#1Morgan Lewis FUNDAMENTALS OF PRIVATE EQUITY FUND FORMATION wwwww#2Forming the Fund Morgan Lewis ⚫ Individuals Step 1: The Venture Capitalists 2#3Forming the Fund Step 2: The General Partner General Partner, LLC • Delaware Limited Liability Company • Limits Liability for Members • Tax Advantages Morgan Lewis Pass-through Capital gains Tack holding periods 3#4Forming the Fund Step 3: The Fund General Partner, LLC Venture Capital Fund, LP • Delaware Limited Partnership or Delaware LLC • Tax Advantages - - Pass-through Capital gains Tack holding periods Morgan Lewis 4#5Forming the Fund Step 4: The Limited Partners General Partner, LLC Venture Capital Fund, LP . High-net-worth individuals, estate planning vehicles • Pension plans • Insurance companies University endowments • Foundations • Funds of funds LP LP LP LP Morgan Lewis 5#6Following the Money $ General Partner, LLC 1% $ Venture Capital Fund, LP $ $ $ $ $ 99% LP LP Morgan Lewis LP Step 1: Capital Contributions LP LP 6#7Following the Money Step 2: Making Investments Venture Capital Fund, LP $ $ $ $ $ $ $ $ $ $ $ $ Morgan Lewis www Portfolio Companies 7#8Following the Money SA $ $ SA EA Step 3: Splitting the Profits Carried Interest General Partner, LLC 20% Venture Capital Fund, LP $ $ $ $ $ 80% Profits LP Morgan Lewis LP LP LP LP 8#9Following the Money Step 4: Paying the Management Fee $ $ General Partner, LLC 2.5% EA Alternative #1 Typical Terms: - Annual fee - Percentage of committed capital - Paid quarterly Funds the operations Declines after investment period ends - Management Fee Venture Capital Fund, LP $ $ $ $ $ Morgan Lewis 9#10Following the Money Step 4: Paying the Management Fee Alternative #2 Management Company, LLC General Partner, LLC Management Fee Venture Capital Fund, LP $ $ $ $ $ Morgan Lewis 2.5% 10#11Building the Franchise General Partner, LLC Venture Capital Fund, LP Morgan Lewis Step 1: First Fund 11#12Building the Franchise General Partner, LLC Venture Capital Fund, LP General Partner, LLC II Venture Capital Fund II, LP Morgan Lewis Step 2: Expand 12#13Building the Franchise Step 3: Success: Multiple Funds General Partner, LLC General Partner, LLC General Partner, LLC II Venture Capital Fund, LP Venture Capital Fund II, LP III Venture Capital Fund III, LP Morgan Lewis 13#14Building the Franchise The Management Company - Permanent entity • Office lease - • Employees and benefits • Trademarks (i.e., fund names) • Insulates liability from any one fund Consolidation • Can pool all excess management fees • May have fewer managers with more power • Controls formation of successor fund Morgan Lewis Step 4: A Management Company 14#15Building the Franchise Management Company, LLC Step 4: Alternative A Management Company #1 i General Partner, LLC General Partner, LLC General Partner, LLC Venture Capital Fund, LP Venture Capital Fund II, LP Management Fee Venture Capital Fund III, LP Morgan Lewis 15#16Building the Franchise Step 4: A Management Company Alternative #2 Management Company, LLC -Management Contract for expenses only Net Fees remain at GP Level General Partner, LLC General Partner, LLC Venture Capital Fund, LP Venture Capital Fund II, LP Morgan Lewis General Partner, LLC Venture Capital Fund III, LP 16#17Building the Franchise Step 4: A Management Company Alternative #3 Management Company, LLC Sole Managing Member General Partner, LLC General Partner, LLC General Partner, LLC Venture Capital Fund III, LP Venture Capital Fund, LP Morgan Lewis Venture Capital Fund II, LP Management Fee 17#18What Are the Mechanisms of Investments? • Offering Memorandum Limited Partnership Agreement • Subscription Agreement Investor Questionnaire Morgan Lewis 18#19What Are the Mechanisms of Investments? • Offering Memorandum - General disclosure document • Terms ⚫ Risk factors Marketing document . Management bios • Track record • Investment focus Not always used by established funds Morgan Lewis 19#20What Are the Mechanisms of Investments? Limited Partnership Agreement - - Sets forth relationships, rights and duties of General Partner and Limited Partners Major provisions emphasize: Economic deal (allocations, distributions, clawbacks) - Investment restrictions (diversity) - Governance issues (no-fault divorce, key man) Alignment of interests Side Letters . Special rights, most favored nations (MFNs) • Can alter terms after first closing Specific regulatory issues Morgan Lewis 20 00#21What Are the Mechanisms of Investments? Subscription Agreement - - - - Investor commitment • GP may accept less if oversubscribed Capital called over time. - LP has maximum utility of $ for as long as possible VC maximizes IRRS Closing Conditions Opinions • Minimum fund size Representations Power of Attorney Allows LP favorable changes to agreement Morgan Lewis 21#22What Are the Mechanisms of Investments? Investor Questionnaire - Information-gathering document • Accredited investor Qualified purchaser • ERISA status Look-through issues • NASD restricted persons • PATRIOT Act compliance • Contact information Use information for exemptions, legal opinions, and general management purposes Morgan Lewis 22#23What Is the Regulatory Framework? • Securities Act of 1933 • Investment Company Act of 1940 • Investment Advisers Act of 1940 • Securities Exchange Act of 1934 Employee Retirement Income Security Act (ERISA) Morgan Lewis 23#24What Is the Regulatory Framework? • Securities Act of 1933 - - Section 4(2), private placement exemption Regulation D, Rule 506 (safe harbor in Securities Act Rules) • Unlimited offering amount • No general solicitation • Accredited investors • Information requirements for nonaccredited investors (therefore don't admit) • Federal preemption of state securities laws Morgan Lewis 24#25What Is the Regulatory Framework? • Investment Company Act of 1940 - - Section 3(c)(1), exclusion from definition of "investment company" • Less than 100 investors; and • Securities not offered in a public offering Qualified Purchaser Pools (Section 3(c)(7)) • Unlimited number of investors if all are Qualified Purchasers (generally, individuals with $5 million and entities with $25 million in "investments") "Look-through" issues • 10% Rule for other Investment Companies in 3(c)(1) entities • "Formed for the Purpose" criteria in Handy Place Morgan Lewis 25 25#26What Is the Regulatory Framework? General Partner, LLC Venture Capital Fund, LP Morgan Lewis wwww Venture Capital Fund - A, LP wwww Portfolio Companies Parallel Funds 26 6#27What Is the Regulatory Framework? Investment Advisers Act of 1940 - Must register if: • The general partners are considered to have more than 14 "clients"; each partnership under management is considered to constitute one "client" • Discretion is afforded investors on choosing individual investments (e.g., pledge funds), therefore seen as individual clients Acting as ERISA fiduciary or a QPAM Review state laws - Morgan Lewis 27 7#28What Is the Regulatory Framework? • Securities Exchange Act of 1934 - Section 12(g)(1) registration requirements (cannot exceed 499 investors) Broker/Dealer exemption under Rule 3a4-1: The General Partner • Is an "associated person" of the partnership; • Is not now nor was in the past 12 months an "associated person of a broker or dealer"; • Does not receive a commission for the sale of the limited partnership interests; • Will perform substantial duties for the partnership; and • Does not participate in an offering more than once every 12 months. Morgan Lewis 28#29What Is the Regulatory Framework? Employee Retirement Income Security Act (ERISA) - - - - - Plan asset regulations - 25% test ("significant participation") Venture capital operating company (VCOC) exemption Management rights letter - QPAM exemption Morgan Lewis 29#30Other LP Issues Affecting Terms • Bank Holding Company Act. • • 25% Ownership 5% Voting Tax-Exempt Investors Unrelated Business Taxable Income (UBTI) ● Borrowing to fund investments Investing in pass-through entities Receiving fees for service (fee offset provisions) Foreign Investors - - Effectively Connected Income (ECI) · Investing in pass-through entities Receiving fees for service Withholding on Distributions Morgan Lewis 30 30#31What Is the Regulatory Framework? Venture Capital Fund, LP wwww VC Feeder Fund International, Ltd. General Partner, LLC Venture Capital Fund -A, LP Morgan Lewis Portfolio Companies Feeder Funds 31#32Other LP Issues Affecting Terms • Foundation Investors - Limited to 20% ownership of portfolio company Subject to excise tax on profits • FCC Regulations - Limitation on media company ownership • Investment Restrictions - Political - • South Africa, Cuba, Northern Ireland, etc. Religious, Moral • Tobacco • Sharia (Islamic laws) Morgan Lewis 32#33Other Regulatory Issues . . PATRIOT Act - Know your client Privacy Act - - Regulated under FTC Rules regarding disclosure of consumer financial information Annual notice, in-house procedures Public Disclosure - - Primarily affects government pension funds State Sunshine Laws Morgan Lewis 33#34Additional Information For more information on the issues discussed here, please contact your Morgan Lewis Private Investment Funds Practice attorney. About Morgan Lewis's Private Investment Funds Practice Morgan Lewis has one of the nation's largest private investment fund practices and is consistently ranked as the "#1 Most Active Law Firm” globally based on the number of funds worked on for limited partners by Dow Jones Private Equity Analyst. About Morgan, Lewis & Bockius LLP Morgan Lewis provides comprehensive transactional, litigation, labor and employment, and intellectual property legal services to clients of all sizes-from global Fortune 100 companies to just-conceived startups-across all major industries. Our regulatory and industry-focused practices help clients craft and execute strategies to successfully address legal, government, and policy challenges in today's rapidly changing economic and regulatory environment. 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