In the last video we ended with a slide that showed the tremendous leverage that is available on the General Partner’s capital.

Before we dig into the economic mechanics of an investment partnership, we need to understand a few concepts:

• Carried Interest
• Preferred Return
• Waterfall

Carried Interest is defined as a share of any profits as long as i) all capital is returned to the investors; and ii) the investors receive their Preferred Return.

Preferred Return is the return on invested capital before the General Partner receives its carried interest.

The Waterfall defines the priority of the distribution of invested capital of an investment fund in general, and from the exit of each discrete investment in particular. The Waterfall is not just for an investment fund, or blind pool; its also applicable if you are raising money for a single asset transaction – such as a single real estate investment.

So, what does a waterfall look like, in other words, what does the priority of distribution look like?

Below is the “Executive Summary” version of a waterfall from one of our offering memorandum templates:

i.     return of 100% of invested capital;
ii.    the Preferred Return;
iii.  100% to the G.P. as a catch-up until the G.P. has received 20% of distributed profits; and
iv.  thereafter, 80% to the partners and 20% to the G.P.

Traditionally, the carried interest on investment funds is 20%

Also, note that the Partners do not receive their Preferred Return AND an 80% allocation of the profits; they receive 80% of the profits. The Preferred Return is the hurdle rate for the G.P.

For example, if the G.P. has been receiving its Carried Interest in the early years of the partnership, but the the partnership sustains some losses so that the Partners’ return is less than the Preferred Return, then the Partners can “Claw Back” some of the Carried Interest received by the G.P. until the Preferred Return is met.

Towards the end of the video in this post I walk through an example of a fund and show how the dollars flow. I also present the IRR for the fund, the Limited Partners, and the General Partners.

You want to establish an investment fund when you are seeking capital to pool capital for investments that have yet to be identified.

Your investors will be committing capital to you based on your experience, track record and the investment profile, or investment theme that your Investment Fund will be pursuing. Since the investors are committing capital  to yet-to-be-identified investments, an Investment Fund is also known as a “blind pool.”

Investment Funds are established as Limited Partnerships, with investors coming in as Limited Partners (“LP”). You, as the Sponsor of the fund, are the General Partner (“GP”).

The GP manages all fot he activities and affairs of the Investment Fund/partnership.

Sometimes the General Partner is the Investment Manager, and sometimes the Investment Manager is a separate entity.

I’ve seen three ways that the relationship between the General Partner, Investment Manager, and Fund are set up (and I’m sure there are more).

The simplest, and the structure I’ve seen the most, is one where the GP and the Investment Manager are one and same, with the GP formed as an LLC.

The second structure is one that I’ve only seen a few times, and it’s one where the GP is formed as a Limited Partnership. An Investment Manager is formed as a separate entity, usually an LLC, and is the General Partner of the GP of the Fund.

There is a dotted line from the Investment Manager to the Fund, which represents the contractual relationship between the two, with the Investment Manager providing services to the Fund such as deal sourcing, negotiating, due diligence, closing and post-closing portfolio management.

The third structure is one where the GP is formed as either a Limited Partnership or an LLC. The Investment Manager is typically fomed as an LLC, and again having a dotted line to the Fund for investment management services.

Some people are not clear about the mechanics of an Investment Fund. When you close on your fund, you don’t collect the investments from your investors at Closing and then deploy the proceeds into investments over time. When you Close on your fund, you’re closing on “Commitments” from the investors. At Closing there will be some amount that gets drawn down to fund the first quarter of management fees, pay Fund Closing costs, which are mostly legal expenses, and finally, fund any pending investments. As you source opportunities, you will draw down, or “call” on the Limited Partner’s commitments.

Finally, as a preview of the next video, there is tremendous leverage to the General Partner’s capital with an Investment Fund. Typically the General Partner will invest 1% of the total commitments of the Fund, with the Limited Partners committing the remaining 99%. The profits, on the other hand, are allocated 80% / 20%, with 80% going to the Limited Partners and 20% to the General Partner.

In the video in Part I we walked through how to figure out how much equity in dollars you will need to provide to your investors to achieve a certain targeted IRR. This equity give-up is accomplished with a security called a warrant.

In this video we walk through i) how to figure out what percent of equity those equity dollars represent; and ii) how many warrant shares will need to be associated with each note you issue.

I’ve had several inquiries about “Debt/Equity.”

And after either spending time on the phone or through email correspondence, what people were looking for was to issue debt with an equity kicker.

Accomplishing this is easy by issuing your debt with warrants. The yield to your investors then is the coupon on your note plus the value of the warrants.

This short video (less than 5 minutes) shows you how a simple spreadsheet can be set up to calculate the IRR for a debt with warrants issuance.

I was talking with a friend of mine that sits on the board of an angel investor group. He told me that one of the first (and favorite) questions they like to ask presenters is what their “pre-money” valuation is.

Unless you’ve been down this road before, or have been coached, then you might be caught off-guard.

In this short video, which I filmed in my car, I give you the simple formula to calculate your pre-money valuation.

