Venture capital is an illiquid asset class. Investments in private companies, whether directly or indirectly (through funds), are locked up to some extent until the company goes public or gets acquired. Secondaries have always been and remain a strong mechanism for investors to achieve some level of liquidity before a traditional exit opportunity arises. However, as the exit market (and therefore liquidity) has dried up over the last few years, the volume of secondary transactions has grown dramatically. The robustness and types of secondary opportunities for investors have similarly expanded, yielding new and exciting opportunities for buyers and sellers. 

What is a Secondary Transaction?

In the private markets, a secondary sale is any sale of ownership in a startup (typically common or preferred stock) where the seller is anyone other than the company itself. For instance, an investor may purchase Series Seed stock and then resell it to another investor several years down the line prior to the company going public or getting acquired (known as “exiting”).

A Brief History

Around the turn of the century, private markets grew exponentially with new capital and investors flooding in. Allocators started investing more, and as the market ebbed and flowed, investors needed liquidity. They turned to secondary sales for this. However, secondary sales had a stigma, leading to a scarcity of buyers, hesitancy from sellers, and tight regulations.

The 2008 financial crisis significantly impacted secondary markets. As liquidity dried up, LPs were forced to hold positions longer than expected, spurring a rise in secondary buyers and transactions. After a period of stability, the market saw a resurgence in 2020-2022, driven by high valuations and substantial committed capital, which led to large, late-stage investments in overvalued companies. Rising interest rates and declining market sentiment caused valuations to drop, closing the IPO market and hindering M&A activity. Consequently, a new wave of secondary vehicles, funds, and marketplaces has emerged to address these liquidity challenges.

Types of Secondary Transactions

Direct Secondaries

The most common form of secondaries occurs via "direct" sales, where the underlying asset is equity in a company. Given the restrictions on shareholders and transaction volume that large private companies are subject to, secondary transactions can be difficult for these companies to accommodate. To bypass these hurdles, investors can use SPVs to buy company equity and then trade shares of those SPVs. While this strategy can unlock liquidity opportunities, such transactions can also be complex and difficult to manage.

Fund Secondaries

Sometimes, shares of private companies are sold as part of a larger fund. When these fund positions are traded, they are called fund secondaries. Fund secondaries make up an entire ecosystem on their own. The exact nature and structure of a fund secondary can take on many forms. Three main mechanisms are the most popular: 

LP-Led Secondaries

If an investor becomes a Limited Partner in a fund, they can also access the secondary market. As private funds often extend beyond their planned divestment date, investors might face liquidity issues. LPs looking for full or partial exits can sell their positions to other fund investors, outside investors, fund-of-funds, or specialized secondary funds. These dedicated secondary funds are becoming increasingly common, providing more options for LPs to achieve liquidity.

GP-Led Secondaries

When a fund is nearing the end of its intended lifecycle, GPs can introduce liquidity by selling the fund’s ownership of select companies in a secondary transaction. This strategy is similar to that of a direct secondary. Often, these positions are bought by private equity firms or secondary funds. This group also encompasses strip sales. 

Continuation Vehicles

If a fund has reached the end of its intended lifecycle, but the portfolio is still not ready for liquidation, GPs can turn to continuation vehicles. These involve effectively rolling the current portfolio into a new fund or vehicle, which can include adding new LPs. Oftentimes, LPs of the original fund can use this to sell their stakes for liquidity, and secondary funds can utilize this technique to gain exposure to late-stage portfolios. Such vehicles have become very popular over the past year, and are expected to be a core focus of the secondary market’s trajectory in the near future.

Benefits of Secondaries 

The primary function of a secondary transaction is to create liquidity for the initial purchaser. This is especially relevant in VC, where investments are typically “illiquid,” meaning that investors won’t receive a return for five, ten, or more years. Secondaries allow VCs to return funds to their LPs without having to wait for a portfolio company to exit.

Secondary sales can also allow VCs to recycle capital back into a fund. Instead of returning funds to LPs immediately, proceeds from exits or secondary sales are reinvested into additional companies. For LPs not needing early liquidity, this recycling can enhance long-term returns by deploying more capital into investments. It also improves fund metrics like IRR and total value paid in (TVPI), aiding in future fundraising efforts. This post by Sapphire Ventures provides an in-depth example of how recycling can impact fund return multiples.

If the VCs don’t have immediate plans for near-term liquidity, LPs can use secondaries for their portfolio positions. Much like a private ETF, secondary investors can buy later-lifecycle portfolios with more mature positions. Conversely, sellers can generate cash flow opportunities outside of the fund. 

On the buyer side, secondary transactions rely on deal access. Secondaries provide a viable opportunity for newer investors, including angels and micro-fund managers, to buy ownership in companies they would not have been able to invest in directly. These are almost always later-stage companies, where there’s more demand for equity given that the companies are more established and have demonstrated success. Newer investors may see this as an appealing way to diversify their portfolio and participate in the value creation of a company soon before an IPO.

Because of these benefits and the increased interest in private markets as a whole, there has been a demonstrated increase in secondary activity over the past several years. Secondaries are particularly appealing to stakeholders such as family offices, high-net-worth individuals, and fund-of-funds that are newer to venture investing and therefore may not have access to primary investment opportunities.

If you're interested in tapping into these benefits and want a hassle-free way to invest, Sydecar can help. We make it easy to navigate secondary investments and boost your returns. Sydecar handles everything from automated banking and compliance to contracts and reporting for secondary transactions, so you can focus on deal-making. Visit our Secondary SPVs page to learn more and get started today.

Max Harris is the co-founder and CEO of Ticker Markets, a platform for private fund LP secondaries. Working primarily as a brokerage, Ticker aims to support liquidity solutions through the fund life cycle, connecting the secondary market to allow for lower mid-market individuals and family offices to access the growing pool of committed secondary capital. Before starting Ticker, Max worked in the aerospace and defence industry at Northrop Grumman, building out next generation space-based solar power technologies. 

“Should I charge management fees on my SPVs?” It’s a question we’ve heard time and again from syndicate leads in our community. As one can imagine, there’s not a one-size-fits-all answer. The fee structure you choose for your SPVs should be informed by your strategy and your LP base, among other factors. Read on to discover the pros, cons, and considerations of different fee structures.

Management Fees: A Foundation for Operational Stability

Management fees, typically ranging from 1.5% to 2.5%, are calculated on committed capital and collected annually or as a one-time, up-front fee upon closing. These fees cover operational costs such as salaries, office expenses, and professional services. Management fees provide a predictable revenue stream, which allows syndicate leads to cover the costs of handling essential tasks like deal sourcing and due diligence. 

However, management fees can raise concerns if not aligned properly with investor interests. Overcharging on management fees could shift attention away from investment performance, causing a disconnect with your investors.

Table: Pros & Cons of Management Fees

Carried Interest: Aligning Interests Through Success 

Carried interest (“carry”) represents a share of the profits from the SPV’s investments and is typically 20% (though it can range from 15% to 25%). Carry serves to align the syndicate lead’s interests with those of the investors by rewarding good performance. Since the majority of a syndicate lead’s compensation typically comes in the form of carry, it keeps them highly focused on generating returns for investors. This structure promotes a shared focus on maximizing returns, but, carry is contingent on the SPV's success, making it an unpredictable revenue stream–it may take years to see them, if they occur at all. We’ll discuss SPV profitability more in-depth shortly.

