Multi-LP Fund Formation:
Best Practices and Insights for Corporate Venture Capital Groups
By William Graves, Legal Principal, TDK Ventures
Forming a multi-LP fund as a corporate venture capital group (CVC) presents unique complications not faced by traditional financial venture capital firms. The need to align with corporate HQ, the mandate to tailor investment strategy to technologies and markets of interest to the mothership, and a willingness to wait years (and sometimes more than a decade) for the payoff are a few considerations that CVCs must face when considering the formation of a multi-LP fund.
When the CVC pursues a limited partnership model with outside investors, the complexity of fund formation is further compounded. Such models often require a balance of diverse and potentially competing interests between the CVC’s mothership and the outsiders. However, the added benefits and potential rewards are well worth the effort. This article outlines the issues CVCs should consider and offers some insights into how to structure and draft agreements to ensure all partners receive the maximum benefit from their participation in a multi-LP fund. These insights were developed, in part, from TDK Ventures’ recent multi-fund formation with our $150 million Decarbonization Fund EX1 and related capital raising experiences. It is our intent that other CVCs may benefit from our learnings during the fund formation process.
Multi-LP Structure and Control
Inevitably and rightfully, given that it will likely contribute the majority of the fund’s investment capital, the CVC’s parent organization will require some degree of control over the fund’s operations. In most cases, the CVC entity (or an affiliate thereof) assumes the role of general partner, acting as the fund’s fiduciary agent and managing day-to-day business operations. Positioning the CVC as general partner will provide the CVC the flexibility it needs to both manage fund investments and allow its corporate parent the freedom to exercise control as the primary limited partner.
For those organizations that intend to create several funds, it may be advisable to institute another level of management via a two-tiered structure. Here, the ultimate parent establishes a limited liability company as a wholly owned subsidiary. This wholly owned subsidiary then acts as the “top level” general partner entity for all current and future multi-LP funds. One may then establish a “second level” general partner entity (for example, a limited partnership) as a subsidiary of the “top level” entity which then acts the general partner attached to a specific fund. This two-tiered structure allows a single entity (i.e.; the “top level” entity) to manage multiple funds, notwithstanding each fund’s unique investment criteria or technology focus. This structure also allows the CVC’s ultimate parent to control all funds and simplifies future fund formation objectives.
Whichever structure the fund adopts, a limited partnership agreement must specify which decisions can be made solely by the general partner and which require a vote of limited partners. For funds in which the ultimate parent and its CVC want to exercise near total control, and where the limited partners are willing to accept a passive role, the partnership agreement should stipulate that most actions may be taken unilaterally.
In these instances, partner voting may be limited to material amendments to the agreement, resolution of conflicts, and actions affecting personal liability or indemnification obligations. Generally, any provision in a limited partnership agreement may be amended or waived pursuant to a majority or supermajority vote of limited partnership interests, so these thresholds should be carefully considered depending on the ultimate parent’s need for control.
Oversight
Similar to control, which is the authority to appoint the management of the multi-LP fund and to vote on material matters concerning the fund, the oversight function is the ability to monitor the fund’s management. Usually all limited partners, by virtue of their financial contributions to the fund, are afforded some degree of oversight. However, in the context of a CVC operated fund, this may not be the case.
The mothership of the CVC will often exercise oversight rights by appointing a management board or similar committee to make decisions on certain material, unusual, or structural matters. Much like a traditional board of directors, an oversight board may be empowered to decide on back-office issues such as the domicile of investment entities, carried-interest allocations, and large expense allocations. The manager of the general partner, and likely the CVC itself, will report to this oversight board.
The fund’s investment committee (IC) plays a significant role in the fund’s oversight as well. Most ICs are comprised of at least three people representing the CVC’s ultimate parent and potentially other significant investors in the fund. For those ICs that include representatives of outside investors, it may be prudent to limit their role to an observer-advisor status, thereby ensuring the outside investors remain passive. As the IC will decide whether and when the fund will pursue a proposed investment, it must be aligned with the CVC’s investment philosophy, including the ultimate parent’s criteria for ROI potential, time horizon, and desired strategic outcomes. To achieve this alignment, most CVCs will be best served by confining IC membership to individuals within its organization and to limit outside representatives on the IC.
Compliance
Most CVCs that form multi-LP funds in the U.S. will qualify for and rely on the “venture capital exemption” from registration as investment advisors with the Securities and Exchange Commission. As long as the CVC follows the SEC’s rules on leverage, redemptions, and qualifying investments, it can claim the exemption as an Exempt Reporting Advisor. If total assets under management are less than $25 million, then the CVC need only file at the state level. However, once assets exceed $25 million (for example, following capital calls where the fund’s cash balance reaches the $25 million threshold), a simple filing with the SEC will be required to take advantage of the venture capital exemption.
Periodic financial reporting is generally mandated by the fund’s partnership agreement. Typically, limited partners are entitled to audit rights and will receive from the fund both quarterly and annual audited financials. In most cases, the parent entity of the CVC will also require audited financials so it can fulfill its consolidated financial reporting obligations. For these reasons, it is highly recommended that the CVC engage an independent accounting and audit firm to meets its financial reporting requirements.
In addition to engaging an independent auditor, the CVC should consider hiring an outside administrator to undertake the fund’s accounting, capital calls, and tax reporting obligations. The administrator should be granted access to fund accounts in order to monitor expenditures and investments. A good administrator will also interact with compliance professionals and assist with any SEC reporting requirements and/or advise the fund of material changes to legal and regulatory requirements both in the U.S. and abroad.
