How to Form an Angel or Venture Fund: Legal, Business and Tax Strategies

© 2017 Haynes and Boone, LLP
How to Form an Angel or Venture
Fund: Legal, Business and Tax
Strategies
Idea to IPO

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Disclaimer: These presentation slides provide a high-level
overview of the legal issues that founders of startups will
encounter and shall not be considered as providing legal
advice, opinions, or recommendations. For any legal issues in
a specific area please consult with an attorney specialized in
such area.
Disclaimer

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ROGER ROYSE
PARTNER – INVESTMENT FUNDS PRACTICE GROUP
Roger.Royse@haynesboone.com
T +1 650.687.8820
F +1 650.687.8702
525 University Avenue
Suite 400
Palo Alto, California 94301
Roger Royse is a partner in the Palo Alto
office of Haynes and Boone, LLP and
practices in the areas of corporate and
securities law, domestic and international tax,
mergers and acquisitions, and fund formation.
He works with companies ranging from newly
formed tech startups to publicly traded
multinationals in a variety of industries.
Roger is a Fellow of the American College of
Tax Counsel and former chair of several
committees of the American Bar Association
Sections of Business Law and Taxation.
Roger has been an instructor or professor of
legal, tax and business topics for the Center
for International Studies (Salzburg, Austria),
Golden Gate University School of Law and
Stanford Continuing Studies.
Roger is a nationally recognized authority on
Agtech – the technology of food production -
and the legal considerations for companies in
this industry. Roger is also the author of Dead
on Arrival: How to Avoid the Legal Mistakes
That Could Kill Your Startup and has been
interviewed and quoted in the Wall Street
Journal, Forbes, Fox Business, Chicago
Tribune, Associated Press, Tax Notes, Inc.
Magazine, Nikkei Asian Review, China Daily,
San Francisco Chronicle, Reuters, The
Recorder, 7X7, Business Insurance and Fast
Company.
Roger is also a Certified Public Accountant
(California non-Attest).
Professional Recognition
Recognized as a Northern California - Super
Lawyer 2011-2019 Martindale Hubbell® Law
Directory with a Peer Review Rating of AV®
PRACTICES AND INDUSTRIES
• Emerging Companies and
Venture Capital
• Corporate
• Mergers and Acquisitions
• Capital Markets and Securities
• Fund Formation and Management
• Tax
• Corporate Tax
• International Tax
• International
• Investment Management
• FinTech Virtual Currency and
Blockchain
EDUCATION
• LL.M., Taxation, New York
University School of Law
• J.D., University of North Dakota
• B.S., Accounting, University of
North Dakota
ADMISSIONS
• California
• New York
• Minnesota
• South Dakota
• North Dakota

PwC Money Tree
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Record Amounts of VC Funds
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Venture Capital AUM
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First Time Funds down
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European Early-stage funding is up
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VC Returns
 Avg IRR (Internal Rate of Return) from 1981 - 2014:
 Top Quartile of VC Funds: 24.89%
 Median of All VC Funds: 11.94%
 S&P 500: 12.66%
 Source: Cambridge Associates
 The top 2% of funds generated 95% of the returns across 1,000 funds.
(Wealthfront)
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Structure
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LPs
Investments
GP
Fund
(Delaware LP/LLC)
General
Partner
(Delaware LLC)
Sponsor Sponsor
LP
U.S. Taxable
Investors
LPs
Offshore Feeder
Companies
(“Blockers”)
Non-U.S. and Tax-
Exempt Investors
Carried Interest
GP
Management
Company
Management Fee

Accelerator Fund model
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Portfolio Companies
Fund LP
(Delaware Limited
Partnership)
US
Investors
General
Partner
(Delaware
LLC)
Service
Income
Mngt fee
Carried
interest
Managers
Blocker Corp
$$
Equity
Foreign
investors
Accelerator Inc.
Or LLC

