Last week, we sat down with Fund Formation and Tax Partners, Yoni Tuchman and Aalok Virmani of DLA Piper to discuss all things venture fund formation. In the first session of our Essential Fund Launch Webinar series, we addressed some of the common questions that typically arise during the fund formation process. At Vector, we work with several emerging managers and have many shared clients with the DLA Piper team, so this was the perfect opportunity to ask some questions and hear some insights and experiences from these expert panelists. In this blog, we’ll cover the answers that Yoni and Aalok shared during the webinar session.
DLA Piper is a global law firm with lawyers located in more than 40 countries throughout the Americas, Europe, the Middle East, Africa and Asia Pacific to help clients with their legal needs around the world. Across the world, our experienced investment funds lawyers provide a dynamic, integrated service to sponsors, fund managers and institutional investors. We advise clients on the full spectrum of private investment funds, all major investment strategies and all stages of a private investment fund’s lifecycle.
When it comes to the essential components of a successful fund formation strategy, there are several key factors a fund manager needs to consider. A good start to is to take a step back and evaluate these several aspects and the feasibility of their approach.
Firstly, the pipeline of investment opportunities. It’s essential to understand how rich and promising the vein of potential investments is. On the other side, the pipeline of prospective limited partners. Does the fund manager have a robust network and or a significant Rolodex of connections and contacts on the investor side to make raising a fund worth their while?
Additionally, what is the fund manager’s ability to deploy the raised capital? Regardless of the particular investment strategy, success hinges on having the capacity to both raise and effectively utilize the funds. The key lies in the ability to execute and generate tangible results. Being a custodian of other people’s capital requires credibility and track record, and investors need to be excited about the fund manager’s story and expertise in their chosen investment strategy.
While these components are pivotal, a fund manager cannot overlook the importance of having the right team in your corner. Especially for emerging managers who are new to this process, having experienced advisors and a supportive team can be invaluable. These service providers not only offer expertise but also can provide guidance based on their extensive experience. They become a critical resource, helping navigate challenges and providing best practices throughout the life of the fund.
There is a plethora of crucial factors when looking at the key legal considerations and compliance requirements of forming a fund. Starting with tax, which is one of the most important aspects of structuring a fund correctly.
This is an essential step that cannot be overlooked.
There are “three legs of the tripod” that represent significant legal and regulatory considerations. The first leg focuses on selling securities to investors and navigating the Securities Act of 1933. Specifically, Regulation D and the importance of conducting private placements to avoid registering the sale of securities in the fund.
The second leg delves into the Investment Company Act of 1940. There are ways a fund can avoid being registered as an investment company, like a mutual fund, by utilizing exemptions. Two key exemptions for a venture capital fund are Rule 3c-1 and Rule 3c-7. Rule 3c-1 restricts the number of investors to not more than 100, while Rule 3c-7 requires all investors to be qualified purchasers with substantial assets.
The third and final leg pertains to the Investment Advisors Act, which governs the management company providing advice to the fund. While the registration process as an investment advisor can be arduous, the VC industry benefits from the VC fund advisor exemption. This exemption is unique to the venture capital community, allowing management companies that exclusively advise private venture capital funds to avoid registration as investment advisors.
There are additional considerations, such as the Committee on Foreign Investment in the United States (CFIUS) for funds investing in sensitive technologies and the implications of accepting money from certain investors, such as pension funds or benefit plans. It is extremely important to understand or work with a legal firm that understands and can navigate these complex legal and regulatory frameworks when forming and operating a fund.
The legal and regulatory considerations involved in fund formation are undoubtedly extensive, but a thorough understanding and adherence to these requirements are vital for the success and compliance of any fund.
Forming a fund comes with its fair share of challenges, as we discussed in the webinar. There are two conflicting tendencies that often arise during the process: over-complication and oversimplification. Striking the right balance is crucial, but it can be a delicate dance for fund managers who may be doing this for the first time and do not fully understand the intricacies of fund formation. To mitigate these challenges, it is essential to tailor the fund structure to best suit the specific strategy, team, and investors.
