form 3 filed upon becoming a “Reporting Person”
• Form 4 filed within 2 days of change in beneficial ownership
• Form 5 filed within 45 days of end of issuer’s fiscal year
• “Short-swing” liability under Section 16(b)
• Reporting Person may be required to disgorge profits
associated with purchase and sales made within 6 month
Fund Operations
• ‘34 Act Reporting Requirements (Section 13)
• Beneficial owners of more than 5% of any class of
issuer’s publicly-traded securities
• 5% threshold aggregates all Funds under common
• May include warrants and options
• File Schedule 13D upon acquiring more than 5% of class
of issuer’s publicly-traded securities, except file
Schedule 13G if:
• Passive investor holding less than 20% of the registered
class of securities
• Acquired securities pursuant to registration statement,
acquired less than 2% of class of securities in the
preceding 12 months, and acquired all reportable
securities prior to IPO
Cooley Godward LLP
Our Venture Capital Practice Group provides sophisticated
counsel to venture capital, leveraged buyout, mezzanine, hedge
and other types of private equity funds in connection with
their fund-raising and investment activities. Since forming
Draper, Gaither and Anderson in 1959, we have developed the
specialized expertise, practical judgment, and breadth of
experience to become a foremost authority on fund formation
in the United States.
Twenty-five attorneys from our offices in Palo Alto, San
Francisco, San Diego, Colorado, and Virginia practice in the
fund formation area and dozens more represent venture
capital and private equity funds in their investment activities.
This presentation is made for discussion purposes only and
does not constitute legal advice. For more information, please
contact your attorney at Cooley Godward LLP or visit