Further, best practices dictate that CVCs establish an internal compliance committee comprised of individuals (ideally involved in their in-house legal and accounting functions) to engage directly with external advisors and to ensure the fund is meeting all legal and financial obligations to its limited partners, including its ultimate parent entity. The compliance committee will serve as conduit between the CVC, the mothership, and all external limited partners. This ensures consistency in messaging and allows for proper alignment of priorities among the key stakeholders in the fund.
Management Fees
All funds incur expenses in connection with their operations, so the partnership agreement must address how they will be discharged. It is best to address this issue early in the formation process (at the term sheet stage) and to have alignment at the onset.
Most traditional financial venture capital partnerships cover these expenses through the assessment of management fees. Assessing management fees is a viable option in the CVC community as well. However, many CVCs operate as divisions or business groups within their parent entity’s organization, so management fees may not be appropriate in the context of the mothership’s intercompany budget processes. If management fees are adopted (which are typically calculated as 2% of total pledged capital per year), the partners must still agree on how to assess them equitably. Should the fees be prorated according to the capital the general and limited partners contribute? Should the general partner also be expected to pay fees, given its contribution to the fund’s management and decision making? Should only external/non-affiliated partners be subject to the assessment of fees? While there is no “right answer” to these questions, it will be prudent to consider the issue of management fees early in the process and thereby avoid unneeded friction in the later stages of negotiations.
Conflict of Interest
Given the number of interests and opinions represented, multi-LP funds managed and operated by CVCs are inherently ripe for conflicts. If the parent entity owns more than a majority stake in the fund, it naturally can render most decisions given its voting control over the fund. It would be natural and easy for the ultimate parent to choose investments that match its growth and marketing position ambitions. Still, it behooves the parent entity as owner of the controlling interest to consider input not only from the CVC and/or management company, but also the fund’s minority partners, in deciding which investment opportunities are best suited to the fund’s mission.
Minority investors most likely will invest only in funds whose financial, commercial, or societal objectives coincide with their own at the highest level. But the devil is in the details, and there are bound to be occasions when the interests of the CVC’s parent entity fail to align with those of the minority limited partners.
The limited partnership agreement should be drafted to both anticipate and resolve potential conflicts of interest. A strong agreement will address many of the ethical and behavioral circumstances that could generate conflicts. Partnership agreements should expressly forbid certain transactions that are inherently ripe for conflicts, such as:
· Neither the general partner, the management company, management-level employees, nor any of their respective related personal accounts may invest for their own benefit in the securities of any portfolio investment;
· The partnership shall not buy any securities from or sell any securities to the general partner, the management company, any ultimate parent, or management-level employees; and
· The general partner shall not direct or permit the partnership to invest in a portfolio company in which an existing fund, successor fund, the ultimate parent, or any affiliate thereof already holds an investment.
While each of these prohibitions may be subject to exceptions and exclusions, the important takeaway is that these issues be addressed in the early stages of the fund’s formation to ensure any risk of impropriety is addressed from the onset.
It should be noted that not all conflicts are foreseeable; therefore, the partnership agreement must include a mechanism for resolving disagreements as they arise. Notwithstanding its majority stakeholder status, the CVC’s parent should not be vested with the power to resolve disputes independently. Instead, the agreement should grant holders of minority limited partner interests a voice in conflict settlement discussions. In some cases, this may include the establishment of an advisory committee of limited partners. This advisory committee would convene on an ad hoc basis to review disagreements, with each member casting an equal vote as to whether a conflict of interest exists and whether to waive the conflict. Only after the advisory committee adjudicates the conflict and authorizes an action will the fund be allowed to move forward with the intended action or investment. Despite the exercise of this power, advisory committee members under most fund structures are not considered to be active participants in the fund’s management. This is important in instances where outside investors are represented on the advisory committee, but the fund’s desire is to maintain such investors as “passive”. This comes into play in those instances where possessing “control rights” (i.e.; non-passive management rights) may trigger undesired scrutiny from regulatory bodies, including the Committee on Foreign Investment in the United States.
Carried Interest
As every venture capitalist knows, carried interest programs are a key element in the fund formation process. Carry is a cornerstone of all traditional venture capital models, rewarding general partners for the long hours and hard work they devote to their funds’ success. A sufficiently generous carried interest reward provides the incentive to attract and retain the best industry talent.
Still, many CVCs face challenges (be it political or structural) in implementing carried interest plans. Traditional carry programs — which require equity allocations from the general partner entity — may not be permissible for CVCs under their parent’s compensation initiatives. In these cases, CVCs may need to settle for substitute compensation arrangements such as phantom equity plans, bonus plans, and “synthetic” carried interest plans. While less tax efficient than traditional carried interest programs, these compensation arrangements may allow the CVC and its parent to maintain discretion over key compensation elements, including which employees may participate, award amounts, and vesting terms. Any such plan will augment the traditional compensation schemes CVCs can offer.
Conclusion
Clearly distinct from traditional venture firms given the ultimate parent’s influence and priorities, CVCs accept the corresponding challenges related to finding synergies and meeting commercial objectives. These additional hurdles, however, should not deter innovative organizations from pursuing multi-LP funds through their CVCs. Multiple stakeholders, including those unaffiliated with the ultimate parent, contribute diverse perspectives, form a comprehensive network of problem solvers, exert greater market influence, and deliver a wealth of benefits to the fund and the portfolio companies. With proper oversight, control mechanisms, compliance initiatives, and conflict resolution capabilities, a multi-LP fund structure can truly accelerate successful venturing.
Happy investing!