In a nutshell, you take the “Post-Money” valuation and subtract the amount of money you are raising.

Your Post-Money valuation is simply the amount of capital you are raising divided by the amount of equity you are offering.

So for example, if you are raising $500,000 and offering 33% of your company to do that, then:

• Post-Money Valuation is $500,000 ÷ .33 = $1,515,000 (rounded)
• Pre-Money Valuation then is $1,515,000 – $500,000 = $1,000,000 (rounded)

Private placements are not just for multi-million dollar deals. Even if you are seeking raise $100,000 to acquire a franchise or a piece of investment real estate, you are still required to present prospective investors with a private placement memorandum, or PPM. The challenge is that PPMs can be expensive to have drafted. A good attorney will cost you $20,000 or more. A PPM consultant will cost $5,000 to $15,000 (and you should still have an attorney to review it). Unfortunately, these costs are either i) out of reach for many businesses and entrepreneurs, or ii) recognized as sunk money if their deal doesn’t close.

A great alternative for many business owners and entrepreneurs is to purchase a Private Placement Memorandum Template. A well-formulated private placement template will help guide the issuer through the process from the term sheet through the business description. Specifically, the template should help the issuer craft the memorandum so that the prospective investor can make an intelligent Go / No-Go decision. Of course the template can only go so far; the issuer must be totally transparent in presenting the business and opportunity – warts and all. There should be no commission of false statements or omission of facts that, had they been presented, would lead the reader to a different conclusion.

Aside from being required to be legally compliant with securities laws, a well-written PPM will present you and your company in a professional manner. Your private placement template should include the same things you would want to see if you were sitting in the seat of the prospective investor. Some of these sections include investor disclosures, a term sheet, risk section, business description, transaction description, capitalization, sources and uses of funds, financial presentation (including discussion and analysis), description of the securities being issued and a tax discussion.

So if you want to save some money and mitigate your risk of ending up with huge busted deal expenses, consider using a private placement memorandum template. Just make sure that its flexible enough to accommodate your transaction and that the template itself is set up to guide you through each section. Finally, regardless of where you purchase your PPM template, make sure that after you get your PPM drafted, have your attorney review it and provide comments.

Whether your business is a start-up or a mature business, one of the most critical activities you’ll face is raising capital. One of the best, and often the most overlooked sources of capital are private investors. And while often times money is raised through friends and family, my view is to stick with accredited investors that are in the deal business each and every day. If you do tap friends and family for capital, make sure that the relationship  can handle a total loss scenario.

An intergal part of the capital raising process is your “prospectus,” which is different depending on where you go for your capital needs. If you are going to a bank, or a non-bank lender (such as an SBIC), you’ll want to have a crisp executive summary that provides the lender with information about your business and the use of funds. Some points that the executive summary should cover include a short history of the business, overview of the transaction (working capital, purchase new equipment, refinance existing debt, buyout of a partner), what products you sell, who your customers are (if applicable, think top ten customers and the last three years of sales for these customers), who your suppliers are (top five or ten suppliers and amounts purchased over the past three years), manufacturing process (as applicable), industry and competition (a SWOT analysis), sources and uses of funds, capital structured (pre and post financing), and summary of financial performance with applicable discussion and analysis.

If, on the other hand you are seeking to raise some type of junior capital, such as equity or subordinated debt, from private investors, you will need to have a private placement memorandum.

Think of the private placement memorandum as the executive summary on steroids. The private placement memorandum, or PPM, provides your prospective investors with the information that is needed to assess the trade-off between risk and return. You will need to articulate what the “deal” is; i.e. what type of security you are issuing, the terms, restrictions and covenants of the security. The PPM should also articulate the risks of the transaction, which includes risks inherent in the business, industry, potential conflicts of interest, risks specific to the security being issued, and corporate structure. The key to this risk section is to not sugar coat it and to not try to mitigate the risks in this section. Put yourself in the shoes of you prospective investor – what information would you wan to know?

Raising capital is not easy, but can be rewarding, aside from actually raising the money. Going through this process will require to think about and talk about your business in ways that you might not have had to in the past. And while you may think you have the best business or business idea (in the case of a start-up) in the world, when exposed to the the light of seeking capital, you will begin to see and think about your business in news ways.

Raising capital, particularly private capital, can take a long time. Depending on what type of relationships you have and how much initial work you do, expect to take six months or more to complete your offering. Even closing on a simple bank financing can take six to eight weeks from start to finish.

Raising capital can also be expensive. In the case of a traditional bank financing, your costs can often be rolled into your financing. Likewise with private placements, except for any placement fees you may pay, your costs can be paid or recouped out of the proceeds of your closing. The biggest risk, however, is the risk of bused deal expenses – your upfront expenses that get paid regardless of whether your transaction closes or not. As an example, your private placement memorandum can cost as much as $20,000 when prepared by an attorney, and bank financing expenses can include commitment fees, appraisal fees, and environmental assessment fees.

At the end of the day, raising capital is something that can be done. Like a lot of things in life, it takes know-how, persistence, and a little luck.