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The Anatomy of a VC Fund

2 min read

Sep 27, 2022 9:51:40 AM | Assure

Success in launching and running a fund is all about effectively structuring and administering vehicles that are used to invest in private assets. This is true whether we are talking about startup companies, real estate projects, secondary opportunities, buyouts, mezzanine debt, or other classes of value-producing assets.

 

A capital-raising SPV needs five main services or areas of expertise that comprise the life-cycle of an SPV:

  • LEGAL

  • TAX

  • COMPLIANCE

  • ADMINISTRATION

  • ACCOUNTING (sometimes)

We will review a capital-raising SPV in the order in which the tasks are usually completed – chronological order – rather than in order of time and resources required by each.


Create the SPV Entity (LEGAL):

The capital-raising SPV will be either an LLC or LP entity. Most common is a Delaware LLC. Assure recommends using a Master Series LLC structure. Here are a few key definitions:

LLC stands for Limited Liability Company. Forming an LLC is the simplest way of structuring your entity or SPV, to protect its assets in case it becomes subject to a lawsuit. LLCs can be owned by one or more people, who are known as LLC "members."

LP stands for Limited Partnership. A Limited Partnership is another simple way of structuring your entity/SPV to protect its assets in case a lawsuit is brought against the entity. An LP structure is slightly less flexible than an LLC and also a bit more expensive.

Investors can certainly use an LP entity rather than an LLC entity, but for the purpose of this article, we will refer exclusively to the LLC entity structure.

Entities are simple legal structures and are state-specific. Most choose Delaware because it is widely considered the most flexible type of business entity in the world. Many states have mirrored Delaware’s flexibility and advantages but Delaware has maintained its reputation and standing as the most beneficial place to register an entity.


Hire a registered agent (ADMINISTRATION):

When you set up an entity, the state you select, for example Delaware or Utah, requires you to hire a registered agent. A registered agent is defined as the liaison between your company and the state. Your registered agent is responsible for making sure you receive your tax forms, notices from the Secretary of State, and any service of process you may receive if someone files a lawsuit against your company. Hiring a registered agent is required by law. Without a registered agent, the state will not set up your entity and if your registered agent resigns and you fail to replace them, the state will void your entity.

It usually takes 1 - 14 days to set up an entity and hire a registered agent.

Once set up, the fund entity becomes operational and can enter into agreements, open a bank account, hire employee team members, rent space, own equipment and do thousands of other things. For a capital-raising SPV, our focus is on a few particular things…namely, the ability to enter into agreements, form and develop partnerships, and hold assets.


Documentation (LEGAL):

At this point, your new entity needs direction and guidance to move forward successfully. An entity that has been set up is essentially an empty shell – it may have endless potential, but it needs leadership, structure and direction. Legal documents govern how this entity behaves, and the rights and rules of those that belong to it. Obviously the documents and the included provisions will differ depending on the use and purpose of the entity. For capital-raising SPVs, the necessary documents include an Operating Agreement, Private Placement Memorandum and Subscription Agreement.

An Operating Agreement governs the relationship between all of the investors and managers of the SPV. A Subscription Agreement covers the committing of capital to the SPV by the investors. The Private Placement Memorandum (also referred to as a PPM) advises all prospective investors of all pertinent data to make an informed decision prior to investing capital.


Obtain an EIN Number from the IRS (LEGAL/ADMINISTRATION):

A capital-raising SPV needs a tax ID number for two key reasons. The first is because the entity will need to file a tax return and deliver K1s to its investors. The second is that if a bank account is required to aggregate all of the investors’ capital, an EIN is necessary. An EIN is obtained by filling out the proper forms and submitting them to the IRS.


Open a Bank Account (ADMINISTRATION):

Although not necessary, most capital-raising SPVs need to aggregate the funds from their investors into a bank account before sending funds on to the target company or completing the asset purchase. Entity creation certificates, entity documentation and the entity’s EIN number are all necessary to establish a bank account.


Onboard Investors (LEGAL/COMPLIANCE/ADMINISTRATION):

Once the entity is set up with finalized documents and a designated bank account is opened, it is time to have the investors enter the deal process. Investors take action by filling out and signing the documents, and by wiring or delivering their funds to the bank account. Investors are required to fill out and sign the operating agreement and the subscription agreement.

By signing the operating agreement, the investors are agreeing to the direction, rights, rules and restriction of the SPV as documented in the agreement. Completing and signing the subscription agreement provides the SPV with the following information of each investor:

  • Who or what entity is signing up

  • How much they are committing to invest

  • All of the relevant detailed information, including address, phone number, tax id numbers, entity type, etc.