Other Fees

Beyond management and carry fees, syndicate leads might impose other charges for specific services, ranging from 0% to 5%, enhancing income while promoting strategic differentiation. These fees cover a variety of activities, such as deal sourcing, portfolio monitoring, or other professional services (e.g., tax, accounting, audit). When charging additional fees, a syndicate lead must be transparent with investors and justify these fees clearly. This avoids potential misalignments or conflicts of interest that could undermine trust or affect SPV performance.

Crafting Your Fee Model: A Strategic Approach

Choosing the appropriate fee model is more an art than a science, requiring a thoughtful analysis of several factors, including SPV size, investment strategy, and market positioning. Managers should aim to strike a balance that ensures operational viability while aligning closely with investor expectations and SPV performance goals.

Here are key considerations for setting your SPV's fee structure:

• Operational Needs vs. Incentive Alignment: Assess the balance between covering essential operational costs and incentivizing performance.

• Market Positioning: Understand your competitive edge and how it justifies your fee structure.

• Investor Expectations: Engage with your investors to gauge their preferences and requirements for fee alignment.

• Transparency and Flexibility: Ensure your fee model is clear, fair, and adaptable to changes in investment strategy or market conditions.

After determining what the best fee structure is for your situation, you may be thinking, “Okay…now when am I going to start making money?” Turning a profit from SPVs often involves a long-term commitment, requiring significant patience and planning. Syndicate leads must understand the timeline for returns and what supplementary income streams exist in order to manage their financial stability effectively.

A Decade to Profitability

It typically takes seven to ten years for a company to reach IPO stage from its founding. Considerable carry returns from seed-stage SPV investments can similarly take a decade to realize. GPs who run a fund can hedge their bets against this delay by charging management fees, providing them with a reliable source of income as they wait for potentially significant carry returns in the long term. Here’s a rough estimate of what GPs can expect to earn on a 2% management fee after other necessary expenses, organized by funding round & fund size: 

However, for SPVs, not all GPs charge a management fee, as Cindy Bi highlighted in our recent Sydecar Session. Likewise, many syndicate leads choose to forego management fees due to investor pushback, relying instead on carried interest. This approach can lead to financial uncertainty due to the lack of a steady income stream. To boost their financial stability, syndicate leads look to other sources of income. Some of the top ways syndicate leads generate additional income include: 

• Consulting fees: Offering advisory services for a fee.

• Early exits: Gaining interim income from early-stage company exits.

• Secondary investments: Selling stakes in companies that have increased in value, before a liquidity event.

• Non-venture investments: Earnings from public stocks or cryptocurrencies.

• Part-time roles or other ventures: Many syndicate leads take on additional, part-time roles to supplement income. Some even pivot to working full-time for a VC fund for the guaranteed salary.

• Newsletter: Operating a newsletter with a large audience to attract advertisers and generate ad revenue. 

• Membership programs: Launching a membership program, similar to Alex Pattis and Zach Ginsburg's "Deal Sheet" from Last Money In, offers a powerful way to generate revenue. Deal Sheet is a paid weekly newsletter that delivers top, actively investable startup investment opportunities directly to subscribers.

Running a syndicate involves balancing immediate financial needs with long-term gains. The typical syndicate lead experiences periods of low income, with occasional high returns. This leads to high turnover among syndicate leads, who may opt for more stable income sources.

With this in mind, deal leads must carefully plan their fee structures and consider their income strategies. In developing a fee model and profitability timelines, it is necessary to balance operational costs with the delayed returns common in venture capital. Syndicate leads should aim for a fee structure that supports operations, aligns with investor success, and remains adaptable to growth and market shifts. 

As you get closer to realizing returns from seed-stage investments, your approach to fees may evolve, reflecting both your strategic vision and market realities. While the path to profitability is lengthy, the potential rewards can justify the investment for those prepared for the challenges.

Sydecar makes it easy for syndicate leads to adjust management and carry fees and provides LPs with complete visibility into deal fee structures. Request a demo below to learn more about how we streamline fee setup. 

How can influencers raise capital for companies or funds, without running afoul of restrictions on “general solicitation”?

The 2012 bipartisan JOBS Act was supposed to empower funds and individuals to raise capital more openly: to publicly advertise their track record and what they’re selling, just like almost every other industry. However, as far as I know, the great majority of private capital raises for funds and companies are still not using general solicitation. Winter Mead, Founder & CEO of Coolwater, an accelerator for emerging fund managers, said: “Fewer than 5 of the 180 emerging managers we’ve worked with are raising via 506c, in order to get in front of more retail LPs, who are generally already following the GP, e.g., through the GP’s newsletter or community. At this point, all of them are currently planning to do 506c again for their next fund.” 

Why has general solicitation not become more widely used among investors in alternative assets? There are four disadvantages to general solicitation. 

• General solicitation creates an obligation to verify that investors are accredited. William Stringer, Founder, Chisos, said, “The benefits of 506(c) were clear when we were raising smaller checks into a small fund from individual accredited investors. However, because of the additional information burden we almost lost a few larger, more sophisticated investors that did not want to be bothered for a relatively small investment.” You can typically outsource this for as little as $60 to companies such as VerifyInvestor.com or EarlyIQ. Or, Yoni Tuchman, Fund Formation Partner at DLA Piper, said, “Include a form letter in your sub docs that the LP can have their lawyer or accountant sign.”

• Time efficiency. General solicitation requires engaging with many potential investors, most of whom are just tire-kickers, not check-writers. Founder Pete Cashmore observed, “Smaller (or non-professional) investors may have unreasonable expectations of returns, which could result in conflict in the case of failure.”

• Signaling. When you’re raising capital for a fund (or private company) you’re fundamentally selling a luxury good, which is seen as more valuable because it’s scarce. General solicitation damages that perception. 

• Inherent conservatism of LPs. Brian Laung Aoaeh, Founder & Managing General Partner, REFASHIOND Ventures, said, “We chose not to do general solicitation for our institutional fund after doing a 506(c) rolling fund because we got the sense that most institutional LPs are not yet very comfortable with the rules. Explaining that a certification from an attorney or accountant would be sufficient did not appear to be sufficiently persuasive.”

With that said, what is the best way to market your capital-raise to potential investors, while staying compliant? This is particularly relevant for influencers who have an audience, as many emerging fund managers do.

David Teten, Venture Partner at Coolwater, interviewed Sydecar’s CEO, Nik Talreja, to provide some guidance based on his deep expertise in this area.

David Teten: Hi Nik. Can you introduce yourself and Sydecar?

Nik Talreja: I’m the Co-Founder and CEO of Sydecar, a fintech company on a mission to bring more transparency, efficiency, and liquidity to private markets. The idea for Sydecar unfolded in my mind during my decade-long career as an attorney working in capital markets and then working directly with startups and VCs on financing events. 

I practiced securities and transactional law at Weil, Gotshal & Manges and Cooley before branching out and starting my own law firm, where I supported early stage startups and investors. The experience of working with stakeholders on all sides of these transactions – companies, VCs, and their LPs – made me realize how fractured the ecosystem is. Every person is kind of speaking their own language and it makes it difficult to communicate and ultimately to transact. Every VC has their own fund model which has to be supported by a service-driven fund administrator. To add to that, there are many gatekeepers – law firms, accountants, tax advisors – who are basically charging rent for customization and tradition.

