#27 Episode - Essential Checklists for VC Fund Formation

Key Takeaways: Today’s article is a set of fund formation checklists:

1. Fund Structure ?? Forming the Fund
2. Fund Mechanics ?? Closing the Fund
3. Regulatory Compliance ?? Post-Closing Obligations

This article provides a basic understanding of the key decisions and material terms for forming and closing a venture capital fund.

Fund Formation Checklist

Part I: Fund Structure ?? Forming the Fund

Under the traditional US fund model, a venture capital fund is formed as a limited partnership by the venture capitalists (VCs) who manage it. To shield themselves from personal liability, the VCs form a limited liability company as the General Partner. Separately, a Management Company is formed for tax and liability purposes.

So, to structure a traditional VC fund, three entities are typically formed:

1. The General Partner (LLC)
2. The Management Company
3. The Venture Fund

The Three Key Entities

1.The General Partner

• Entity Type: LLC
• Taxed as: Partnership, Carry is a profits interest
• Entity Naming Convention: [Fund Name] + [Fund Number] + GP[,] + LLC

—Example 1: Adventure Capital I GP LLC

—Example 2: Adventure Capital II GP, LLC

• Jurisdiction: Delaware
• Legal Forms: Certificate of Formation, LLC Agreement (Operating Agreement)
• Rights: Capital Interests, Carried Interests, Voting Interests

2. The Management Company

• Entity Type: LLC
• Taxed as: Partnership or S-corporation
• Entity Naming Convention: [Fund Name] + Management + [Company][,] + LLC

—Example 1: Adventure Capital Management LLC

—Example 2: Adventure Capital Management Company, LLC

• Jurisdiction: Delaware
• Legal Forms: Certificate of Formation, LLC Agreement (Operating Agreement), Management Agreement with GP
• Purpose: The Management Company is often utilized for multiple vintages —Fund I, Fund II, etc. often have the same MC.

3. The Venture Fund

• Entity Type: Limited partnership, LLC or Series
• Taxed As: Partnership
• Entity Naming Convention: [Fund Name] + [Fund] + [Fund Number] + [Parallel Fund][,] [L.P.]

—Example 1: Adventure Capital Fund I L.P.

—Example 2: Adventure Capital I-A, LP

The Structure (Diagram)

Part II: Fund Mechanics ?? Closing the Fund

The next step after formation is to proceed with an eye towards closing investors.

Most fund managers kick off this process by sending potential LPs a non-binding term sheet, pitch deck, LP due diligence and fund subscription materials.

• Download LPA Term Sheet (2023)

In Law of VC #24, we went over the key terms of a venture capital fund, but in brief, here is a good place to start your review process:

Most Important Key Terms

• Fund Size: Targeted, Minimum, Cap
• LP Commitments: Minimum Subscription, Maximum Subscription, GP Commit (%)
• Fund Term: Date of Target First Close, Investment Period, Follow-on Period, Term Extensions
• Investment Thesis: Stage, Geographic Focus, Industry / Verticals
• Fund Economics: Management Fees (%), Frontloaded, Step Down; Carried Interest (%), Hurdle (%) Carry Catch-up (%)

An important task in preparing for closing is preparing your due diligence to share with LPs.

• Due Diligence Questionnaire—see e.g., ILPA DDQ v2.0 (2021)-PDF
• Pitch Deck
• Term Sheet
• Limited Partnership Agreement (LPA)
• Subscription Agreement and Investor Questionnaire
• Due Diligence Folders

Fund Economics:

• LPs make a capital commitment to the venture fund upfront, but contribute capital over time, expecting a multiple return on their capital contributions (3x+) with 100% money returned first and then 80% of profits split thereafter;
• A percentage of profits is allocated to the GP in the form of 20% carried interest; and,
• Additionally, management fees are paid to the Management Company at a rate of 2.5% of each LP’s capital commitment for each year that the fund operates.

Part III: Compliance ?? Post-Closing Obligations

The 3 Laws That Support 80%+ of Venture Fund Law

It took me over a decade of practicing law to finally realize that venture capital fund law is primarily supported by only three laws:

1. The Securities Act (LPs): Regulation D offers a safe harbor for fund managers to raise a fund without registering with Securities & Exchange Commission (SEC).

