As a founder, and CEO of a fintech company that serves companies and funds, I have oftentimes found some of the largest and hardest problems to solve could have been avoided with simple steps but are pushed and delayed because other “more important” tasks hijack the time. By encouraging your portfolio companies or your team to follow these 5 suggestions, you can be sure that you will be ready when it comes time to handoff bookkeeping tasks, convert to a c-corp or prepare for tax season.
Successfully launching and running a fund has everything to do with properly structuring and administering investment vehicles that are used to invest in private assets. This is true whether these private assets are start-up companies, real estate projects, secondary opportunities, farmland, art, films, cannabis, crypto-currency, opportunity zones or almost any form of private asset with the potential of creating value.
The deal is closed, you are invested, but what happens next? The fact is the work is not yet done. Any number of events can require your attention, varying in degree from casual company updates to distribution and exit activities. These Post Closing Activities (PCAs) can happen at any time and for any number of reasons. It is difficult to define the limits of what a PCA is, so here we will focus on four of the most common PCAs and some of the implications of those events. The PCAs will specifically be viewed from the perspective of investments made through a Special Purpose Vehicle (SPV), an LLC where investors subscribe to and have ownership of the SPV, not the asset itself.
There are four common types of convertible debt that founders will often issue: Convertible Notes, Simple Agreements for Future Equity (SAFE), Keep It Simple Security (KISS), and Simple Agreements for Future Tokens (SAFT). Each of these are distinctive and may include standard terms that make them preferable over each other in certain circumstances. Below are descriptions of the instruments and the terms that would typically come with each.
Limited Liability Corporations (LLCs) and Limited Partnerships (LPs) share many of the same beneficial characteristics in that they are both flexible in how they are used, and both provide pass-through tax treatment.
A Special Purpose Vehicle/Entity (“SPV”) is a business entity that has a special limited purpose. SPVs are often created to protect assets and separate liabilities of a parent or subsidiary company. Each SPV, which may share the same managing and sponsoring entity (an “SPV Organizer”), has its own operating structure, ownership structure, balance sheet, and is financially independent of any other SPV with the same SPV Organizer. While an SPV can be any entity type, they are usually either a limited liability company (LLC) or a limited partnership (LP).
While there are hundreds of success stories of startups that started in a garage and went on to change the world, many companies, for one reason or another, cannot succeed in the marketplace. There are a million reasons why a company may shut down, however, there are two primary means that a business will facilitate the closing of their business, bankruptcy and out of court dissolutions. In all circumstances discussed below, the company should file dissolution paperwork in the state they are incorporated, which officially ends the existence of the business.
Since their inception in 1977, Limited Liability Companies (LLC) have been the preferred method of organization for Special Purpose Vehicles (“SPVs”). LLCs gave individuals limited liability and pass-through tax treatment, without the restrictions on investors imposed by an S Corporation. 19 years later Delaware created the Series LLC, giving LLCs even more functionality making them an attractive alternative to corporations.
Reaching your Company's Ultimate Success: In venture capital, the Initial Public Offering (IPO) of a company is regarded as the ultimate success. For the company, an IPO reflects a coming of age, having successfully navigated the volatile waters of start-up life to become an industry leader, and often a household name. For investors, it is often the highest payout they will see, and often a time where they will let go of some of their previously held responsibilities. However, more so than any other type of exit, the IPO comes fraught with any number of complexities, be it regulatory, interpersonal, or strategic. With all of the positive attention on the company, there comes an enormous amount of scrutiny. The company suddenly has a responsibility to disclose a large amount of information they previously were able to keep private. For fund managers, general partners, and angel investors, the IPO process can lead to significant wealth, however, it is important they understand the process both before and after the stock is publicly listed.
Investors new to investing in start ups will likely run into many terms that they are not familiar with on the public markets. One of the most important and frequent they may see is convertible debt. There are two circumstances where an investor is most likely to run into convertible debt. First is when the investment company is in the early stages of existence. When a young company is seeking financing, it is not beneficial to either the investor or the founder to spend a significant amount of time and money working on the details of an equity round. The time founders and investors spend determining a valuation could easily derail a company, and the legal costs associated with negotiating and drafting a complex legal structure, while always cumbersome, could do serious harm to a company. In addition, a company may opt to use a note round between equity financing rounds. If their revenue turned out to be not as high as projected, or the burn rate was higher than the founder had hoped, the company may find themselves short on cash. A note round allows the company to receive quick financing without all of the efforts of an equity round. Within the various types of convertible debt, there are several important terms that an investor needs to understand. Below are some of the key terms within convertible debt.
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,
An analysis of Assure data shows that for over 1,500 venture capital fund financings in which fund organizers are entitled to carried interest, the average total carry percentage is 18.24%, with the overwhelming majority (1,214) of financings designating 20% carry for fund organizers (which tracks closely to traditional fund manager carry). Assure has seen designations ranging from 5% or less (30) to as high as 50% (1) and 252 financings between the threshold of 5% and 15%.
What is Carried Interest?
Fund organizers (often the general partner or manager) receive compensation for putting together an investment fund in two ways: (1) an annual management fee to cover the administrative costs associated with managing the fund and investing fund capital (generally 2% of assets under management); (2) performance fee (or carried interest) a fund receives upon a closing where profits are distributed.
Entitlement to carried interest, which is often disproportionate to the organizer’s capital contribution, is based on the premise that organizers invest tremendous amounts of time and effort in putting a fund together, providing on-going investment advice, and developing a strategy for maximizing the value of each investment. As such carried interest is typically the primary motivation for fund organizers, with carry viewed less as a right of passage and more as a means of rewarding and incentivizing fund organizer participation.
For tax purposes, carried interest is treated as a long-term capital gain (taxed at a rate between 15-20% with an additional 3.8 percent investment tax) if held for the requisite three-year vesting period per the newly enacted Tax Cuts and Jobs Act. If the three-year holding period is not met the interest is taxed at the ordinary income tax rate.
Mechanics of Carried Interest
The mechanics of receiving carried interest are typically formalized in the investment fund’s operating agreement. The operating agreement defines the carry percentage (generally 20% of the fund’s profit), any associated carry floors or hurdles (rate of return percentage above initial capital contributions), and distribution allocation priorities. In the event, the fund does not receive any profits the fund organizer is not entitled to any carried interest.
A common distribution allocation proceeds in this order:
(1) payment of any outstanding fund debts or obligations;
(2) payment to the members until they receive an amount equal to their initial capital contribution;
(3) payment to the organizer based on the established carry percentage;
(4) payment of any profit remainder to the members, organizer, and manager in proportion to their initial contributions.
Fund organizers at times assign or waive carried interest for specific situations. Organizers often provide incentives to their investors in the form of side letter agreements waiving a percentage of carry attributable to the investor. When the fund receives a distribution, the associated allocation will account for the waiver. Additionally, organizers often assign to third parties a portion of the carried interest they are entitled to in return for investment advice, management services, or other compensable actions related to the fund’s investment.