It occurred to me that there could be a better way of approaching fund administration, where product mediates the back and forth between stakeholders, and where basic structures are standardized. It was also important to me that the fund administration model isn’t connected to any marketplace that dictates how you should operate. While pursuing my legal career, I began investing behind some of my clients and worked hard to build a small LP base. I didn’t want to bring hard-earned relationships to a marketplace where they’d be exposed to other fund managers – and I figured other new managers would feel the same. Sydecar was born as a result.

David Teten: Does Sydecar currently support fundraising via general solicitation?

Nik Talreja: Sydecar's standard SPVs and Funds are governed by 506(b) meaning that general solicitation isn’t permitted; managers can only raise from people they have an existing relationship with. We can support select 506(c) deals and are happy to discuss with customers on a case-by-case basis.

We’ve thought about more widely supporting 506(c) funds in the future, especially if it’s something that our customers want. But to start with, we saw the most demand for raising under 506(b) and so chose to focus on that. It’s been interesting to see how some of our customers leverage communities they have built to help them fundraise even without the ability to generally solicit. We’ve seen a lot of creativity.

David Teten: Can you share more about that? How can someone who has built a following online successfully raise from their community under 506(b) without general solicitation? 

Nik Talreja: Sure thing. To start with, it’s important to really understand where the line is drawn between 506(b) and 506(c). Under 506(b), you can raise capital from any accredited investor so long as you are not using general solicitation. Practically speaking, this means that one cannot raise money for an investment vehicle (SPV or fund) from individuals that they don’t have a “substantial preexisting relationship” with. This includes marketing the investment opportunity on social media, websites, television, radio, or any other public channel. As a result, individuals who want to avoid 506(c) general solicitation and have a large Twitter following or newsletter can’t directly ask their audience to invest into a specific deal or fund that they are raising for. 

Rather than marketing a specific deal or fund, people with online audiences can market themselves and their expertise to stay compliant under 506(b). Using marketing and PR channels to highlight your general success as an investor and then giving people a way to get in touch can be an effective mechanism to convert an audience to an investor base. The big takeaway here is that you have to establish a “substantial preexisting relationship” with an investor before inviting them to participate in a specific deal.

In 2015, the SEC issued a “No Action” letter to Citizen VC relating to the topic of general solicitation and the definition of a “substantial existing relationship”: “ a "substantive" relationship is one in which the issuer (or a person acting on its behalf) has sufficient information to evaluate, and does, in fact, evaluate, a prospective offeree's financial circumstances and sophistication, in determining his or her status as an accredited or sophisticated investor.”  Read the full letter here. 

The bottom line is that you cannot market the opportunity directly to people you don’t know without triggering 506(c). In the eyes of the SEC, you do not know your audience. However, if a member of your online audience fills out a form sharing information about their background and you subsequently schedule a 1:1 phone call with the investor, that generally meets the standard for a substantial existing relationship. 

So the key points are:

• Do not market specific opportunities broadly.

• Do not market an opportunity directly until you’ve established a “substantial preexisting relationship” with the investor.

• Filling out a form and jumping on a call constitutes a “substantial preexisting relationship” in the eyes of the SEC.

While it may take more time, it’s not impossible to establish a relationship with someone you met through social media or a newsletter sign-up before sharing deal flow with them. Of course, when raising from a large audience, managers should expect a low conversion as compared to raising from a traditional warm introduction. Having a smooth process in place to establish relationships and share information is key. 

A final note on all of this is that whether it’s 506(b) or 506(c), the investors involved need to be accredited. For 506(b), the investor can check a box to confirm they’re accredited once a “substantial relationship” has been established. For 506(c), the investor will need to provide proof of accreditation through sharing account statements or providing a signed letter from an accountant or lawyer.

David Teten: If the potential investor participates in a webinar or an in-person gated event, does that suffice?

Nik Talreja: A "pre-existing substantive relationship" exists when there has been some interaction between the two parties, whereby the investor communicates sufficient information to the issuer (in this case, the fund manager) for the issuer to determine their financial circumstances and sophistication. If the investor is just an attendee of a webinar hosted by the manager, and the two parties don’t directly interact, then they have not established a pre-existing relationship.

If participation in the webinar (or any other virtual or in-person event) involves the investor disclosing their financial status and investment experience to the manager, and if it is reasonable for the manager to believe the investor, then yes, this would be permitted. 

David Teten: Do you have any examples of folks who have done this successfully?

Nik Talreja: A good example is Nik Milanovic, founder and GP of The Fintech Fund. Nik launched his newsletter, This Week in Fintech, in 2019 as a way to share his thoughts about the evolving fintech landscape with friends, family, and select coworkers. The newsletter grew and people started asking Nik how they could invest into the companies he wrote about. Before too long, Nik had a full-blown syndicate. Because his newsletter subscribers were initially all people he knew personally, they were fair game to raise money from under 506(b). As the newsletter and syndicate grew, Nik built out a process for converting a subset of newsletter subscribers (those who were accredited and had a genuine interest in his deal flow) into syndicate investors. 

Once an investor is accepted into his syndicate, Nik adds them to a private Slack channel where they can see new deals, discuss diligence, and ultimately decide if they want to invest. The investor relationships and track record of success that Nik built through his syndicate investing ultimately allowed him to raise a $10M Fund 1 in 2022 (also under 506(b)).

David Teten: Can you expand on the process that Nik built out for converting a subset of newsletter subscribers into syndicate investors? 

Nik Talreja: The benefit of Nik having run a newsletter in which he shared his perspective on emerging companies with his reader base was that they started to get comfortable with – and then interested in – how he thought about these companies. He started to receive inbound demand from readers asking how they could invest in early-stage fintech companies and grow their dealflow. That made it pretty easy to consolidate them into a group and build the syndicate off an active, dedicated early group.

David Teten: What are examples of compliant language fund managers have used to alert investors to the investment opportunity in funds?

Nik Talreja: Keeping your language general is key to staying compliant under 506(b). You can talk about investing. You can even talk about the opportunity for people to invest alongside you. You cannot invite people to invest in a specific opportunity.

Here are some examples of language that can be used to alert investors of the opportunity without triggering 506(c):

“We’re always looking for new investors to collaborate with! If interested in participating as an LP or co-investor, please fill out this form or reach out directly.”

“Thinking about your first investment? We’d love to learn more about your interests and see if there’s room to work together.”

“We’re holding a webinar for accredited investors only to learn more about our fund and the companies we think are highest potential. RSVP here.” [RSVP form includes a self-attestation of accredited investor status.]

Here are some public examples: The Council Angels, @TheRideShareGuy, @JeanineSuah

David Teten: What are the ‘red lines’ that people with online audiences should avoid hitting which would trigger 506(c)? 

Nik Talreja: Here are some examples of language that would trigger 506(c):

“I’m raising a $10M fund! Reach out if you want to invest.”

“We are running an SPV for SpaceX. If you want to invest please reach out.”

You’ll notice that the language for 506(b) from earlier is general and pushes towards gathering more information from the investor, while the language that triggers 506(c) is specific.

Being general with your language and driving potential inventors to provide more information is key in order to satisfy the “substantial preexisting relationship” rule that sits between 506(b) and 506(c).

