Investment Funds – Structure and Mechanics Part I

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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.

Using Warrants When Issuing Debt, Part II

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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.

Using Warrants When Issuing Debt

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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.

Calculating Pre-Money Valuation

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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)

Get Professional With A Private Placement Memorandum Template

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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.

Raising Capital For Your Business

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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.

Reg D – What Is It?

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Reg D, or Regulation D, refers to the SEC exemption provided to businesses for issuing debt or equity securities without going through the SEC registration process. These type of security offerings are targeted at private investors. Within Reg D, the SEC provides three rules that guide the amount of the offering and who the target prospective investors are. These rules are know as rule, 504, 505, and 506.

The document used to comply with Reg D is known as a Private Placement Memorandum, or PPM. The PPM can be thought of as a prospectus for a private offering. A PPM can be accomplished in one of three manners – through a competent securities attorney, a private placement writing service, or through the purchase of a private placement template. Having an attorney draft your private placement memorandum can cost north of $20,000. There are several private placement consultants that will draft your private placement for $5,000 to $15,000. And finally, a private placement template will cost you around $300. However, in the case of writing your own PPM with a template, or using a private placement service, you should factor in the cost of have a good securities attorney review and sign off on your PPM before you hit the streets.

Writing your PPM is not difficult, but will take you some time. While this is a little of an oversimplification – the PPM essentially your business plan with a term sheet. Of course, it more than that, but the bulk of your PPM will be the who, what, where, how and why of your business:

  • who you are
  • what your company does
  • what your company sells
  • why  customer buy what you sell
  • who your customers are
  • how you manufacture or go to market
  • who your competitors are
  • what are the industry drivers
  • how your financial performance has been

I think, based on the calls I receive, the hardest part for business owners is trying to figure out what type of security to issue and what the cost of that security should be. Again, not hard, but if you are not familiar with certain corporate finance terms and concepts, there can be a very steep learning curve.

The other difficult part of writing your offering memorandum, is the risk section. In this section you will want to discuss all of the risks of your company, the industry, and your transaction. You should do this without giving in to the natural inclination of wanting to mitigate each risk (hey, your trying to get a deal done, right?). You should approach this section as coming up with all of the reasons that an investor wouldn’t want to invest in your deal.

Once you have your private placement memorandum drafted and signed off by an attorney, you are ready to start “smiling-n-dialin.”

Regulation D provides companies with a great opportunity to raise private capital for their business needs. A security issued under Reg D can be accomplished by a start-up or a existing mature company.

Do You Need An Attoney To Write A Private Placement Memorandum?

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A question posed by one of my visitors was whether you needed an attorney to write a Private Placement Memorandum. While the question was in the context of someone who wanted to draft a PPM for a client, the answer has broader applications. The short answer is yes and no.

First the ‘no.’ Your PPM has several sections, some of which are boilerplate and some of which require information that is specific to your business, transaction and issuance. The boilerplate sections include the investor legends, the description of the securities and tax discussions, some of which may need to be tweaked depending on your situation, but generally they are boilerplate sections.

Where you will spend most of your drafting time will be the term sheet, risk section and business discussion section. These are aspects of your offering that your attorney can help with by providing input around the edges, but generally will not be drafting for you. Lets look at each of these sections.

TERM SHEET – The term sheet is that section of your PPM that describes the security you are offering to your prospective investors. The main section of the term sheet will describe:

  • the type of security you are offering (debt or equity, and all of the flavors in between);
  • the price you are willing to pay for the capital you are raising (straight interest or dividends, warrants, success fee; convertible provisions, any preferred return provisions);
  • how you will be paying the return to investors (PIK, cash pay);
  • how the issuance ranks relative to other capital in the business (or fund); and
  • affirmative and negative covenants.

You’ll want to spend time on this section first to make sure you have the right capital structure in place and, two to make sure you price the issuance properly. Price it too cheaply and you won’t clear the market (and run the risk of tainting your offering); price it too dear and you’ll leave money on the table.

Where your attorney can help with the term sheet is to make sure that you capture and think about all of the nuances of whatever type of security you are seeking to issue. For example, if you are raising subordinated debt, you will need to think about intercreditor issues with the senior lenders and what type of standstill provisions need to be in place. A good securities attorney can draw on years of experience across a variety of transactions, deal structures and types of offerings.

As a metric on how long this might take you, I spent about an hour drafting a term sheet for a client earlier this year. This was after we spent about an hour talking about what made sense and I spent some time on my own noodling different scenarios. But the drafting part took about an hour, and I’m comfortable and experienced with writing term sheets.

RISK SECTION – The Risk Section is where you’ll discuss all of the reasons why a prospective investor shouldn’t invest in your offering. It important to be very transparent in this section and not hold anything back. You’ll want to present and discuss all of the risks you would want to know about if you were on the other side of the table. You will also want to resist the temptation to state a risk and then mitigate it, a natural reaction.

The Risk Section is where your attorney can add a lot of value. It is usually just a few word changes that make the discussion more transparent, and by adding certain risks that are related to legal/corporate/security issues, rather than business issues.

BUSINESS DISCUSSION – The business discussion section is where you discuss your business and strategy, as well as discussion why the business is seeking to raise capital. Some of the points you will want to discuss include:

  • history of the company
  • what you sell
  • who your customers are
  • why they buy from you
  • your suppliers
  • manufacturing process (if applicable)
  • capitalization
  • sources and uses of funds
  • historical financial performance with discussion and analysis
  • projected financial performance with discussion and analysis

So at the expense of sounding wishy-washy, the answer to whether you need an attorney to draft a private placement memorandum is both yes and no. ‘No’ in that there is so much of the PPM that only you will be able to write. ‘Yes’ in that your attorney can add value to the process, but after you have the bulk of the PPM written. And, my strong suggestion to all of my clients is to always have an SEC attorney review and comment on your private placement memorandum before you start talking to prospective investors.

Hedge Fund Management – The High Water Mark

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A high water mark is a tool used by hedge fund managers to align their interests with those of their investors. The high water mark sets a threshold wherein an investor will not be charged a performance fee by the manager for past under-performance.

Watch the video below for more information on what a high water mark is, how a hedge fund uses one while calculating performance and what it means to the industry. This video also covers why it was put into place by hedge fund managers for investors.

Related Hedge Fund Private Placement Memorandum Articles

Raise Capital With Private Placement Memorandum

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Use a Private Placement Memorandum Template from TransCapital Pro to raise capital for your business – whether its $100,000 or $10,000,000. You can raise capital for your business, private equity fund, or real estate transactions. Our templates are valid in all 50 states and are easy to navigate to  customize for your purpose.

Writing your own private placement is not as daunting an assignment as it sounds. A good template will guide you through all of the various sections. And, at the end of the day, you are essentially articulating your business plan to your prospective investors – and who knows your business better than you.

One of the critical sections of the private placement is the Risk Section. Here you will want to be totally transparent. I advise my clients that they should provide the information that they would want to know if the roles were reversed. You should never commit an intentional lie, or a lie of omission.

The other advice I give clients who choose to write their own private placement memorandum is to not sell. Just stick to the facts of the business and of the transaction. If you need a sale document, prepare a power point presentation.

Finally, make sure you get your attorney to review your PPM. Where I’ve found attorneys to add value is by tweaking the language in the Risk Section. I think its human nature to want to mitigate the risk your are stating (because you want to get your deal funded). But this goes against the grain of what the PPM is all about, and your attorney will take an objective view of this section and make sure its “just the facts.”

Private Placement Memorandum Templates for private equity and debt offerings from TransCapital Pro.