Types of Startup Funds
 What is Venture Capital?
 Micro VC – angels with other people’s money
 Seed Stage Fund – early, first institutional money
 Mid Stage – B and beyond
 Late Stage
 Special Purpose Vehicles (SPVs)
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Types of VCs
 Thematic Investors bet on their thesis of what is next
 Domain Investors focus on an industry that they know well
 Quant Investors focus on data
 People Investors bet on the jockey, not the horse
 Tech investors bet on the horse
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Accelerators, Incubators and Venture Studios
 Incubators help entrepreneurs develop business ideas.
 Accelerators provides training and guidance and seed funding to existing
companies in exchange for equity. The program to validate the business.
 CoWork and programs may provide some infrastructure and facilities.
 Venture studio creates startups by providing the team, strategy and capital.
 Unlike VCs, venture studios are closely involved in the day-to-day operations and
strategic decisions of growing the new business.
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The General Partner
 Separate Entity – usually a passthrough with limited liability to sponsors (LLC)
 Receives a portion of gains (carried interest) and management fees
 Management fee is sometimes carved out into affiliated advisor company,
i.e. the “investment adviser”
1. GP entity can divide up GP economics in a tax efficient manner
2. Separates division of sponsors and advisors agreement from the Fund
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The Fund and Fund Investors
 Limited Partnership or limited liability company (LLC)
 Most funds are LPs for legacy reasons
 Term of Fund and Investment Period
 Example - deploy over 5 years and return over 10 years – 7 plus one year
extensions
 Target Fund Size
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Fund Investors
 Venture is a subclass of private equity
 Public equity, bonds, alternative assets (private equity, venture, hedge funds, real
estate) and cash
 Types of Investors
 Pension funds
 Endowments and foundations
 Sovereign wealth funds
 Finance and insurance companies
 Family offices and HNIs
 Corporate funds
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Investment Strategy
 What will you invest in?
 Why are you best suited for this strategy?
 Why now?
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Fund Investor Due Diligence
 Management team
 Experience, expertise
 Strategy
 Sourcing, stage, sector, size
 Structure
 Fees, carry, governance
 Track Record
 Previous funds, co-investors
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Some Fund Metrics
 Size
 Including reserves
 Stage
 Early, seed, late
 Sector
 Industry, market
 Number of portfolio companies
 Geography
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Performance Metrics
 Internal Rate of Return (IRR) = annual effective compound
rate of return.
 Cash on Cash = the amount of money received divided by
the investment amount.
 Multiple on invested capital (MOIC) = investment return
metric that compares an investment's current value to the
amount invested.
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Size of Fund and Returns
Gains Required over 10 Years to Generate
Fund Size 15% IRR 20% IRR 30% IRR
$50M $38.4M $62.3M $123.5M
$100M $76.9M $124.6M $247M
$400M $307.6M $498.4M $968M
Source: Ramsinghani, The Business of Venture Capital
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Fund Economics
 Carried Interest – 20% of gains
 Management Fees – usually 2% to 2.5%
 Based on committed capital
 From date of initial closing
 Fees stop at end of fund term or liquidation
 May reduce by rate, base or both
 Example reduce to 1% of capital after 5 years
 Or reduce to 2% of remaining capital
 Who has the economic burden of management fees?
 Is it specially allocated against the LPs capital accounts?
 Fee-less funds
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Carried Interest
 1. Percentage
 Sometimes tiered so that rate increases after a certain IRR
 Catch up allocations
 2. How is it calculated?
 Applied against total fund gains or gains net of expenses?
 3. When does GP get carry?
 European waterfall - Return contributed capital prior to taking carry
 American waterfall – deal by deal distribution
 4. Clawback
 If deal by deal, could be early winners and late losers
 GP must return overpayments of carry
 Usually backed by sponsors of GP
 Not often collected
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Distribution Waterfalls
 American versus European Style
 Catchup Allocations
 100% to LP until capital returned, then 100% to GP until GP has 20% of all
distributions, then 20/80; or
 100% to LP until capital returned, then 20/80
 Deal by Deal and Clawbacks
 Clawbacks avoided by use of SPVs instead
 Hurdle Rates
 Most funds have a hurdle rate of a 7 – 8% priority internal annual rate of return to
LPs
 Not common in small funds