If you do have a “substantial preexisting relationship” with an investor, it’s 506(b).

If you do not have a “substantial preexisting relationship” with an investor, it’s 506(c).

David Teten: Given the current market sentiment of institutional LPs being more cautious about deploying into VC, do you expect to see an uptick in 506c offerings in the coming months?

Nik Talreja: No, I expect the contrary. I think we’ll see a decrease in the number of deal and fund managers overall, and the people who continue deploying capital will be those who have quality relationships with LPs and access to quality investment opportunities. These repeat managers tend to rely on 506(b) given their strong relationships with LPs and meaningful track records.  The quality of your relationships has become increasingly important through the down market – and I expect this will continue to be the case. 

For an aspiring manager to be successful in this environment, they have to spend more time deepening trust with LPs, sharing their decision-making process, and explaining the quality of their deal flow. 506(c) type offerings assume that low-touch LP relationships are sufficient, which is at odds with what I expect in the current environment.

David Teten: Are there any differences in the types of investors that invest into 506b offerings, versus 506c?

Nik Talreja: 506(c) offerings typically involve more participation from "retail" investors, or people who invest non-professionally. The term has been used to describe investors who aren’t well versed on an asset class, don’t have institutional relationships, and don’t have access to invite-only deals.

In this sense, 506(c) offerings cast a wide net -- there is no need for a deal sponsor to have a relationship with an LP, or vice versa -- and so a sponsor can post an offering on social media where anyone can view details and get involved, including retail investors.

David Teten: What are the consequences of unintentionally using general solicitation and failing to switch to a 506c offering?

Nik Talreja: It's always best to consult your attorney to ensure you get a full download on your particular situation, so consider the following with a grain of salt. If you generally solicit an offering that is registered under 506(b), you may lose your securities exemption under 506(b) and the result could be that:

1. Your securities are considered "unregistered" and investors may have a right to cancel or recall their investment.

2. You could be penalized and have to pay fees to regulatory authorities.

How large is this risk? Tough to say, but there are many cautionary enforcement actions. Bottom line: it's always best to consult counsel if you are thinking about raising for an SPV or fund and have questions about how you are or are not allowed to source investors.

David Teten: Is it worth avoiding 506(c)?

Nik Talreja: Ultimately, this is a matter of personal preference. 506(c) is doable if you’re willing to jump through the hoops of verifying each investor’s accreditation. It’s another step in the process, but it shouldn’t make or break an investor’s decision.

That being said, taking on LPs that you don’t personally know creates new risk – just like doing business with strangers. Whether you run a 506(b) or 506(c) process, it’s important to understand who you’re working with and connect with their LP base as much as possible in order to build a long term relationship.

Any manager who is considering raising under 506(c) should consult their legal counsel and / or fund administrator. While Sydecar doesn’t generally offer a 506(c) fund structure, it’s something that we’re actively exploring via a pilot program. To learn more, request a demo with a member of the Sydecar team today. 

The information provided in this article is for informational purposes only and should not be construed as legal advice. The content is intended to offer general guidance and insights on the topic discussed. It is not a substitute for professional legal advice tailored to your specific situation. Always consult with a qualified attorney or legal expert for advice pertaining to your individual circumstances

Further reading: 

• The JOBS Act: Did It Accomplish Its Goals?

• Fundraising hacks for VC and private equity funds (includes lists of LPs interested in emerging managers)

• 15 Steps to Fundraising for Your New Venture Capital or Private Equity Fund

• 5 Innovative Fundraising Methods for Emerging Venture Capital and Private Equity Funds

• 11 Ideas to Organize an Event Family Offices Want to Attend

• Should you give an anchor investor a stake in your fund’s management company?

• Should Small Emerging Managers Use Placement Agents?

• Limited partner checklist for evaluating funds

Navigating the complexities of tax season is a constant challenge for venture capitalists. In this comprehensive guide, we dive into important tax considerations for VCs and share how Sydecar can help you have a stress-free tax season.

VC Tax 101
The majority of VC investment vehicles (i.e. venture funds and SPVs) are pass-through vehicles, meaning that the responsibility to report gains and losses for tax purposes is passed through to the underlying investors. This setup avoids the double taxation typically seen in corporations, where income is taxed at both the corporate and the shareholder levels. The most common forms of pass-through entities used in venture capital include Limited Partnerships (LPs) and Limited Liability Companies (LLCs). All SPVs and funds formed on Sydecar are formed as LLCs.

Key Tax Components for Venture Funds
Carried interest, often a significant portion of your earnings as a fund manager, is taxed as a capital gain. A fund’s governing agreement (LPA or LLCA) outlines how carried interest is allocated to GPs and other investment team members, who are then liable for taxes on this income.

Management Fees are taxed as net income, which is the gross income from the fee minus operational expenses. These are subject to ordinary income tax rates.

Realized Gains: Both GPs and LPs pay taxes on their share of the fund's income, primarily coming from profits earned through liquidity events. The tax rate on capital gains for each partner, as reported on their Schedule K-1, varies based on how long the fund has held the investments. A common consideration here involves the three-year holding requirement for GPs to claim the more favorable long-term capital gains (LTCG) treatment. It’s best practice to consult your tax advisor if this affects you as LTCG rates can vary widely from ordinary income rates. 

Reporting Requirements: Schedule K-1
GPs and LPs use the Schedule K-1 form to report their share of the fund's profits and losses for taxation purposes. This form helps partnerships in the U.S., like venture funds, to share their taxable income with partners. The deadline for filing K-1s is March, but investors can request an extension until October 15. 

K-1s are issued by the fund administrator, often in partnership with a specialized tax firm. Sydecar handles tax filing and preparation internally, using our standardized infrastructure to automate K-1 preparation to ensure accuracy and timeliness of delivery. Check out our 2023 blog post about how we delivered K-1s to thousands of investors prior to the due date. 

"Throughout my 10 years in venture capital, I can attest to the importance of getting K-1s done right and on time.” - Gale Wilkinson, VITALIZE Venture Capital

Additional Tax Considerations for Private Investors
Private investors need to be mindful of several tax components beyond factors like carried interest and Schedule K-1 Forms. Here are some key considerations:

• Investment Clawbacks: In some cases, carried interest may be subject to clawbacks, where a fund manager must return profits if certain conditions aren't met. This can affect how carried interest is taxed, so make sure you know any clawback clauses in your fund agreement.

• Cost Basis Tracking for IPO Shares: Venture capital funds often choose to distribute portfolio companies' shares following an IPO. Investors must accurately track the cost basis of these shares, which can be complex due to the length of holding or multiple investment rounds in the company. Correct cost basis calculation is essential for accurate capital gains tax reporting, especially given the fluctuating values in venture capital.

• Qualified Small Business Stock (QSBS): Investing in certain small businesses can offer unique tax benefits. To qualify for QSBS benefits, the business must be a C corporation with assets under $50 million at stock issuance. Holding the stock for over five years can lead to excluding up to 100% of capital gains from federal taxes, subject to certain limitations.

Understanding the nuances of fund taxation is key for emerging managers because it directly impacts the financial performance and legal standing of their funds. Sydecar’s standardized approach simplifies all of this by automating back-office tasks like tax filings, cutting down the need for costly external services, and ensuring the timely preparation and delivery of Schedule K-1s. Book a demo with us to see how Sydecar can transform your fund’s back-office operations.