Over-complication can occur when fund managers feel compelled to adopt complex structures or offshore vehicles without fully understanding their necessity. For example, if a fund manager is accepting non-U.S. LPs, it doesn’t necessarily always require an offshore structure.
Oversimplification, on the other hand, can lead to overlooking important considerations. For instance, combining multiple entities into one may seem simpler, but it can have legal and tax implications that need to be carefully evaluated. Separating the management fees and carried interest from the fund and utilizing separate entities can provide tax advantages and safeguard assets.
In addition, understanding the tax implications is crucial in structuring the fund. Different income streams, such as capital gains from investments and fee income for services, are treated differently for tax purposes. Separating entities allows for proper treatment of each income type, taking into account how different states tax business income versus non-business income.
From an operational perspective, maintaining separate entities for the fund, management company, and general partner can streamline the flows of capital, reducing complications in handling expenses and money management.
The challenges of forming a fund can be mitigated by working with a fund formation provider who can tailor the documents specifically to your needs and really understand tax implications.
It is important to understand that using templatized documents will largely depend on the fund. For smaller funds, these offerings can be cost-effective and make a lot of sense for the structure. For a larger, more complex fund, it becomes increasingly important to set up a structure that precisely suits your needs. Typically, institutional investors tend to often prefer working with funds that have tailored products rather than off-the-shelf solutions. As a fund manager, raising capital becomes your livelihood, and the documents governing your relationships with portfolio investments and investors are crucial. Even if using a template, it’s essential to closely understand every word and its implications for all stakeholders involved.
While there may be situations where templatized documents make sense, it’s important to know their limitations and be prepared to make necessary adjustments. Ultimately, the decision to use off-the-shelf solutions or seek more bespoke services depends on factors like fund size, complexity, and the level of customization required.
There is absolutely a place in this industry for funds to utilize templatized documents and products, such as Sydecar, especially for smaller funds. However, as funds grow and become more complex, it likely is more beneficial to work with service providers who can offer tailored solutions to meet your unique needs. Understanding the trade-offs and making an informed decision will ensure the formation process aligns with long-term goals and maximizes the fund’s potential.
When determining the overall optimal structure of a venture capital fund, several factors come into play. At DLA Piper, they use a product that takes various inputs, such as the location of the fund, the origin of limited partners, and their tax positions and uses an algorithm to generate the ideal structure. While it may sound like a joke, this algorithm represents our tax knowledge and expertise.
In most cases, the algorithm points to a Delaware limited partnership as the fund structure, along with a Delaware limited partnership for the management company and a Delaware LLC as a top-level entity. This diamond-shaped structure allows for efficient fund management and tax optimization. However, there can be variations based on factors like the GP’s location and tax obligations, which may require adjustments to the structure.
Tax considerations play a significant role in determining the optimal structure, with regulatory aspects also coming into play. For instance, the exemption for avoiding investment advisor registration applies if the fund has no more than 100 investors on a look-through basis. In cases where a non-U.S. fund is formed with U.S. investors, only the U.S. investors are counted towards the 100 limit. This can be addressed by forming parallel funds or establishing an offshore fund to accommodate non-U.S. investors and maintain compliance with the exemption.
Finding the optimal structure involves a mix of careful consideration of tax implications, regulatory requirements, and the specific circumstances of the fund and its investors. By leveraging tax expertise and analyzing these factors, fund managers can ensure their structure aligns with their goals and regulatory obligations while maximizing tax efficiency.
When comparing a Limited Partnership (LP) and a Limited Liability Company (LLC), the primary difference lies in their tax treatment. An LLC is a versatile entity that offers limited liability to its members, making it convenient and appealing. In the US, an LLC is treated as a flow-through entity by default for federal income tax purposes. However, it’s important to note that most non-US jurisdictions treat an LLC as a corporation, considering every beneficial owner to have limited liability. This can create complications, especially when dealing with non-US investors or investing outside of the US.
In contrast, Limited Partnerships are generally preferred because they are treated as transparent in most jurisdictions. Limited Partnerships allow for smoother international operations and can be more advantageous when expanding strategies beyond the US.
