Structuring M&A Funds

As an investor, your business purchases increase in size and volume as you evolve.  With the growth, you need more funding for down payments and working capital.  You might have exhausted all available debt financing, however.  At this point, you need equity financing.

You have two fundamental options in getting equity financing: (1) you can find equity partners; or (2) you can bring in passive investors.  I am sure you are familiar with the difficulties and pain of working with partners – that is the subject of another presentation that I give.  Our topic today is the second option – working with passive investors.  Instead of partnering to bring in capital, you find passive investors.  They bring the money, you run the business. 

I will try to give you a bird’s eye view of some of the bigger issues in structuring an M&A fund for passive investors.  I will address two basic parts of organizing a fund: first, structuring the fund itself, and second, complying with securities laws when bringing in investors.

M&A funds are very complex.  This is not something to learn as you go.  Organizing a fund is a big step up in complexity.  You’ll need the help of accounting, tax and legal counsel who are experienced in the area.  In particular, securities law compliance is not a game for the uninitiated.

One last word to the wise: With a fund, you are responsible for other people’s money.  That’s a heavy burden.  The burden is heavier if your investors are friends and family, which usually is the case with new fund managers.  Many would-be fund managers give up after their first fund because of the added responsibility and stress.  In any case, without further ado, let me discuss structuring the fund and complying with securities laws when bringing in investors.

1. Structuring the Fund.  There are countless legal issues involved in structuring your fund.  All of the issues are potentially crucial.  That said, I will introduce three issues that are always important: the term of the fund (put otherwise, your deadline for returning your investors’ money); keeping control over your fund; and getting paid for managing the fund.

1.1. Term of the Fund; Mandatory Return of Capital.  Here is the dilemma.  On the one hand, your fund is not a mutual fund and you lack the liquidity to return an investor’s capital at will.  Nearly all of your investors’ capital will be tied up in portfolio companies.  This means you must liquidate a company to return an investor’s money – this may be impossible or disastrous.  On the other hand, investors need an exit.  Investors won’t trust you with their money for an indefinite term.

Solution: To solve this dilemma, you must understand the timeline for your portfolio companies.  If your fund has one portfolio company or a few companies with the same timeline, you can write into your fund charter an exit for the investors based on the common timeline.  For example, you might provide that the fund will exit its portfolio companies and wind down by some date certain, e.g. five years after formation.  Or you might have a long timeline for high cash-flow companies.  The key is that you, the manager, must do the timeline analysis, and must give a reasonable exit plan to the investors.

Note: My fund charters contain provisions that let the managers extend the term for a reasonable time to effect an orderly sale of portfolio companies.  I also permit the investors to change their mind if a portfolio company has special circumstances.

1.2. Control.  Control is one of the primary considerations for choosing a fund structure.  Anyone who has worked with partners knows the limitation of a partnership structure.  It is very hard to run a business by consensus.  

Hence you choose a fund structure: your investors are passive and they lack operational control.  You, the manager, control the fund.  The investors retain overall control only through their ability to replace the managers, and perhaps through certain specified veto rights. 

A veto right is a right held by the investors to block certain specified actions, for example, amendments to the charter documents; affiliate transactions; dissolution; etc.  The investors as a group exercise a veto right by the votes of a certain percentage of ownership (for example, 51% or 75% of the membership interests).

1.3. Manager Compensation.  Manager compensation is where the negotiation gets difficult.  I have seen many variations on how managers are compensated, but as a general matter, managers usually receive a combination of management fees + “carry” + reimbursement of expenses.

1.3.1.  Management Fees.  For small funds, I frequently set management fees at some annualized percentage of the portfolio companies’ net income or cash flow.  The percentage amount can be based on the annual cost of hiring a third party professional to perform the manager’s functions.  The fund pays fees monthly or quarterly.

1.3.2.  Carry.  A carry is essentially the managers’ share in fund profits.  A carry kicks in when the fund distributes money to investors.  A common formulation is for the fund to distribute all money to the investors until they have received 100% of their contributions plus a 10% preferred return.  After that, the investors and the managers divide all excess profits based on some agreed split, for example, investors 70 / managers 30.

1.3.3.  Expenses.  Sophisticated investors are wary of how the fund pays expenses.  The issue is the allocation of fund expenses either: (i) to the fund (that is, to be paid by the investors out of their profits), or (ii) to the managers (that is, to be paid by the managers out of their fees).  This issue frequently stays hidden, but it is very important. 
 

2. Securities Laws.  When your fund offers or sells ownership interests to investors, the fund is conducting a securities offering.  A securities offering is a highly regulated and complex undertaking.  For every offering, the fund must comply with federal securities laws and the laws of each state where an investor resides.  This can add up to a lot of law.  Further, you cannot opt out of these laws – securities laws will apply to your fund whether you want them to or not.  Pretending the laws don’t exist won’t save you.

2.1. Exemptions.  When complying with securities laws, small funds usually work within various exemptions, for example, state and federal private placement exemptions.  Most of the law applicable to your fund’s offering is in the relevant private placement exemptions. Exemptions are the key to any private offering of securities, but they are too complex and intricate for me to discuss at any length here.  I will only introduce some topics that in my practice I have found to be troublesome for organizers of funds.

2.2. Manner of the Offering.  You may not sell interests in your fund to just any person by any means.  When selling interests in your fund, you may not advertise or otherwise solicit the general public.  This applies to the fund and anyone acting on its behalf (usually managers and brokers).  Hence you may not use any advertisement, article, notice or other communication in any newspaper, TV or similar media.  You may not use seminars whose attendees have been invited by any general solicitation or advertising.  In brief, you may only sell to investors with whom you have a pre-existing, substantive relationship.

2.3. Brokers.  Not only must you sell interests in the fund in the manner described above, you also must be very careful about the people who help you sell the interests in your fund.  Extensive broker regulations apply to you and all other people who sell interests in your fund.  In brief, no one involved in the offering may be regularly engaged in selling securities unless that person is licensed as a securities broker.  Many professionals in the field forget about broker regulations (instead they concentrate exclusively on the exemptions).  This can be a fatal mistake if the investors bring litigation.

2.4. Liability.  Securities violations usually come in two flavors: a technical defect in compliance with your applicable exemption, and/or securities fraud.  Securities fraud occurs when you misstate some material fact or fail to disclose some material fact.

As a final matter, I will quickly summarize the consequences of violating your applicable securities laws.  In brief, purchasers of securities may bring an action against the fund and even you personally.  Generally, investors seek the return of the money they invested.  A technical defect in your exemption compliance can be the most frustrating for you, because an investor can leverage it into forcing you to return the investor’s money – you become an unwilling guarantor of the investment. 

Lastly, if you remember nothing else, remember this: securities laws favor the investors, not you, and you can become personally liable for your fund’s violation of securities laws.

Call me to schedule a legal consultation: 510-796-9144