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3. ENTITY FORMATION

e. Internal Documents

You may need to create various internal documents in addition to the documents filed with government agencies.

A fund management company may need the following internal documents, among others:

• owner's agreement
• owner register
• certificates of ownership
• notices, minutes, and resolutions
• business plan

A private equity fund may need the following internal documents, among others:

• owner's agreement
• owner register
• certificates of ownership
• notices, minutes, and resolutions
• non-disclosure agreements
• private placement memoranda
• investor questionnaires
• subscription agreements
• investor side letters

Owners' Agreement

Every business entity should have an agreement among the owners. In a fund management company, the owners are the founders and any passive investors. In a private equity fund, the owners are the managers or their management company, and the investors.

The form of the owners' agreement depends on the type of entity. An LLC has an “operating agreement”, a corporation has “bylaws” or a “shareholders' agreement”, and a limited partnership has a “limited partnership agreement”.

Together, the articles and the owners' agreement govern the internal affairs of the entity. The owners' agreement covers the same issues as the articles as well as additional issues. Typical issues include business formation, capitalization, ownership structure, management, allocations of profits and losses, distributions, ownership transfers, information disclosure, dissolution, indemnification, and dispute resolution. Any matters not addressed in the articles or owners' agreement are governed by the default laws of the state of organization.

Occasionally, the applicable state laws may allow the owners' agreement to exist in oral form. For example, in California, the operating agreement of an LLC may be oral. However, the better approach is to put everything in writing in order to resolve latent problems, manage expectations, and avoid misunderstandings.

The owners' agreement of a private equity fund contains the rights and obligations of the fund manager and investors. In the typical structure, the manager receives (i) an annual fee equal to two percent (2%) of the net assets under management; and (ii) a "carried interest" of twenty percent (20%) of the net cash flow from operations. The carried interest is often subject to a "hurdle rate", meaning that payment is delayed until the investors receive a certain return. The standard hurdle rate is an internal rate of return ("IRR") of eight percent (8%).

Owner Register

Applicable state law may require entities to maintain a written register of the names, contact information, and ownership stakes of the owners. Even if not required, such a register is advisable -- especially when the entity has passive investors. Be sure to keep the register up-to-date.

Certificates of Ownership

States may require or allow business entities to issue tangible certificates of ownership, such as stock certificates of a corporation. California and Delaware allow but do not require certificates. On the positive side, certificates may facilitate accurate record-keeping, promote employee morale, and give comfort to passive investors. On the negative side, problems may arise when certificates are lost, destroyed, pledged as collateral, or transferred without authorization. The modern trend is to avoid using certificates.

Notices, Minutes, and Resolutions

States may require entities to hold annual meetings. For example, except for “close corporations” electing otherwise, all California corporations must hold annual shareholder meetings. LLC's and limited partnerships are not required to have annual meetings of their owners. California does not require annual meetings of the directors of any type of entity. However, periodic board meetings are customary and recommended.

Even if applicable law does not require meetings, the governing documents of an entity may impose such a requirement.

Entities must conduct their meetings in compliance with applicable law and governing documents. The law and documents typically require the following, among other things:

• prior written notice to the participants, unless they unanimously waive the notice
• notes (“minutes”) taken by the Secretary
• votes and resolutions recorded by the Secretary
• written approval by the participants of the minutes and resolutions

Business Plan

Business plans are probably not required by applicable law. However, a business plan may be appropriate for a fund management company. If the company seeks debt capital from a lender, the lender may want to review a business plan as part of its "due diligence" process. In addition, the process of drafting a business plan would cause the fund personnel to narrow their focus, develop concrete steps for achieving success, and lay the foundation for marketing materials such as brochures and websites. A business plan is especially useful for companies with multiple personnel.

A business plan is usually not appropriate for a private equity fund. Instead, the fund may need to create a private placement memorandum (discussed below).

Non-Disclosure Agreements

When raising capital for a fund, the fund manager should require every potential investor to sign a non-disclosure agreement (NDA) before receiving a copy of the private placement memorandum. From a legal perspective, the NDA helps maintain the "private" nature of the private placement of securities.

Private Placement Memoranda

The securities laws require issuers to disclose all material information to investors regarding their potential investment. In the case of a private equity fund, the fund itself is the "issuer" of securities and the fund management company is an agent of the fund. In order to satisfy the disclosure requirement, fund managers typically distribute a private placement memorandum (PPM) to each investor. A PPM is similar to a "business plan" but not identical. A PPM discusses the securities offering, investor qualifications, fund structure and operations, investment strategy and criteria, risk factors, legal disclaimers, and other topics. The PPM may contain financial projections, unless they are too speculative.

The fund manager should distribute the PPM's as early as possible in order to give the investors time to digest the information and perform due diligence. If changes occur prior to the conclusion of the securities offering, consider distributing amended versions of the PPM's.

The fund manager should keep careful records of all PPM deliveries and significant communications with the investors. To the extent feasible, number each copy of the PPM for record-keeping purposes. The fund manager should distribute the PPM only to investors believed to satisfy the qualifications of the securities laws.

Investor Questionnaires

When a fund raises capital from investors, the fund manager should require every outside investor to fill out an "investor questionnaire". The questionnaire helps the manager verify that the outside investors meet the wealth and "sophistication" qualifications to exempt the securities offering from registration.

Subscription Agreements

When raising capital for a fund, fund managers sometimes require investors to sign a subscription agreement. The subscription agreement requires the investors to contribute capital to the fund upon the request of the manager. Such requests are known as "capital calls". Thus, subscription agreements are generally appropriate only if the fund will receive capital over an extended period of time. Otherwise, a subscription agreement may not be necessary, and the owners' agreement can include the equity purchase provisions.

Investor Side Letters

Potential investors in a fund may request changes to the owners' agreement and subscription agreement. The fund manager may accept the changes for all investors or merely the ones requesting changes. In the latter case, the fund executes "side letters" with the investors that requested the changes. However, in such event, fiduciary concerns may compel the manager to disclose the side letters to the other investors, which in turn may compel the other investors to seek the same changes. For this and other reasons, fund managers should generally resist executing any side letters.