“VCs shine the brightest when they're investing in and supporting the best founders of tomorrow, not handling backend paperwork. That’s why I’m a huge fan of Sydecar: their platform streamlines tax prep, giving fund managers more time to focus on identifying and supporting the next generation of world-changing entrepreneurs." - David Zhou, Alchemist Accelerator

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What is co-syndication?

Co-syndicating is when two or more syndicates team up to run an SPV together, leveraging capital sourced from both of their networks. Typically, one of the managers will identify the deal, secure an allocation, and then invite another lead to share the deal with the network. The two managers will collaborate on management responsibilities, including filling the allocation and communicating with the company, and then will share economics (carry and management fees) from the deal.

Why should managers co-syndicate?

Co-syndication is especially valuable for emerging syndicate managers who are looking to grow, operationalize, and level up their business. The benefits of co-syndicating for emerging managers include the opportunity to:

1. Expand your network and collaborate with other emerging managers. Unlike traditional venture capital managers, who tend to be highly competitive with one another when it comes to winning deals, syndicate leads are often collaborative with one another. Syndicates are typically more flexible when it comes to portfolio construction and deal size, as they aren’t optimizing for ownership percentage in a company.

2. Meet new LPs from your co-syndicator’s network who may be interested in your deal flow.

3. Access a larger pool of capital, which can make it easier to win allocation into competitive financing rounds and gives you a larger upside potential.

4. Increase your deal flow and opportunity to see deals with mitigated risk, because they have already been sourced and diligence and an allocation has been secured.

5. Get upside via shared economics without having the sole responsibility of organizing a deal and filling an allocation. For a newer manager with a limited investor network, co-syndication can often be the difference between closing a deal or not.

6. Do more with less. Leverage the power of a shared network to efficiently identify deals, and diligence companies, fill allocations, and support founders.

7. Diversify your portfolio by gaining access to deals that you might not otherwise see.

8. Provide better support and more value-add to startups through the power of an extended network.

“Co-syndicating creates so much alignment of incentives and leverages the collaborative nature of early-stage, emerging syndicate managers that does not exist within traditional VC. It has also become my strongest deal flow channel, allowing me to do hundreds of deals per year through my syndicate.” - Alex Pattis, Riverside Ventures

What are some key considerations when co-syndicating a deal?

While co-syndication can be a powerful tool for emerging managers, it also requires thoughtfulness, communication, and coordination. Here are a few things to keep in mind if you’re considering co-syndicating a deal with another manager:

1. Deal Leadership: While there are benefits in managers co-owning deal responsibilities, it’s often more efficient to have one true deal manager. It can be helpful to divide up areas of responsibility; for example, choosing one manager as the main point of contact for the company to avoid any confusion.

2. Shared Economics: Typically, when a deal is co-syndicated, carried interest is share between the two managers. Make sure to align on the economic split prior to launching the deal. It may be 50/50 or the deal originator may take slightly more carry if they are more involved in sourcing and managing the deal.

3. Communication and Expectation-Setting: Maintain open and regular communication among syndicate members throughout the investment process. This includes making sure investors from each syndicate know who their main point of contact is for deal information.

4. Investor Exposure: Keep in mind that, when you invite your investor network to participate in a co-syndicated deal, you are exposing them to a new manager with unique deal flow. Make sure to communicate clearly with the deal originator about expectations for communicating with investors once the deal has closed.

5. Pro-Rata and Follow-Ons: Discuss and agree on the pro-rata rights for future investment rounds. This includes decisions on whether syndicate members will invest together in subsequent rounds and how to handle situations when one or more syndicate members choose not to follow on.

6. Distribution Preferences: Co-syndicate partners should have a mutual understanding of the exit strategy and distribution expectations, including timelines and a process for distributing cash, selling shares, or managing an IPO.

Like any collaborative undertaking, proactive communication and thoughtfulness is key to a successful co-syndication. With these best practices in mind, you’ll be able to develop ongoing relationships with other managers who become regular co-syndication partners.

In the investing world, the last decade has been characterized by a notable shift from an individualistic, self-interested approach to investing to a more communal one. New generations of investors have embraced the impact of investing alongside a community, driven by a shared purpose, camaraderie, sustainability, and trust – all of which have a demonstrated positive impact on financial returns. Since 2020, the term  “investing community” has become part of the shared lexicon as investors realize that they thrive within social ecosystems. Financial decision-making and investing rhetoric are more commonly occurring in open, inclusive spaces rather than behind closed doors. 

Several key dynamics have contributed to this shift: 

1. Digital Transformation of Investment Committees: The adoption of digital communication for investment decision-making, especially at the highest levels, has become more widespread since the onset of COVID, allowing for remote collaboration.

2. Increased competition in venture capital: The VC asset class has surged in popularity, prompting firms and individuals to look for new ways to create value and competitive advantages. 

3. Investment tooling has improved:  It used to cost $20,000 in legal fees to get a deal done. Today, both the cost and complexity of investing legal processes have significantly decreased, with new software emerging that has made it much easier to share financial upside and ultimately encourage collaboration.

   
   

What does community actually look like in an investing context?

An investing community can broadly be defined as an interconnected network of stakeholders who share a vested interest in the success of an investment or fund or the group itself. Community members can include founders, investors, employees, advisors, and even customers.  Communities focus less on ad hoc transactions and more on creating collective value. A community is meant to win and grow together. 

As communities grow, they generate a power that becomes more than the sum of its parts. Alex Pattis, GP of Riverside Ventures, believes:

“Communities create the best flywheels which can create access to the right people or companies for all sorts of business opportunities.”

In the VC ecosystem, community takes on many forms: 

Syndicates: A syndicate is a formal or informal group of investors who pool capital, resources, and insight to invest in a startup together. While some operate collectively, most are led by one or a few individuals who act as primary decision-makers. Digital platforms (like Sydecar) have also made it easier to form and manage syndicates with multiple stakeholders and shared incentives.

Zachary Ginsburg, GP of Calm Ventures, says:

“Community can take a long time to build – but, once you have it, you can move a lot quicker. At Calm, we’ve seen this momentum within our syndicate. From the outside, it may seem like it’s just me running everything – but, in reality, our community of syndicate members, including angels, VCs, operators, founders, and scouts, is the engine that allows us to invest in over 100 startups annually.” 

Founder Networks: Founder networks offer platforms for knowledge exchange, resource sharing, and potential customer leads amongst startup founders. These groups are typically formed and supported by VC firms and have become a powerful source of deal flow. They also provide an opportunity for founders to invest together in other startups. Notably, alumni networks from major tech companies like Airbnb, Google, and Coinbase have transformed into active founder networks, investing in startups launched by former employees.

Alex Pattis loves these communities:

“I’ve seen the Airbnb, Uber, Lyft, and Google alumni syndicates deploy meaningful capital into their ex-employees’ new companies. Startups love having these communities on their cap table given the relevant operating backgrounds and unique access of the members. It’s a true win-win.”

Online Forums & Social Media: Increasingly, investors and founders are taking conversations to Twitter, LinkedIn, and specialized forums to source deals, discuss strategies, and gain insights. Some of these groups are rallied together by a syndicate lead or fund, but others form more naturally to later join forces as a syndicate or fund. 