However, it’s worth noting that an LLC can still be suitable in specific situations, such as when the strategy is entirely US-focused with US investors and a US-based investment manager. In such cases, the LLC structure may work perfectly fine. But if there are plans to broaden the strategy and establish a presence outside the US, it is advisable to opt for a Limited Partnership to ensure a smoother tax and regulatory experience.
When LPs consider investing in a fund, the terms they focus on vary depending on the fund and its investor base. For emerging managers raising their initial funds, investors often include high-net-worth individuals and family offices who prioritize their familiarity with the fund’s founders rather than extensively reviewing the documents. However, institutional-level funds with larger investors might take a different approach. These types of investors will engage law firms to thoroughly negotiate and scrutinize every aspect of the fund’s documents and side letters.
While various topics can be negotiated, the economics of the fund are crucial and must align with the investor’s expectations. Market-standard economics, such as the distribution of profits, are typically sought after. Additionally, tax-exempt investors are concerned about structures and covenants that safeguard them from receiving certain types of income that may impact their tax-exempt status. Non-US investors, on the other hand, look for provisions that protect them from incurring income subject to US tax obligations. These examples highlight the importance of tailoring the fund’s structure to meet the specific needs of the investor base.
Attracting high-quality LPs goes beyond terms alone. LPs are interested in the fund’s track record and the potential for significant returns on their investment. While the structure of the fund may not excite LPs, it must be solid and protect their interests. Ultimately, LPs are primarily focused on economic terms and the founders’ track record, seeking assurance that their investment is a promising opportunity.
First and foremost, it’s important to acknowledge that the current market conditions are challenging. Funds tend to be smaller than what most managers initially anticipated, and the fundraising process often takes longer. However, amidst these challenges, there are notable trends worth mentioning.
One significant trend is the digitization of the subscription process. Gone are the days of emailing out physical subscription booklets, printing, scanning, and filling them out manually. Instead, fund managers are increasingly adopting digital solutions that streamline the subscription process, making it seamless for investors, law firms, and fund administrators. This digital transformation ensures all parties have access to the necessary information, allowing for efficient review, corrections, and finalization, culminating in countersigned agreements.
Another noteworthy trend is the utilization of public private placements, specifically under Regulation D Rule 506(c) of the Securities Act. This regulatory framework enables fund managers to sell securities to investors privately without requiring registration with the Securities and Exchange Commission (SEC). Simultaneously, it grants fund managers the ability to publicly discuss and promote their funds through various channels, such as social media and podcasts. While this approach has its pros and cons, many fund managers are embracing it as an opportunity to showcase their fund’s unique value proposition and reach a broader audience.
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If a fund manager decides to raise third-party capital through an SPV for pre-fund deals, it’s generally recommended to keep those deals within the SPV itself. By doing so, the track record can be leveraged and established through access to these deals, showcasing the ability to source attractive investment opportunities. However, it’s important to note that attempting to transfer the assets or investments from the SPV to the fund can be complicated and raise questions regarding investor returns and incentives.
If the GP has enough capital to invest in the deal individually and then sell to the fund at cost, that is a very common option. If the investment size exceeds what a GP can undertake individually, raising capital within the SPV and maintaining its structure, tells the investors that they can later invest in the fund alongside other third-party investors. This approach eliminates the complexities of transferring assets between entities and with investors.
Nevertheless, it’s crucial to consider the timing and practicality of each approach. Ideally (and some free legal advice from the DLA Piper team), if a fund manager needs to make an investment, forming the fund quickly and having the SPV investors become part of the fund through a micro closing is an optimal solution. This approach provides tangible benefits to investors, as they can actively participate in a fund from its early stages. In contrast, warehousing investments in the SPV for an extended period may result in changing valuations and potential transfer pricing issues, which can complicate the eventual transition to the fund.
Ultimately, the choice between these strategies depends on the specific circumstances and investor preferences. It’s essential to consider the practical implications, including the transfer of assets and the inherent complexities involved in each approach.
DLA Piper works with several offshore jurisdictions to facilitate venture capital fund formation. The three most prominent jurisdictions are the Cayman Islands, the British Virgin Islands (BVI), and surprisingly, Canada.