Once an investor has signed all of the documents and wired their funds, they are considered onboarded. The legal aspect of this step includes tasks such as reviewing subscription documents for completeness and answering investors’ questions regarding the documents. Compliance encompasses KYC/AML checks, accreditation verification and complying with investor limits and a variety of other rules. The administrative aspects of this on-boarding includes working with investors and answering their questions, such as:

  • “I signed, so now what?”

  • “Did you receive my wire?”

  • “When will the deal close?”

  • “Has the deal closed yet?”

  • “Now has the deal closed?”

  • “Why haven’t the documents been countersigned yet?”


Signing the Purchasing agreement and wiring funds to the company (LEGAL and ADMINISTRATION):

Purchasing the asset is the entire reason this SPV was set up. Once all of the investors have been onboarded (which means documents have been signed and funds have been wired), it is time to use those funds to purchase the asset. The nuances of “purchasing an asset” depend on the type of asset. When investing in a startup, for instance, a purchase agreement is laid out, discussed, and signed by the manager of the SPV. The funds are then wired to the company.


Now for a quick recap:

  • The entity has been set up.

  • Documents have been signed.

  • Funds have been wired.

  • The purchase agreement has been signed.

  • Capital has been sent to the startup company.

  • Investment has been made.

We’re done with the process, right? Well, yes and no. Yes, we are done with the crucial first step: the investment has been made. But a capital-raising SPV has two additional requirements to be a formal entity:

  • Preparing individualized capital account statements

  • Building a cap table


Get all of the SPV investors their Capital Account Statement (ADMINISTRATION):

The first requirement is known as a capital account statement. Now that the investment has been made, the investors want a receipt that recognizes their commitment to this SPV and tells them basic information about the SPV and everyone who participated. A capital account statement is this receipt. The partnership capital account is an equity account in the accounting records of a partnership that contains the contributions made by all partners in the partnership. The organizer prepares and delivers a capital account statement to each investor with the details of their contribution to the SPV.


Build and save the Ledger or Cap Table for the SPV (ADMINISTRATION):

The final requirement is called the “cap table,” or “ledger.” For proper record keeping and – more importantly – for taxes, distributions and other activities, the managers of the SPV need to create a ledger or cap table that lists all of the investors and their relevant information. This cap table will be used and referred to frequently throughout the lifecycle of the SPV.


Complete and File your Security Filings to the SEC and relevant states (LEGAL and COMPLIANCE):

When you use a capital-raising SPV to pool capital for the purpose of investing in private assets, like a startup, the Securities and Exchange Commission (SEC) have defined those actions as “selling securities.” Additionally, state security and exchange commissions also identify said behavior as “selling securities.” Both federal and state compliance filings, as well as fee requirements, must be met to sell securities. To comply with federal security laws, the entity needs to file a Form D with the SEC. To comply with state security laws, the entity must file blue-sky filings with every state in which an investor that participated in the SPV resides.


Circle back and make sure everything is finalized for the investment (ADMINISTRATION):

Finalizing is good practice for an organizer, where documents are double-checked and the execution of all of the documents is confirmed. Many times, an investor making a private asset assessment will wire funds, sign documents, and deliver countersigned documents and final drafts to investors before the group raising funds for their startup or project has actually ended their fundraising phase. Failure to ensure that everything is finalized and in order can result in years going by before realizing that investors never received a fully executed document package.

Part three of a Capital-raising SPV is comprised of all of the tasks that pop up on an inconsistent time frame, generally stretched out over several years: These include, for example: taxes, future financing rounds, corporate actions, distributions and wind-downs.


Prepare and file taxes and deliver K1s to your investors (when needed) (TAXES):

Capital-raising SPVs are classified as partnership tax returns by the IRS. Partnership tax returns only need to be filed when there is a taxable event. Assuming your SPV had a taxable event, you will need to prepare a form 1065 that is filed with the federal government and any applicable states. Filing a 1065 generates a K1 for each investor. Capital-raising SPV tax returns are far less complex than returns for companies that are ongoing concerns, but still poses a seemingly endless list of rules and requirements for capital-raising SPVs that you will need to understand and comply with.


Prepare and distribute financials for the SPV (ACCOUNTING):

Preparing financials is a potential requirement for a capital-raising SPV. The need for financial statements to be prepared and shared with the investors is contingent on several key factors. The most compelling of these is the asset that the SPV has invested into. If this asset generates frequent cash flow, then producing financial statements should be seriously considered. If the asset does not produce cash flow, as is typically the case when investing into a startup company, then financials statements are not necessary and can be considered as optional.


