This article describes the next stage of development of a corporate venturing business, being its transformation into a fully fledged venture capital funds management business. This is shown in the diagram [click here].
1. The Investment Manager
As shown in the diagram, the corporate venturing business is now carried on by a separate legal entity (in this case called the "Manager") which is usually a wholly owned subsidiary of Corporate and may take the form of a company or limited liability partnership (or limited liability corporation in the US). The investment team typically no longer works directly for Corporate but are often members/employees of the Manager which, although a wholly owned subsidiary of Corporate, now operates as a separate business with a larger degree of independence.
For tax purposes and for employee motivation reasons, part of the Manager can be in time transferred to the management team. After all, Manager investment is what is encouraged at the portfolio company level. Becoming members of the Manager LLP or LLC can also be tax advantageous for the team members.
The Manager is authorised by the relevant regulator (the Financial Services Authority in the UK) so that it can carry on the regulated activities of operating and managing funds and associated activities such as arranging and advising on investments. This regulation typically involves satisfying a range of requirements related to the identity and experience of the people carrying on that business, compliance procedures and regulatory capital. Obtaining such authorisation is necessary in order to operate a "fund" as opposed to entering into a series of independent investments. It also provides additional flexibility in promoting investment opportunities to external investors and arranging for them to participate in investments. The obligations related to regulatory authorisation are usually the trigger for forming a separate legal entity which employs relevant staff, as this facilitates compliance and prevents the compliance obligations from extending into the whole of Corporate’s business.
2. Funds
In addition, a separate "fund" has been established for the purpose of allowing the Corporate and the external investors to make investments. A limited partnership is typically used as a vehicle for venture capital investments as it is tax transparent, flexible, provides limited liability and is suitable for a range of investors. The participants in a limited partnership consist of limited and general partners. The investors are limited partners and their liability is, broadly, limited to the amount they contribute to the fund (i.e. in the event that the fund is insolvent they are not required to make any further contribution to it beyond the amount of their commitment). Typically, limited partners are, however, prohibited from taking part in the management of the limited partnership. Each partnership must also have a general partner. The general partner, unlike the limited partners, has unlimited liability for the debts and obligations of the limited partnership. For this reason, the general partner is typically a company that is specially formed to be the general partner of each partnership and has minimal assets.
The fund may be set up as a limited partnership either on-shore (e.g. as an English limited partnership in the UK) or as an off-shore limited partnership (e.g. in Guernsey or the Cayman Islands). Both options typically provide a tax effective vehicle that is suitable for venture capital investments. The choice can be driven by the preference of investors or tax structuring as off-shore vehicles can, for example, provide savings in relation to VAT.
3. Investors
Each Investor (including the Corporate) would make a Commitment to the fund. That Commitment would not all be paid to the fund immediately but would be drawn down over a period of time in order to make investments and pay the fund’s expenses. The Manager would be responsible for sourcing and conducting due diligence on investments and making the final decision as to whether to make an investment. This is in contrast to the last article in this series where the Corporate and external investors each make their own decision on whether to invest in each portfolio company. That said, the Corporate and Investors can be permitted to co-invest directly to Portfolio Companies. Also the Corporate might already be a shareholder in a Portfolio Company, if it had spun out of the Corporate.
4. Investments
Each fund will be permitted to make investments for a period of time (typically 4-5 years). After that time a new fund in which Corporate and external investors will participate is formed. Over a period of time the proportion of each fund which Corporate represents is likely to decline (typically from an initial proportion of 50% to something in the region of 20%).
5. Manager economics
As investors are committing to a formal fund structure, this is also the stage where the Manager (and, therefore, Corporate) begins to generate revenue not just from its own investments in portfolio companies but also from investments made by the external investors. This revenue is typically in the form of a management fee charged on the amounts invested by external investors together with a share of the profits which are generated by their investments (called "carried interest") which is typically equal to 20% of the Fund’s profits subject to investors first receiving a preferred return. 50% of the carried interest could be paid to Corporate if the fund manager is mostly "captive", with the balance being split between the members of the investment team who are employees/members of Manager.
6. Captive Manager?
The final step in this process is where the fund management business carried on by Manager is spun off as an independent business or sold. The fact that relevant staff are now principals of / employed by the Manager would facilitate this process.
Conclusion
This concludes our corporate venturing journey from start up to a fully fledged funds management business.
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Key FSA Regulatory Requirements
Any person who carries on a regulated activity in the UK must be authorised by the FSA or exempt (an appointed representative or some other exemption).
As an authorised firm you will be supervised by the FSA. Certain persons within your organisation will have to become an approved person if they carry out certain "Controlled Functions" and will have to undertake training and competency assessments.
As an FSA regulated entity, it will be obliged to do some of the following:
- pay annual fees to the FSA;
- meet reporting requirements;
- comply with financial promotion restrictions;
- appoint a compliance officer; and
- maintain a minimum capital prescribed by the FSA.
As part of the authorisation process, you will be required to provide the FSA with a variety of supporting documents, including a business plan, compliance procedures, monthly profit and loss forecasts etc.
Key Fund Terms
- Term – usually 10 years, subject to an additional two 1 year extensions
- Investment Period – usually 5 years, subject to one additional extension
- General Partner Share (or management fee) – typically between 1.5% and 2.5% depending on the size of the fund
- Carried Interest – typically 20% above money back plus a preferred return to investors
- Clawback – if the fund is wound up the founder partner (the recipient of the carried interest) may have to repay any amount received, if it exceeds an amount which it would have been entitled to receive if all distributions had been made on an aggregate basis
- Key Person – provisions setting out what happens in the event that any one or more named key persons leave the fund -typically a suspension of the investment period until a replacement is found.
MJ Hudson LLP, The Alternative Asset Law Firm
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