The Cayman Islands stand as the most well-known and widely used offshore jurisdiction in the fund formation landscape. It has established itself as a reliable and popular choice for fund managers due to its favorable regulatory environment and tax benefits.
Following closely behind is the British Virgin Islands (BVI), which serves as another attractive option for offshore fund structures. The BVI offers a flexible legal framework and various tax advantages, making it a preferred destination for emerging fund managers seeking offshore alternatives.
Additionally, Canada emerges as a notable choice for offshore fund formation. While not traditionally considered an offshore jurisdiction, Canada’s regulatory and tax framework has garnered attention from fund managers seeking viable options for their funds.
Other offshore jurisdictions such as Luxembourg, Mauritius, and Jersey are also frequently considered depending on the investment profile and the location of investors. Each jurisdiction has its unique set of advantages and considerations, making it crucial for fund managers to carefully assess their specific needs before making a decision.
While these offshore jurisdictions offer numerous benefits for fund formation, it’s important to acknowledge that they come with their complexities and regulatory requirements. Navigating the regulatory landscape in these jurisdictions can be challenging, and specialized legal expertise is often required to ensure compliance and optimize fund structures.
The choice of offshore jurisdiction depends on a range of factors, including the nature of the fund, the profile of investors, and the investment strategy. The Cayman Islands, BVI, and Canada are some of the top contenders, but each fund manager should evaluate their unique circumstances and objectives before selecting the most suitable offshore jurisdiction for their venture capital fund.
The purpose of a blocker in venture capital fund formation is to shield non-U.S. investors from direct U.S. taxation and prevent tax filings in the United States. When a fund invests in flow-through operating companies, such as LLCs or partnerships, the non-U.S. investors’ share of the portfolio company’s economics can create upstream income. Without a blocker, this upstream income could be considered effectively connected income, subjecting non-U.S. investors to U.S. taxation.
The blocker serves as an intermediary between the fund and the non-U.S. investors, mitigating their tax liabilities. By channeling the income through the blocker, non-U.S. investors are not directly subject to U.S. taxation, reducing the risk of tax nexus and eliminating the need for U.S. tax filings. Moreover, the blocker’s share of corporate income tax typically bears a lower tax rate than the tax rate imposed on non-U.S. investors’ direct income.
Additionally, the blocker can be structured to minimize dividend withholding taxes and optimize the repatriation of fund returns to non-U.S. investors. Overall, the blocker helps preserve the non-U.S. investors’ after-tax economics and ensures a more tax-efficient investment structure. By understanding the intricacies of blocker entities and tailoring them to the specific needs of the fund and its investors, venture capital fund managers can attract a broader range of international investors and enhance the overall attractiveness of their fund offering.
For a California-based venture capital manager, there are specific compliance and tax responsibilities to consider. First, it’s essential to qualify all Delaware entities with the California Secretary of State. This involves informing the state that your entities are operating within its jurisdiction and paying the required annual fees, typically a few hundred dollars per entity.
On the federal level, venture capital managers are primarily concerned with compliance under the federal private placement rules, specifically Regulation D, which is the safe harbor widely used by most funds. The federal rules preempt the state’s own Investment Advisers Act regime and private placement rules. However, California managers should be mindful of the San Francisco gross receipts tax, which applies to certain revenue generated within the city. To avoid unnecessary taxes, it’s crucial to separate the carried interest and capital economics from any activities subject to the San Francisco gross receipts tax.
Overall, California-based managers can focus on federal compliance and qualification of entities at the state level. By adhering to these requirements, venture capital managers can confidently operate in California and navigate the complexities of fund formation and management in this state.
So if you have any questions on that or interested in attending, definitely sign up for those coming up here in a couple of weeks and I will shoot over some more information about daily paper and Yoni and Loop as well so you can contact them after if you have any more questions or are launching a new fund. I need an amazing information provider.
We are so grateful to Yoni, Aalok and the DLA Piper team for doing this webinar session with us and for sharing their wealth of knowledge and expertise. Yoni and Aalok provided incredibly valuable insights, best practices, and expert guidance for venture capital fund managers embarking on the fund formation journey. Should you have any further questions or require additional assistance, we encourage you to contact DLA Piper for exceptional support on your fund formation endeavors.
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