Fund Formation

What is fund formation?

Fund formation is the work of turning a fundraising plan into a functioning investment vehicle: forming the entities, drafting the partnership agreement and subscription documents, choosing an adviser registration position, closing capital, and making the securities filings that follow the first sale. It ends at a first close, not at a signed term sheet.

The entities

A venture fund is normally three entities, not one.

• The fund itself, usually a Delaware limited partnership. Under Delaware's limited partnership act, forming one requires a certificate of limited partnership executed by all general partners and filed with the Secretary of State, carrying the name of the partnership, the address of the registered office and the name and address of the registered agent, and the name and business, residence or mailing address of each general partner. The partnership exists from the time of that filing, or a later date stated in the certificate, provided there has been substantial compliance.
• The general partner entity, which holds the carried interest and is the partner with liability for partnership obligations.
• The management company, which employs people, signs the office lease, and receives the management fee.

The split is not decoration. It separates the carry from the payroll, which matters when partners join and leave, when carry is allocated and vested, and when a later fund needs a different GP entity with a different ownership split.

Delaware then charges rent on the structure. Every domestic limited partnership and every foreign limited partnership registered to do business in Delaware pays an annual tax of $400, due June 1 following the close of the calendar year or on cancellation of the certificate, with $100 per registered series.

What is the regulatory position

Two questions decide the filings: what the adviser is, and what the fund is.

On the adviser side, a first-time manager usually chooses between two Advisers Act exemptions. The private fund adviser exemption under Rule 203(m)-1 applies to an adviser that manages private fund assets of less than $150 million, with the same $150 million test applied to assets managed at a U.S. place of business for non-U.S. advisers. The venture capital fund adviser exemption under Rule 203(l)-1 has no size limit, but the funds must fit the rule's definition: the fund represents to investors and potential investors that it pursues a venture capital strategy; holds no more than 20 percent of aggregate capital contributions and uncalled committed capital in assets that are not qualifying investments; does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15 percent of aggregate capital contributions and uncalled committed capital, with any such borrowing for a non-renewable term of no longer than 120 calendar days; issues only securities whose terms give no right, except in extraordinary circumstances, to withdraw, redeem or require repurchase; and is not registered under section 8 of the Investment Company Act and has not elected business development company treatment.

That 15 percent, 120-day condition is where subscription lines get funds into trouble, and the 20 percent basket is where secondaries, tokens and fund-of-fund positions get counted.

On the fund side, the vehicle must avoid registration as an investment company. Section 3(c)(1) excludes a fund whose outstanding securities other than short-term paper are beneficially owned by not more than 100 persons, with 250 permitted for a qualifying venture capital fund. Section 3(c)(7) excludes a fund whose outstanding securities are owned exclusively by qualified purchasers. A Fund I with 60 investors is comfortably inside 3(c)(1); a Fund III with 180 is not, and the choice of exclusion changes who may be admitted.

Then the offering itself is a private placement of securities, which brings the notice filing. An issuer relying on Regulation D must file a notice of sales on Form D no later than 15 calendar days after the first sale of securities in the offering, with the deadline rolling to the next business day if the fifteenth day is a weekend or holiday. Blue sky notice filings in the investors' states follow on their own schedules.

Worked example

The figures below are hypothetical, apart from the statutory items named above.

A manager targets a $50 million Fund I with a 2 percent annual management fee over a ten-year term and an organizational expense cap of $350,000.

Step one, the first close. Subscription documents are countersigned and the first capital call is issued on March 3, bringing in $22 million of the $50 million target. The first sale of securities occurred on March 3, so Form D is due no later than March 18.

Step two, investable capital. Fees are 2 percent of $50 million, which is $1 million a year. Across ten years that is $10 million, or 20 percent of the fund. Organizational expenses take another $350,000. Investable capital is $50 million less $10 million less $350,000, which is $39.65 million.

Step three, position sizing. At an average initial check of $750,000, $39.65 million supports roughly 52 initial positions with nothing held back, which is not a portfolio, it is a spreadsheet. Reserving half for follow-ons gives about $19.8 million of initial capital, or 26 first checks of $750,000, with the balance reserved.

Step four, the regulatory picture. Private fund assets are far below $150 million, so the adviser can file as an exempt reporting adviser under Rule 203(m)-1. If the strategy might later include a large secondaries allocation or a standing credit facility, the 20 percent basket and the 15 percent, 120-day leverage condition of Rule 203(l)-1 are the constraints to check before writing them into the LPA.

Step five, the count. Forty-two investors are admitted at the final close. That is inside the 100-owner limit of section 3(c)(1) with room for a Fund II strategy change, and it means qualified purchaser status does not have to be verified for every subscriber.

The document set

• Certificate of limited partnership, plus the GP and management company formation documents.
• Limited partnership agreement: term, investment period, fee, carry and waterfall, GP commitment, key person and removal provisions, advisory committee, expense allocation, and the organizational expense cap that appeared in the arithmetic above.
• Subscription agreement and investor questionnaire, which is where accredited investor and qualified purchaser status is represented.
• Private placement memorandum or a shorter disclosure package, depending on the investor base.
• Side letters, which is where most-favored-nation rights, excuse rights, advisory committee seats and reporting bespokes land.
• Form D, state notice filings, Form ADV as an exempt reporting adviser, an EIN, a bank and custody arrangement, and a fund administrator.

Common mistakes

• Treating first close as the finish line. The fee stream starts, the clock on the investment period starts, and the deployment pace has to be defensible to LPs who have not yet closed.
• Sizing fees against target rather than closed capital. A fund that targets $50 million and closes $28 million still pays for the same audit, admin and legal work, so the expense ratio lands on the LPs who did come in.
• Missing the 15-day Form D window because the first close was papered informally.
• Writing a strategy into the LPA that quietly breaks the venture capital fund adviser exemption, then discovering the problem when a subscription line is drawn for longer than 120 days.
• Building the GP entity as an afterthought. Carry allocation and vesting among founders is far harder to renegotiate after Fund I is deployed.

Related terms

A first close is the milestone fund formation targets. Committed capital is what the documents secure and what the fee is charged against. A management company is the entity fund formation creates alongside the fund itself, and the exempt reporting adviser position is the regulatory status most first-time managers end up in, with the Form D filing as the first deadline that actually bites.

Related tools and reading

• Carry Calculator
• Waterfall Calculator
• Best Startup Accelerators
• Series A Guide