Hustle Fund’s Angel Squad is a great example. Zachary Ginburg notes:

“Angel Squad has done a great job of establishing a large group of accredited investors with shared goals. I’ve seen others try to build national angel groups in the past, but Hustle Fund seems to have succeeded by putting the community first and continually engaging them via education, networking, and deal flow access.”

Brian Nichols, Co-Founder of Angel Squad, notes:

“The best part of our approach is that the community extends outside of just the angel members to our portfolio companies as well. Angels have an opportunity to get in the weeds with portfolio companies in meaningful ways. As an example, one of our angels who works at Nike connected a portfolio company that they invested into the right team at Nike, which became that startup's biggest contract in company history.”

Incubators/Accelerators: These groups serve as vibrant mini-ecosystems, offering startups not only capital but also a supportive community of fellow entrepreneurs, mentors, and alumni. Y Combinator stands out as a prime example, fostering an active and interconnected network of founders. 

Community is a Competitive Advantage 

The value of community in VC cannot be overstated. In a competitive and rapidly evolving landscape, an authentic community can differentiate and strengthen an investment strategy and provide a network ripe for support and collaboration.

However, establishing a community isn’t as simple as bringing together a group of individuals with shared interests or goals. The term community is often used to describe a large social following or group of newsletter subscribers. In reality, these groups are more likely audiences. Importantly, a community involves two-way interactions and mutual engagement, whereas an audience typically engages in a one-directional manner with the leader. For example, a newsletter would be considered an audience because the subscribers cannot communicate with each other. A founder network hosted in Slack would be considered a community because the members are able to (and encouraged) to communicate with each other.

Zach Ginsburg has experience with both. In reflecting on the process of building up the following for his newsletter, Last Money In, Zach notes:

"Part of building an audience is delivering consistent value and transparency. The shift from audience to community comes from engagement, which could come from real-life events or Slack groups. Creating opportunities for two-way interactions is key in transforming an audience into a community.”

The line between audience and community is often blurred, with many groups embodying elements of both. Newsletters often extend their reach by creating Slack groups for subscribers to connect. Similarly, venture capital firms may lead founder networks, periodically engaging members through updates and newsletters. The key distinction lies in the nature of interaction: communities foster mutual engagement among all members, while audiences primarily interact with the leader.

An audience, if well taken care of, can become a community. And a community, if neglected, may slip back into an audience.

Brad Jenkins, Co-Founder and CEO of Seed Round Capital agrees:

“The difference between a community and an email list is consistent two-way engagement. If community members don’t have a way to interact with you or their fellow members, it’s not going to be as rewarding.”

Communities, inherently more complex and powerful, have the potential to become self-sustaining, growing organically through member interaction. Conversely, the vibrancy of an audience depends solely on the leader's activities. However, an audience, particularly in the form of an extensive email list or social media following, can still offer substantial benefits, especially to investors.

Julie Weber, GP of The Helm, notes:

“Investing alongside a community can also feel more impactful; where one small check may not feel like it moves the needle when capital is pooled, a little can turn into a lot very quickly. It’s exciting to feel part of something bigger and to know that you’re investing alongside others whose values are aligned with your own. Additionally, depending on the round dynamics, many founders won’t take small angel checks, so investing as part of a community provides access to sought-after investment opportunities that wouldn’t otherwise exist for angels.”

How do investors effectively foster community?

For investors aiming to cultivate a sense of community, the journey begins with fostering interconnectedness and encouraging active participation. A syndicate, initially a list of individual investors receiving deal memos, can evolve into a community through events, forums, and facilitated connections. No single step can make an audience a community, but a consistent effort to encourage interconnectedness will push things in the right direction.

As Jason Burke, Co-Founder of All Stage, explains:

“Successful communities are about give and take. Like any relationship, the communities are ones in which the value exchange is bi-directional. Encourage everyone in the community to contribute and engage.”

Hearing about Paige Finn Doherty’s path into VC is like getting a masterclass on building a track record. What is perhaps most inspiring about Paige’s story is that she never once waited for permission; time after time, she took initiative based on the path she envisioned for herself. 

We recently sat down with Paige to learn more about what was going on behind the scenes as she grew her Twitter following from 300 to 30k, published a children’s book, and raised over $10M to invest into startups. Aspiring angel investors, syndicate leads, and fund managers can learn from Paige’s story what it really takes to build trust, credibility, and a personal brand online.

Building community through writing

If there is one throughline to Paige’s journey as an investor, it’s community. As a 2020 college graduate, Paige was forced to navigate a tricky post-grad landscape and fell back on the community she built at San Diego State University to help guide her. In her first post-grad job at an early-stage startup, she missed the sense of community that she’d enjoyed so much in the SDSU entrepreneurship program. Since it was the peak of the pandemic, Paige, like so many others, turned to the internet. She reignited her personal blog and started publishing pieces like “How to Land Your Dream Job” as well as a virtual workshop on cold outreach. Through this work, she began connecting with like-minded individuals from across the world. 

“Writing online is like a tuning fork. You put an idea out and see who it resonates with.” 

Entrance into VC

As Paige continued sharing her work with peers and through Twitter, she started to feel tuned in a specific direction. Having studied entrepreneurship at SDSU and subsequently gone through On Deck’s Angel Investing program, she was pulled towards working with startups. After binge-watching Silicon Valley, Paige knew she had to find a way to experience the world of venture capital for herself. Frustrated by the lack of simple explanations of VC, she started writing Seed to Harvest, a children's book about venture capital. Coming to the industry as a beginner herself, Paige felt like she was well-equipped to educate her community about this complex, opaque topic.

The conversations she had while writing the book, along with her education, gave Paige a wealth of knowledge about the VC industry. And then, the magic moment: Paige discovered that she could start investing herself despite being an unaccredited investor. While you have to be accredited in order to invest in venture funds, you don’t meet any income, wealth, or certification thresholds in order to organize a venture fund or SPV. In fact, by organizing an investment vehicle, you actually become accredited for the purposes of investing in that vehicle.

Paige navigated countless hurdles when setting up her first few SPVs. The further she dug into the legal framework of SPVs, the more questions she had – questions that she couldn’t find answers to while working with legacy SPV administrators. Should I charge a management fee? How much? Am I even legally allowed to charge a management fee? 

Are you a syndicate lead who has asked yourself these questions? Sydecar is here to help – check out our article on Management Fees and peruse the rest of our Learning Center.

Sourcing your first deal and getting allocation

Paige’s first syndicate investment was into a company called Pallet which builds infrastructure to manage job boards. At the time, she was writing Seed to Harvest and using Twitter as a way to meet people to interview for the book. The founder of Pallet reached out to learn more about Paige’s approach to content and community, but Paige had something else in mind:

“I remember hearing Kai outline his vision for Pallet and having this overwhelming sense of conviction. As soon as we got off the call, I was like: “Hey, I'd love to have like a $50K allocation in your pre-seed round.” He told me he’d have to check with his other investors because the round was oversubscribed, but they ended up letting me in. And then, I realized that I had $50K in allocation and probably like a grand in my bank account.” 

Filling your first allocation

At that point, Paige had built up a small following on Twitter and decided to get scrappy. She understood that she couldn’t post about the allocation publicly, so targeted people who were “mutuals” and drafted short, personalized blurbs telling about the opportunity to invest in Pallet.

