One of the largest factors that makes investing in private companies high risk is the general lack of liquidity. An investor can invest $50,000 in the seed round and not be able to move or derive any benefit from that investment for the next decade, if at all. Luckily, there are ways an investor can move in, cash out, or just reorganize their investments. If the investor uses a Special Purpose Vehicle (SPV), there are ways to leave the investment in a way that still complies with federal securities regulations. In this article we will focus on the mechanics, common scenarios, and common pitfalls of fund transfers. Fund transfers discussed here refer only to an investor (or manager) moving in or out of an SPV that is the legal possessor of the asset purchased, rather than the transfer of the asset itself from one holder to another. Some of these transactions are voluntary, while others are mandatory,
The most common type of transfers occur when an investor transfers their membership interest in an SPV to another investor, who may or may not be new to the fund. These membership transfers are most often voluntary, but at times can be involuntary. An involuntary membership transfer might occur if an investor dies or has to split their ownership via a court order, while voluntary membership transfers are at the election of the investor. In all of the above circumstances, there are different contractual and regulatory requirements that need to be catered to. For example, if the investor is transferring their interest to an outside third party with money involved, the process is fairly complex. Even if the transferor is not taking a profit from the investment, the transfer could constitute a sale. In this case there should be a purchase agreement introduced with the proper representations and warranties being made by both the buyer and seller, and then signed off by the manager of the fund. Additionally, since there are new investors to the fund, they will need to certify that they fall within any exemptions the fund uses, and go through any KYC/AML processes that are in place.
On the other end of the membership transfer spectrum in terms of complexity is when the investor is transferring to themselves, or an entity in which they are the sole beneficiary. There are no new investors, and there is not any money exchanging hands, so the transfer documents would be straightforward. However, if there were an individual transferring to an LLC, and the LLC had multiple members, all of the members of the LLC would need to certify compliance with any pertinent exemption or regulation.
In an investor leaves the fund it will shrink in size. In relation to SPVs, this is often referred to as a redemption. Depending on the type of investment, and rules within that vehicle, the redemption may be voluntary or involuntary. An involuntary, or compulsory redemption, may occur if the investor loses their accreditation status. Redemptions are less common in angel syndicates, specifically single asset angel syndicates, in which case once the original investment is made there are no leftover funds to return to the redeeming investor. In this circumstance an investor faces a compulsory redemption, so often the best route may be to try to find a replacement investor to take their place and complete a membership transfer as described above.
On the other hand, voluntary redemptions are when the investor opts to cash out of the fund, often taking profits along the way. There are some risks involved with this, as the investor could potentially revalue the investment based on the amount they receive, along with any regulatory concerns. Voluntary redemptions should only be done in specific circumstances and with the guidance of an experienced transactional attorney.
Occasionally, it is not the investor at all who is leaving the fund, but the organizer or manager of the fund itself. Here the person who gathered the investors and oftentimes is responsible for making the investment decisions resigns from their own fund. There are a couple of reasons this may happen. First, if the organizer is an entity, and the entity fails, the organizer entity will need to hand off their ongoing responsibilities to someone else. Second may be for regulatory reasons. If the manager of the fund runs up against a regulatory limit for assets under management, they may resign from their position in a fund that they think is less likely to succeed in order to be able to pursue an opportunity in a fund that appears more promising. Here there are tremendous opportunities for the new manager of the fund. Since the manager of the fund is often entitled to carried interest (a portion of the profits should the investment succeed) when the original manager resigns, there is a tremendous potential upside for the new manager. Changing the manager is often a creature of contract, so a simple assignment after the manager resigns should be sufficient, and the rights and responsibilities between the new manager and the old manager can vary greatly based on what was negotiated.
Transferring an interest in a fund can offer tremendous benefits and some level of liquidity in a market that is renowned for its illiquidity. It can also offer the opportunity of benefits while risking several pitfalls to those who do it without consulting an experienced professional on the matter.