 Tax Distributions
 Income allocations may not match distributions
 Allows GP to make distributions to pay taxes
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Capital Accounts
 Partner GP LP
 Starting Capital Account $0 $100
 Year 1 income and distribution of $25
 Alternative 1 – allocate to LP
 Income allocation $0 $25
 Distribution $0 (25)
 Ending Capital account $0 $100
 LP has $25 of income but did not get a return of its $100
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Capital Accounts – Alternative 3
 Partner GP LP
 Year 1 income and distribution of $25
 Alternative 2 – allocate $25 to GP
 Income allocation $25 $0
 Distribution $0 (50)
 Ending Capital account $0 $50
 LP has $0 of income and a return of its $100 BUT
 GP has $25 of income and has gotten nothing
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Capital Accounts – Tax Distribution Clause
 LP has $0 of income and a return of its $100 BUT
 GP has $25 of income and has gotten nothing
 GP may distribute some percent of $25 to GP to cover its taxes
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Capital Accounts – Management Fee example
 Partner GP LP
 Total management fees (2% of $100 times 10) = $20
 Total proceeds: $200
 Gains ($200 - $100) $100
 Alternative 1 – fee charged to LP and carry based on $100 = $20 (20% of
$100)
 Alternative 2 – fee split and carry based on $100 - $20 fees ($80) = $16 (20%
of $80)
 Liquidation in accordance with capital accounts
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Capital Contributions
 Capital Commitments, Capital Calls and Defaults
 Capital is drawn down as needed (affects ROI)
 GP may be expected to contribute 1% or more
 Defaults – reduction of capital account, treated as recourse obligation, loss of
voting rights, removal
 Final Closing
 Bookups or interest charges
 Additional Partners
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Distributions
 In cash or in kind
 As soon as liquid
 Must be valued by committee if in kind
 Reinvest or recycling capital
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Reports
 Interim financials
 Audited Annual financials
 Tax information
 Website reporting
 Need for back office support
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Other Terms
 Investment or Advisory Committee
 LP representation
 Values investments
 Removal and replacement of GP
 For cause or key person event
 Supermajority no cause removal
 Organizational Expenses
 Hurdle rates
 Bookups or interest charges
 Fund Size, term, minimum GP commitment
 Tax allocations
 Co-Investments, Parallel Funds, Blockers and SPVs
 Side letters
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The PPM
 Does a fund need a PPM?
 Marketing and Disclosure Purposes
 Team – Key Persons
 Investment Strategy
 Market and Industry Information
 Track Records
 Financials
 Risk Factors
 Tax Considerations
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Securities Law Issues
 Investment Act of 1933
 506(b) exemption
 506(c) exemption
 4(2)(a) exemption
 State Blue Sky Laws
 Investment Advisors Act of 1940
 venture capital exemption
 private fund exceptions
 Investment Company Act of 1940
 Section 3(c)(1) exception
 Section 3(c)(7) exception
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Regulatory Matters
 Broker Dealers and Finders
 Form ADV, Part 1
 ERISA
 Regulation of Crypto funds
 Bank Holding Act
 Tokenized Funds
 Exchange Traded Funds
 Advertising and Solicitation
 SEC Enforcement Actions against investment advisers
 State regulatory actions
 Other regulatory: e.g. FTC
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Placement Agents
 77% of funds have used placement agents (Preqin surveys)
 Broker dealer registration
 Mangement fee offset
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Tax Matters
 Capital Gains Treatment to LPs
 Taxation of Foreign and Tax Exempt LPs
 Special Holding Period for GP
 Management fee (and carry) waivers
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IRC 1061
 Partners, including GPs, entitled to capital gains tax treatment on Fund gains
from sales of portfolio companies
 20% plus 3.8% NIIT plus state taxes
 Sec 1061 - 3 year holding period for capital gains treatment for GPs
 GPs will split interest between applicable partnership interest and capital
interest
 Waivers of 1061 gains
 Recent pro taxpayer regulations
 Biden position on capital gains
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Management Fee Waivers
 Management Fee taxed at ordinary rates (37% FIT)
 Carry taxed at 20% (plus 3.8%)
 Strategy to waive fees and substitute more carry
 IRS is hostile to the strategy
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Tax Exempt Partners - ERISA
 Insignificant participation exception
 Funds can be exempt if they limit ERISA benefit plans to holding less than 25% of
the value of any class of equity interest in the fund.
 Venture Capital Operating Company Exception (VCOC)
 Fund has at least 50 per cent of its assets invested in operating companies that