“I've always valued the art of very personalized cold outreach at scale in tandem with building an online audience. And it's a skill that I used to raise $60K from 17 investors in two weeks. Ultimately, that skill translated into a lot of the tactics that I used to raise our first fund, which was five million dollars. Of our 120 fund investors, a lot of those relationships originated from Twitter, including folks like Andy Weissman from USV, Heather Hartnett from Human Ventures, and Jenny Lefcourt from Freestyle.”

Building trust in public 

There was no playbook for Paige to follow as she set out to build an audience online and translate that audience into an investor community. Rather than navigate the challenges she faced alone, she chose to share her journey at each step of the way. By doing so, she was able to crowdsource crucial information about setting up her first few SPVs – but later on, she realized that sharing her journey publicly had a larger impact as well. As she shared her challenges and successes publicly, her followers started to learn how she thinks and makes crucial decisions. They started to trust her, without even knowing her personally. She started to build trust at scale.

“I was pretty shameless when I started. I found people who followed me on Twitter, which constitutes an existing relationship, so I could legally reach out to them. I’d tell them about the opportunity, what I liked about it, and maybe some of the co-investors. The conversion rates were pretty high because I had spent time building trust with people in public. Even if they didn’t know me personally, they had built trust by following me online.”

Building a track record: from SPVs to a fund 

When Paige set out to raise her first SPV, $50K felt like an infinite amount of money. Just one year later, she found herself closing a $5M fund, more money than she had ever conceived of. And yet, she still had people telling her that she should raise more. Telling her that $5M wasn’t enough capital to implement a successful investing strategy. 

As she reflects on what allowed her to build a track record (while she was a new college grad in a moderately paid startup job), Paige is grateful for her conviction and passion. Without that, she might not have chosen to muscle her way through the fundraising process for what feels like a relatively small amount of money today. 

“Knowing what I know now, raising a $60K syndicate from 17 investors is an insane amount of overhead.”

Many managers would argue that syndicating a deal with this investor-to-capital ratio is more trouble than it’s worth. Considering how much harder capital is to come by today compared to 2021 (when Paige was raising her first SPV), it’s easy to feel cynical about the opportunity for those without traditional experience, network, or access to capital to build a track record. Paige herself admits that she no longer syndicates many deals, preferring to deploy the readily available capital out of her fund. 

However, all hope is not lost for aspiring syndicate or fund managers. Young startup operators can be some of the most valuable capital allocators. Having your boots on the ground in the startup ecosystem creates a valuable network from which to source deals, diligence companies collectively, raise capital, and, perhaps most importantly, provide hands-on support to founding teams. You just need to have the right combination of resourcefulness, shamelessness, and conviction.

“I think there's still an opportunity there for people who are willing to go against what I know now, which is that syndicating deals requires a lot of work. But it got my foot in the door. And, if I could go back and do it again, I’d do it every time.”

The good news: the tools available to syndicate smaller deals have evolved significantly over the past few years. Sydecar was built to provide a flexible on-ramp to capital allocators who, like Paige, have incredible value to provide to founders and to the startup ecosystem as a whole. If you’re thinking about pursuing this path, look for an admin partner who can support your growth from syndicating your first deal to raising a committed capital fund. Sydecar is here to help.

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Looking to syndicate your first deal but don’t know where to start? Learn more about our Syndicate product and get in touch today.

Co-investment strategies have gained popularity over the past several years. Co-investing allows LPs to back individual deals alongside fund managers rather than (or in addition to) committing to a blind pool fund. Emerging managers often use co-investments as a way to build relationships with and create value for prospective fund LPs. High-net-worth individuals and family offices, who often back emerging managers as LPs, are particularly drawn towards co-investment opportunities given that they tend to prioritize customized and relationship-based investing more than institutional investments. Co-investment strategies are particularly attractive to investors during periods of macroeconomic volatility because it allows them to deploy capital more slowly and with more control. 

We recently hosted an office hours session with Coolwater Capital to discuss the value a co-investment strategy can play for emerging fund managers. The conversation was full of rich insights and tactical takeaways, so we’re sharing an overview along with the full recording with our community. If you’re an emerging manager or syndicate lead who’s looking to expand your investor base and strengthen relationships with LPs, this is for you.

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Coolwater Capital is an educational community and fund-of-funds for emerging managers. Since launching in 2021, they have:

• $1.5B raised across cohort funds

• 298 LP-led themed modules

• 924 1:1 value-added intros made

• 41 in-person events hosted since 2022

• 62% funds with diverse GPs across 159 funds

• 3600+ portfolio companies across funds pre-cohort

• 2500+ portfolio companies targeted across funds by 2025

• 83 NPS score rated by GPs

Sydecar and Coolwater have partnered to provide emerging fund managers with the full-stack resources they need to launch and manage their investment business while setting the foundation for an enduring firm past Fund I. 

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Co-Investing as a Competitive Advantage

Key takeaways:

• Co-investment has distinct benefits for managers, LPs, and founders

• Managers can deploy more (and increase their upside) into deals they love

• Managers can split economics with other funds or syndicates to align incentives

• Potential LPs can get deal-by-deal access before committing to the fund

• LPs who are already in the fund can increase their exposure to exciting deals

• Managers can increase their value-add to founders and win more deals if they can deploy larger checks through a co-investment network 

• Co-investments can give founders access to additional value-add angels that may not be able to meet fund minimums 

Should co-investment opportunities only be offered to fund LPs?

• Up to the manager to decide how to leverage the opportunity.

• Can be used as a way to build trust with potential future LPs.

• Can also be used as an exclusive benefit of being in the fund.

• A hybrid solution is to offer different terms for different participants. For example, LPs in the fund could pay 10% carry while potential future LPs could pay 20%.

How can managers avoid making one-off SPV investments feel transactional?

• Be intentional with your outreach and positioning. Approach LPs with investments that you believe will be especially valuable and relevant to their strategy.

• If you’re investing out of your fund and using a co-investment SPV to top off allocation, the conviction is clear.

• If you’re not also investing out of a fund, be active and transparent in your communication. 

“Present the deal as an opportunity, not a sales pitch. If you’re excited about a deal but can only fill part of your allocation because of your fund size and mandate, give investors an opportunity to increase their exposure as though it is a gift. There’s immediate alignment if you’re already putting in money from the fund, which can make it feel less transaction.”

- Zander Rafael, Founder and GP of Spring Tide Capital, who has deployed over $100M through 20 SPVs

If you are able to fill your allocation through co-investment, how do you manage the risk of coming up short?

• One of the biggest challenges of syndicating capital is managing founder expectations. Underpromise and overdeliver.

• Know your LPs. The better you know them, the easier it will be to estimate how much you can raise in early conversations with the founder. 

• Build a process to gauge interest from investors and calibrate it over time.

• Founders will have more patience for your process when markets are slow vs. hot. 

“It’s much better if you try to come back and ask for a bit more than to have to go back to the founder and tell them you couldn't fill it. You want to start to get a window that you can share with the founder, which should be a conservative estimate. The more you do it, the more opportunity you’ll have to calibrate and refine your process.”

-Rob Lusk, Head of Partnerships at Sydecar

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Want to dive in further? Listen to the full recording of the office hours session here: https://youtu.be/Tx5uYat7uBE.

