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5. FINANCIAL MATTERS

a. Capitalization

Initial Requirements

Many new companies fail due to lack of sufficient capital to cover the start-up period. To avoid this situation, the founders of a new fund management company should create a detailed budget of initial expenses and then "capitalize" the company to meet the budget. From a legal perspective, undercapitalization would create the risk of personal liability under a "veil-piercing" theory.

When investing in a start-up company or new project, the fund managers should consider the similar risks of undercapitalization at the portfolio level and perhaps increase their investment amounts.

The typical fund management company must wait a few years before generating significant revenue. The private equity industry has a long-term focus. Typically, portfolio projects have an investment horizon of 5-7 years, funds have a minimum duration of 10 years, and the carried interest of the manager is delayed until investors receive a threshold IRR of 8%.

Debt vs. Equity

Capitalization of the fund manager may take the form of debt or equity. If the capital comes from the founders themselves, it is typical to treat a portion as equity and the balance as debt. The debt portion should have a specified interest rate, compounding schedule, and repayment period – for example, 10% per annum, compounding annually, with a one-year term. Your company may also seek a loan from a bank or other financial institution, but such loans are usually not available to start-up companies in the formation phase.

The specific ratio of debt-to-equity varies by company. Work with your CPA to determine an appropriate ratio. Note that the larger the debt percentage, the greater the risk of recharacterization by tax authorities on grounds of “thin capitalization”. The traditional ratio is 1:1 -- in other words, 50% debt and 50% equity.

Equity Investors

A fund management company may seek equity capital from outside investors. The outside investors may consist of friends and relatives, angel investors, or professional venture capital investors.

The securities laws may determine the type of investor. Certain exemptions from registration are available for offerings to some investors but not others. For example, Rule 506 (the most popular exemption) requires offers and sales only to "accredited" investors or up to 35 unaccredited but "sophisticated" investors. "Accredited" investors are company insiders, wealthy individuals, and other types of investors. "Sophisticated" investors have (or at least appear to have) sufficient knowledge and experience to understand the risks of the investment.

The fund sponsor may further limit the securities offering to investors meeting the desired residency requirements.

Investor Rights

Outside investors often demand preferential economic and governance rights. The typical solution is to create a second class of ownership interests. If your company is a corporation, it must be a “C corporation” and not an “S corporation” because federal tax law prohibits “S corporations” from having more than one class of stock. (In this regard, shares are different classes only if they have different economic rights.) In addition, California law prohibits statutory “close” corporations from having more than one class of stock.

In California, "C corporations", limited liability companies (LLC's), and limited partnerships (LP's) may have an unlimited number of classes unless their governing documents provide otherwise.

In the typical structure, the founders own “common stock” of their corporation or “Class A interests” of their LLC or LP, and the outside investors receive “preferred stock” or “Class B interests”. The outside investors have priority rights to distributions, plus the rights to receive information, vote on major decisions, and audit the books and records of the company.

California companies are generally free to prohibit investors from participating in management. However, certain information and inspection rights are mandatory. These rights may also apply to certain “foreign” companies registered to do business in California.

Investment Documentation

Debt and equity are both treated as “securities” under state and federal law. If your business entity offers or sells securities to outside investors, you should “paper the deal” properly. That means executing written documents between the company and investors. The documentation will provide various benefits, such as avoiding misunderstandings, reducing the risk of liability for misrepresentations, and persuading tax authorities to allow deductions of interest on debt.

Debt transactions may require the following documents, among others:

• non-disclosure agreement (NDA)
• business plan
• investor questionnaire
• loan agreement
• amended articles and bylaws, or LLC operating agreement

Equity transactions usually require a combination of the following documents:

• non-disclosure agreement (NDA)
• private placement memorandum (PPM)
• investor questionnaire
• subscription agreement
• purchase agreement
• investor rights agreements or “side letters”
• amended articles and bylaws, or LLC operating agreement

In addition, you may need to file notices with government agencies. Securities laws require registration of all securities offerings unless exemptions apply at both the state and federal levels. Exemptions typically relate to the amount of capital being raised, the locations of the investors, the wealth and “sophistication” of the investors, and other factors. Many start-up companies raise capital under the exemptions for “private offerings”, “limited offerings”, or “intrastate offerings”. Other exemptions may apply.

Even if an offering is exempt from registration, the issuer of securities must still comply with disclosure requirements. In general, the securities laws require the accurate disclosure of all “material” (important) information regarding the offering and issuer.

Securities offerings are very complicated and require the assistance of experienced counsel. Legal violations may result in civil and criminal liabilities. At a minimum, investors usually have the right to get their money back, perhaps with interest. In California, the current interest rate is 7%. Applicable law may also require reimbursement of attorney fees and other litigation costs. If the violations were intentional, punitive damages may also be available. In California, for example, investors may recover treble damages for securities fraud. The individuals responsible for the fraud may incur personal liability.

Finders

Fund managers may hire a third party to source investors and otherwise assist with fund-raising. Such third parties are known as “finders” or “placement agents”. For small offerings, they usually charge a fee in the range of 4-7% of capital raised. They may also demand a piece of the equity of the issuer. The typical amount is 2-5% of the equity of the offering, or perhaps the entire company. Together, the fee and equity percentages may fall in the range of 6-10%.

Applicable law may require the finder to register as a licensed “broker-dealer” with FINRA (formerly NASD). If you use an unlicensed broker-dealer, the legal violation may give rise to the same civil and criminal liabilities discussed above in regards to registration and disclosure violations.

Fund Capital

Fund managers may receive investor capital up-front or on a rolling basis. If capital is received prior to its deployment to portfolio investments, the cash should be held in an interest-bearing bank account with the interest allocated among all the owners of the fund. If the fund managers fail to use the capital by a specified deadline, they must either return the capital to the investors or get their written consent to change the deadline.

Transfer Restrictions

If you sell equity to investors in an exempt offering, the securities laws will restrict re-sales of the equity interests. First, the re-sale must comply with exemptions from registration. Second, the re-sale may not occur until the expiration of the period required by law (six months or one year, in the case of federal law).

The governing documents of a private equity fund or firm may impose further restrictions on re-sales. For example, investors may need the prior written consent of the manager or founders to any transfers. Also, the existing equity holders or the management company may have preferential rights to purchase the equity being sold. Such rights are known as "rights of first refusal".