provide it with management rights
 Must also exercise those rights during each 12 month period after the date of its
first investment
 Management Rights Letters
 Management rights can include rights to appoint directors or officers to an
operating company’s board, the right to examine its records, and other rights.
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AML/KYC
 Anti Money Laundering/Know Your Customer
 Bank Secrecy Act (BSA) creates basic framework for federal AML laws.
 Financial institutions must maintain records and reports on suspected money
laundering transactions.
 The Patriot Act passed (after September 11, 2001). Financial institutions must
establish programs to identify and verify customers and develop and
implement AML programs
 Financial Crimes Enforcement Network (FinCEN)
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Privacy
 California Consumer Privacy Act
 GDPR
 Gramm-Leach-Bliley
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Foreign managers
 Non resident Aliens
 No tax on carry
 Taxed on management fee based on source
 Foreign Funds have FATCA issues
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Foreign LPs
 Withholding taxes
 Reporting
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Foreign Funds
 Passive Foreign Investment Company (PFIC)
 PFIC if either 50% or more of the foreign corporation’s assets are passive or 75%
or more income is passive
 Interest charge
 Qualified Electing Fund election
 CFC, Subpart F, GILTI taxes
 Controlled foreign corporations
 Subpart F – foreign personal holding company income
 FATCA reporting
 Foreign Account Tax Compliance Act (FATCA) requires foreign entities to disclose
information that relates to US persons.
 30 percent withholding tax on US source investment income held by the foreign
entity unless it is FATCA compliant
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CFIUS Issues
 CFIUS – The Committee on Foreign Investment in the United States
 an interagency committee to review certain transactions involving
(1) foreign investment in the United States and
(2) certain real estate transactions by foreign persons,
in order to determine the effect of such transactions on the national security
of the United States.
 CFIUS operates pursuant to Section 721 of the Defense Production Act of
1950.
 The Foreign Investment Risk Review Modernization Act 2018 (FIRRMA) was
signed into law on August 13, 2018.
 FIRRMA Regulations (2018 – 2020)
 Final Rule on Mandatory Declarations for Certain Foreign Investment
Transactions Involving Critical Technologies (September 2020)
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CFIUS and FIRRMA
 Federal, interagencycommittee reviews foreign investments into U.S. businesses
 Acquisitions of “controlling” stakes inU.S. businesses
 Board or observer seat
 Access to “material nonpublictechnical information”
 Other influenceover substantive decision making
 May review andunwind transactions post-closing
 Foreign InvestmentRisk Review Modernization Act of 2018
 Thefundmust becontrolled and managed exclusively by a U.S. general partner or fundmanager.
a U.S. general partneror fund manager.
 Thefundmust not beindirectly controlled by anyforeign person, entity orgovernment.
foreign person, entityor government.
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Small Business Investment Company: SBIC
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 Venture fund that is licensed by the SBA (Small Business Administration)
 Fund can borrow with SBA guarantees
 SBA matches SBIC funds at the rate of $2 of debt for every $1 the SBIC
 SBICs must invest:
• 75 percent of total capital in U.S. small businesses, defined as having the following:
• No more than 49 percent of employees overseas
• Less than $19.5 million of tangible net worth
• Less than $6.5 million of after-tax net income averaged over the previous two years
• At least 25 percent of total capital in U.S. smaller enterprises, defined as having the
following:
• No more than 49 percent of employees overseas
• Less than $6 million of tangible net worth
• Less than $2 million of after-tax net income averaged over the previous two years

SBIC
 SBICs may not invest in:
• U.S. small businesses with more than 49 percent of employees overseas
• Real estate
• Project finance
• Re-lenders
• More than 10 percent of investable capital in any one business
 SBIC regulations are at 13 CFR Part 107,
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Bibliography
 Secrets of Sand Hill Road, Scott Kupor
 The Business of Venture Capital, Mahendra Ramsinghani
 Venture Deals, Feld & Mendelson
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Contact Details
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Partner
Investment Funds Practice Group
Roger.Royse@haynesboone.com
Tel: +1 650.687.8820

How to Form an Angel or Venture Fund: Legal, Business and Tax Strategies

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