Post Close - Participate or ignore Pro Rata Allocations when future financing rounds occur (LEGAL/COMPLIANCE/ADMINISTRATION):

This action is specific to startup companies. When a startup company grows and raises more funds, some of the early investors will have the right to invest more capital in the company. These rights are called pro-rata rights. In venture capital, a pro-rata clause in an investment agreement gives the investor the right (but not the obligation) to participate in one or more future financing rounds in the interest of maintaining their percentage stake in the company. Pro-rata opportunities are typically addressed in one of three ways:

  • Released or ignored – additional capital is not invested.

  • Existing investors in the SPV contribute additional funds and the cap table of the SPV will change.

  • A new capital-raising SPV is set up to pool capital and invest.

Participating in a future financing round will require many of the tasks outlined in Part One and Part Two of a capital-raising SPV – documentation, setting up a bank account, onboarding investors, completing the purchase agreement, security filings, ledger/cap table creation and finalization. In addition, participation will impact taxes and distributions.


Post Close - Deal with Membership Transfers (LEGAL/ADMINISTRATION/COMPLIANCE and TAXES):

It may take several years between SPV start-up and shut-down, especially when investing into startup companies. Investors may need to transfer their investment from one entity to another. This is called a membership transfer. A membership transfer requires legal documentation and cap table updates. It is considered a taxable event, so the SPV will generate a tax return and K1s. We are not referring to selling a membership interest but simply transferring one. Some examples include:

  • Investing as an individual and then setting up an LLC to aggregate all of your investment activity – in which case you will want to transfer this SPV investment into your new LLC entity.

  • Divorce: You may need to split the asset into two –- in other words, transfer half to a former spouse.

  • Trust: Setting up a trust in order to pool all assets into said trust.

  • Death: If an investor passes away, the asset needs to be transferred to their respective heir(s).


Maintain the Entity each year so it doesn’t get cancelled (ADMINISTRATION):

SPV managers must maintain the entity through the payment of annual fees.


Post Close - Manage all of the Corporate Actions that require your attention (LEGAL/TAXES/ADMINISTRATION and maybe ACCOUNTING):

Corporate actions occur when the asset that the SPV has invested in requires – or when its principals desire – that its investors will vote on one or more matters. Using our example of investing in a startup company, there is a long list of matters that may arise that will be presented to the SPV, as an investor, to sign off on. These matters vary in their level of importance. The request generally comes in the form of legal documents and the results of the action may impact the value of the investment -- either positively or negatively. Here are some examples of corporation actions when investing in a startup company.

  • Shareholder resolutions

  • Shareholder meetings

  • Changes to the board

  • Company restructuring

  • Asset sale

  • Stock splits

  • Round extensions

  • Bankruptcies

  • IPOs

  • Acquisitions

  • Exits

  • Etc....

Exits are considered corporate actions – and the reason for making the investment in the first place. An exit is the very broad term for all outcomes, both positive and negative, for a private asset investment. Bankruptcy, ABC, shut-down, acquisition and IPO are the most common exits.


Collect and send out Distributions to your investors (ADMINISTRATION and TAXES and if applicable ACCOUNTING):

Distributions from a startup company investment usually come in one of two forms: cash or shares. When distributions occur – and ideally they will occur often and in large amounts – the SPV needs to distribute the cash or shares in the correct amounts and to the correct investors. This is a moment of truth for your administrative activities as you confirm that the ledger/cap table was correct on day one and that it was correctly adjusted when pro-rata allocations were exercised and when membership interests were transferred. The cap table is vital in getting distributions correct to ensure that investors never receive less than they should or receive another investor’s amount instead of their own. Further, distributions will affect the tax returns and, if applicable, also the financials.


Shutting down the SPV is usually called a wind-down (ADMINISTRATION AND TAXES):

When the asset has fully liquidated and the SPV no longer serves its purpose, the SPV needs to be shut down and a final tax return needs to be filed. The IRS needs to be told that the entity is dissolved, and that they should not expect to see any future returns.

- Entity shut-down is similar to entity set-up: filling out forms and paying a fee. Once completed correctly, the entity is shut down. This is essential as the need for the entity ends and there is no longer a requirement for maintenance to be met.
- Taxes: The IRS and the SPV investors need to be told that this entity has run its course and is shut down, so a “final tax return” is required to be prepared and filed. Each investor receives a “Final K1.”
This, then, is the anatomy of a capital-raising SPV.


A quick recap: 4 or 5 major categories:

  • LEGAL

  • TAX

  • COMPLIANCE

  • ADMINISTRATION

  • ACCOUNTING (sometimes)

An Assure capital-raising SPV has three parts:

  • Setup, documentation, onboarding and purchasing the asset

  • Securities filings, Capital account statements and finalization of the investment,

  • Taxes, corporate actions, exits, distributions and wind down.