Structuring and Licensing
[This is the third article in a 4-part series on fundraising] Read the previous chapter on fund strategy.
If you aren’t an investment professional, a lawyer or a banker, fund set up and the mechanics of how LP-GP structures work can be somewhat challenging to understand.
The majority of the business community are familiar with corporate entities limited by shares. But market practice and conventional wisdom seem to dictate that most funds be structured as partnerships. It happens to be the most common and most widely acceptable structure in the PE/VC world.
If this seems complicated, just remember:
At the crux of every commercial entity—be it a corporation or a partnership — is decision making.
Playing by the rules of the game. A typical PE fund structured as a partnership looks something like this:
In the above structure, the main responsibility of operating the fund on a day-to-day basis lies with the General Partner. The Limited Partner (being “limited” by definition) contributes capital but does not have any decision-making rights (much akin to the notion of preference shares in a corporation).
The ‘rules of the game’ — so to speak — are being defined in the Limited Partnership Agreement (“LPA”). Comparatively speaking, instead of the usual board of directors in a corporation, decision making resides in the Investment Committee, which is a group of people nominated by the GP and LPs (the same way shareholders nominate the board of directors). Naturally, those who contribute a larger share of the economics get a larger say in terms of who sits on the board or in this case, the investment committee.
There are many comprehensive resources detailing the mechanics of both partnerships and corporations, but below is an extremely simplified table outlining the few key commercial ‘equivalents’ which illustrates how partnerships in funds operate as contrasted to a typical corporate entity:
The process of ‘receiving’ investors (LPs) into the fund is all about defining the ‘rules of the game’ i.e. Formalizing them in the LPA. A fund formation lawyer can help do this, but as the fund manager, you will need to provide them the game plan, as well as the ‘boundaries’ of the playing field.
Amongst a ton of many things to consider here, some of the key commercial items to take note include:
(i) Amount of management fees and carried interest (profits from exiting an investment)
(ii) When the carried interest will be paid
(iii) Redemption — if, how and when limited partners can withdraw their capital
GPs may carve out special arrangements or preferential economics for different LPs in a side letter. Nothing is stopping you from including these clauses in the main LPA but eventually, it’s really all about how generic you want this to be.
Fund structures and LPAs — being legally drafted — are pretty much predicated on market precedents, which is ultimately driven by demand, i.e. the investor pool. If a structure has been tried and tested in the market, an LP is more likely to use it. This partly explains also why the popular 2–20 fee arrangement has not really changed significantly in the last three decades.
Ultimately, it boils down to managing risk and uncertainty. Most investors (LPs) will try to be more conservative and stand by something which is easier to justify — for a good reason because huge amounts of institutional capital are at stake here.
Is there a need to be regulated / licensed? Broadly speaking, any regulator, fund formation lawyer or sponsor will always advise you to be licensed, for a good reason: to provide more credibility, as well as to protect the interests of the most important stakeholders (the LPs) in your fund, which again in turn, drives credibility.
If you are receiving money from ‘mom and pop’ investors, the answer to being regulated is always yes. In most mature fund jurisdictions, the general rule is: As long as you take monies from any institution (including accredited investors), you need to be regulated / licensed.
What if I just raise capital from people I know? In the eyes of the external parties, getting a fund properly licensed puts the fund manager in good publicity, and is also synonymous with endorsement by the local regulatory authorities. Investors are generally get more comfort that if a fund is licensed, the basic regulatory checks have been done.
In theory, you could even operate a “fund” without being licensed or regulated if you have an extensive proprietary network of individuals who are ready to commit capital with you. The key risk or consideration here is whether or not these investors can seek adequate recourse in the event you screw up.
In reality, most funds are set up for the purposes of taking in institutional money for long periods of time. Therefore, regulation and licensing not only allows for proper governance but paves the way for raising more third party capital in the future.
One of the biggest financial hurdles with getting licensed is of course the upfront expenses (potentially up to $1 million paid-up capital required). Most first-time fund managers may not be willing to part with such a huge amount of capital especially if there is no certainty in raising the fund.
[This is the third article in a 4-part series on fundraising] Read the final chapter on the fundraising process here.
This is true for many investment banks. And people pay for complexity.
But it's an odd world:
Founders chasing publicity on social media, focusing on “story-telling” instead of "product-selling".
Companies (especially funds) announcing (and celebrating) an investment or acquisition in a business, almost sounding like: “Look, we bought these guys” or “Hey I pulled that off, can you?”
Entrepreneurs focusing too much on beautifying powerpoint slide decks and looking for investors instead of devoting more resources towards building a real product and looking for customers.
Some people spend too much time going around begging angel investors and VC funds for money to build their business. I once told a friend: raising capital is equivalent to "cash flow from financing". Why don't you focus more on delivering "cash flow from operations?".
The same applies to private fund raising: If you have to wait to bring in OPM (other people's money) before kickstarting your fund, maybe you really shouldn't be in the PE/VC business.
The end result is the same: solving for that funding gap.
You are much better off spending your time and resources looking for customers (who are by the way, non-dilutive to shareholding) rather than "road-showing" month after month to investors.
I think many of us nowadays over-relate to what we read in social media. We constantly see how different forms of a Jeff Bezos and Elon Musk manifest themselves as visionaries of businesses: People who make sweeping, yet inspiring remarks about their entrepreneurial ambitions, and making the headlines through that process. A few days later, a large venture capital or private equity firm, a middle eastern sovereign fund, or some other titan of an investor with deep pockets take a minority stake in the company.
And weirdly (for a lot of people), a part of the brain puts one and one together concluding: "Go big, or go home", "If I passionately try hard enough, someone will acquire us some day", or "some big company will buy us out". It's easy to get caught up with the hype and optimism. After all, there are many precedents of successful tech founders who started from humble beginnings.
While it is true that if you don't die trying, you won't make it, too many folks forget that the most important part of doing any business is reeling in customers, not telling stories to investors (but what do I know, right?)
I also know a handful of folks who place too much emphasis on pursuing egotistic corporate titles, lamenting on why they aren't promoted or not given nice-sounding C-suite positions. Those who crave the adulation of social media and in the process, overcompensate themselves have no chivalry.
They are all doing it backwards. Real business is in working the P&L, not in fluffy words and lofty titles.
There is no point in calling yourself Chairman, CEO, CFO, CIO, (or any permutation of a CxO), Head of Business Development or Head of Investments if you have a lousy report card to show for. It's useless to garner a thousand followers if you can’t successfully monetise your product.
You can call yourself anything you want really, but at the end of day if your designation doesn't get the job done and bring home the bacon, then what is the point?
“Rome wasn’t built in a day but they were laying bricks every hour.”
"The problem is that it can be really easy to overestimate the importance of building your Roman empire and underestimate the importance of laying another brick. It’s just another brick. Why worry about it? Much better to think about the dream of Rome. Right?
Actually Rome is just the result, the bricks are the system. The system is greater than the goal. Focusing on your habits is more important than worrying about your outcomes. Of course, there’s nothing necessarily impressive about laying a brick. It’s not a fantastic amount of work. It’s not a grand feat of strength or stamina or intelligence. Nobody is going to applaud you for it.
But laying a brick every day, year after year? That’s how you build an empire."
[Excerpt from James Clear]
I've seen too many people attempt to be "heroes" in their organisations. They seek the recognition, adulation, whatever you call it. But a five-minute fame is short-lived. At the end of the day, it is about whether you and the company can bring home the bacon. That's all that matters.
In a fast moving and digital world that seeks instant gratification, patience and foresight, are two highly underrated attributes amongst the young and inexperienced.