• Rule 506(b) (private placements) and Rule 506(c) (general solicitation offerings) allow venture capital funds to raise an unlimited amount of capital.
• While Rule 506(b) remains the leading framework for private capital funds because it loosens LP verification rules, Rule 506(c) permits public advertising with a requirement to take reasonable steps to verify investor accreditation.

2. Investment Company Act (Funds): A fund must register with the SEC as an “investment company” unless an exemption exists under the Investment Company Act of 1940. The two exemptions available for VC funds are:

• Section 3(c)(1) exemption—100 “beneficial owner” LP limit, which increases to 250 for venture capital funds with $10 million or less in fund size.
• Section 3(c)(7) exemption—Only for “qualified purchasers”. A 3(c)(1) fund can be formed together with a 3(c)(7) fund to raise the beneficial owner count from 100/250 LPs to an additional 1,999 LPs, provided that all LPs in the larger fund are qualified purchasers. This is called a parallel fund structure.

3. Advisers Act (GPs): Exempt reporting advisers (ERAs) can avoid the regulatory requirements associated with being a registered investment adviser (RIA), which is costly and time-consuming. To qualify as an ERA, you must meet either the venture capital adviser exemption or the private fund adviser exemption:

• Venture capital adviser exemption—§203(l): Advise “venture capital funds”.
• Private fund adviser exemption—§203(m): Advise non-VC “private funds” (crypto, secondaries, etc.) with <$150 million in assets under management.

Other Post-Closing Matters

LP Subscription Packet

• Limited Partnership Agreement (LPA)
• Subscription Agreement and Investor Questionnaire
• Privacy Policy
• Side Letter (Optional)

Government Compliance and Securities Disclosures

• Form ID + Form D
• Blue Sky Notices (NASAA)
• Form ADV
• KYC/AML/PATRIOT Act compliance
• ERISA Status
• CFIUS

Securities Exchange Act of 1934

• §12(g)(1) registration requirements (public registration > 2K investors)
• Broker/Dealer exemption under Rule 3a4-1
• No bad boy disqualifications (fraud, crime, NASD/CRD, etc.)
• GPs cannot receive transaction-based compensation, directly/indirectly—In other words, fees and carry cannot be issued based on the LP capital raised or deployed into portfolio companies
• Recipient must not be an “associated person” of broker-dealer
• Recipient performs “substantial” and “primary” duties on behalf of the fund
• Does not participate in any offering more than once every 12 mos.

Regulation S

• Regulation S provides a safe harbor to VC funds and third party placement agents. An offer must be an “offshore transaction” which does not involve any “direct selling efforts” in the US.

California (or jurisdiction of fund managers’ residency)

• Foreign State LLC Registration
• Certificate of Good Standing (Status)
• Statements of Information
• Certificate of Registration for Out-of-State Limited Partnership
• CA, NY or state of domicile of Fund Managers
• Note: In California, an unregistered foreign LP is subject to a penalty of $20 for each day it transacts intrastate business in California without registration, up to a maximum of $10,000. (Cal. Corp. Code § 15909.07)

Auxiliary Documents

• Management Agreement
• To allocate management fees from GP if not in the Fund LPA
• Clarify the Management Company is the Investment Adviser
• Compliance Manual for ERA
• Managing Directors and employees commit to conflicts of interest policies such as no insider trading policy, pay-for-play rules, etc.
• ERAs still subject to and must comply with certain provisions of the Advisers Act, the Exchange Act, and general anti-fraud regulations.
• Amendments/Adjustments to Subscription Agreement
• Assignment and Assumption Agreement
• Cancellation and Release Agreement

Employee and Venture Partner Agreements

• Advisor Agreements
• Non-Disclosure Agreements
• Carried Interest Award Agreements

Bonus: The Overall Checklist

• 23-point fund launch checklist?

Doug Dyer—TheFundCFO. Legal is only one part of the overall fund formation process.

Disclaimer: This article is intended to provide VCs with an overview of the key aspects of forming a venture capital fund. However, it is not intended to be an exhaustive resource, and other factors may apply to your specific situation. You are strongly encouraged to seek guidance from experienced fund counsel to ensure compliance with the issues discussed above.

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Chris Harvey