The past several years have brought significant evolution for the venture capital industry, from updated regulatory frameworks, the explosion of venture capital, and a decades-long bull market followed by a meaningful downturn. Now, even more changes are afoot — this time, in the form of regulatory shifts. In what has been called the biggest rule-making event in venture capital (VC) since Dodd-Frank, the SEC recently passed a series of rules that have significant implications for any private fund managers, including venture capitalists. 

The five new rules passed by the SEC cover a range of issues under the Advisers Act. This Act, which was passed in 1940, regulates anyone who receives compensation for advising others on buying or selling securities. The law requires all advisers (GPs) to either register with the SEC, making them a Registered Investment Adviser (RIA), or qualify for an exemption. One avenue for exemption is by qualifying as an Exempt Reporting Adviser (ERA), which is the path taken by most VCs. As an ERA, you can pursue a venture capital strategy (meaning that 80% of your investments are made directly into private companies) and raise capital from accredited investors while avoiding formal registration with the SEC. Instead, ERAs file a truncated Form ADV. 

An overview of the rules

Keep in mind that these rules have changed slightly from the proposed versions that we highlighted in our Sydeletter on August 22, 2023. Overall, most of the rules were adjusted to restrict certain behaviors rather than prohibit them altogether.

Out of the five rules that were passed, two directly impact ERAs, while the rest will only impact RIAs. The rules that are most relevant for VCs who are registered as ERAs are: 

Advisers (GPs) are prohibited from offering preferential redemption or information rights to a subset of investors unless such rights are offered to all investors at the same time. Any preferential treatment relating to material economic terms offered to a subset of investors (e.g. via side letters) must be disclosed to all current and prospective fund investors (Rule 211(h)(2)-3).

Advisers who engage in certain sales practices, conflicts of interest, and compensation schemes must disclose (and get consent for certain activities) from all fund investors (Rule 211(h)(2)-1). Those restricted practices include: 

• Non-Pro Rata Fee & Expense Allocations: Generally, advisers cannot charge fees related to a portfolio investment on a non-pro rata basis when multiple funds managed by the adviser are participating – unless the adviser distributes advance written notice of the charge with a description of how the allocation approach is fair and equitable under the circumstances.

  • E.g., if your primary fund is investing in a company and you’re also launching an SPV for co-investors, you will have to share legal and other expenses that benefit the fund and SPV pro rata across both vehicles.

• Certain Regulatory Fees & Expenses: Advisers are prohibited from expensing fees to the fund that are associated with any regulatory, examination, or compliance fees related to the adviser unless the fees are disclosed in advance. Expensing fees to the fund that are associated with an investigation of the adviser is prohibited unless there is written disclosure to and consent from all investors. If an investigation results in adviser sanctions, the adviser may not expense such investigation fees.

  • E.g., you cannot expense fees for your annual Form ADV filing to your primary fund or SPVs, as this is an expense that benefits you as the adviser to these entities rather than the fund or SPVs directly.

• Reducing Clawbacks for Taxes: Advisers are prohibited from reducing the amount of a clawback obligation by actual, potential, or hypothetical taxes applicable to the adviser unless they disclose the pre-tax and post-tax amount to investors within 45 days of the end of the fiscal quarter.

  • E.g., if your fund has an American waterfall and, at the end of the fund, you determine that received more carry than you should have – because earlier liquidity events were more successful than later ones and you received more carry across all investments than what you agreed to receive – then when your excess carry is “clawed back”, you can no longer reduce the amount you give back to the fund by taxes you paid on the earlier pay–outs without appropriate disclosure. 

• Borrowing: Advisers are prohibited from borrowing money, securities, or other fund assets, or receiving a loan or an extension of credit from a fund unless they provide written notice of the borrowing terms and obtain consent from a majority of the fund’s investors.

The three additional rules are specific to RIAs: 

• 211(h)(2)-2: Fairness opinion or valuation opinion are now required for private fund adviser-led secondary transactions.

• 206(4)-10: A mandatory audit of private fund financial statements to, among other things, serve as a check against misappropriation of assets and calculation of adviser fees is now required. 

• 211(h)(1)-2: RIAs must deliver fund quarterly statements with certain specific information, including uniformity in fee presentation. 

The intention of the rules is clear: to increase the level of transparency between fund managers (GPs) and their investors (LPs). If you are at all familiar with the lengthy document called the Limited Partnership Agreement, or LPA, that is signed by all investors in a fund, you might be surprised to hear that the SEC feels like there isn’t enough transparency between GPs and LPs. LPAs are typically several hundred pages long and include a huge number of requirements and disclosures between the two parties. The document limits everything from what the GP can invest in, how long they can invest for, and even how they spend their time outside of investing. However, given that venture capital is still, relatively, a cottage industry, there is a lot of grey area around what is or is not allowed. Because most venture capital investors benefit from the Venture Capital Exemption and are considered Exempt Reporting Advisers, they have relatively limited compliance or regulatory obligations to the SEC or to their investors (outside of what is explicitly laid out in their LPA). This gives VCs, who operate in an industry that moves quickly and is largely based on relationships, a fair bit of flexibility with how they operate their businesses. 

As an example: there is a long history of GPs negotiation special LP arrangements outside of their LPA through side letters (or secondary agreements used to create bespoke terms between two parties). The primary purpose of a side letter is to give an investor (either a VC or LP) some special or additional rights that are not granted to all of the other investors involved in a transaction. In almost all cases, these additional rights are advantageous to the investor. Venture fund managers use side letters to grant preferable terms to specific investors, oftentimes in order to secure their anchor or an otherwise large or strategic investor. Under most LPAs, the fund manager is not required to disclose any side letters to their other investors. 

Organizations like the Institutional Limited Partner Association (ILPA) have expressed their support for these rules, highlighting that additional regulation would help to level the playing field for all parties and ultimately increase the efficiency of private markets. They also point out that close to 97% of LPAs are initially drafted by the GP’s external counsel, and that the terms have become increasingly GP-friendly, especially with the consolidation of law firms leveraged by VC firms. Given that a fund investment is typically a 10+ year commitment, having terms that align the interests of GPs and LPs is crucial to a healthy ecosystem. 

Additional scrutiny of private markets can be attributed to the increase in private market participation over the past few years. In the past five years alone, there has been an 80% increase in the gross assets of private funds. Despite popular narratives, this growth has not been significantly hindered by the current market downturn: private markets are expected to hit $13 trillion by 2027. As attorney Chris Harvey points out: 

“Several years ago, private markets started outpacing public markets in terms of financing volume for private deals. Even with a down market in 2023, private markets still eclipse public markets in terms of total amount raised for equity financing. In fact, just the private funds industry alone has eclipsed the U.S. banking industry since 2021.”

What does this mean for emerging fund managers?

Many VCs are discouraged, rightfully so, by the push for tighter regulation; meanwhile, proposed rules that could decrease barriers for fund managers (like increasing investor limits or granting accredited investor status via a knowledge-based test) have fallen by the wayside.

However, don't despair just yet. Because emerging managers are already starting with limited leverage and bargaining power, these changes may have less of an impact if you are raising your first fund versus your fourth, fifth, or tenth. The biggest hit will likely be to mega funds, many of which have existed on the cusp between true VC funds and private funds for years. Funds like Andreessen, Bessemer, and Sequoia became Registered Investment Advisers over the past few years, largely driven by the desire to invest more into non-VC-qualifying assets like crypto, secondaries, and public companies during the bull market.

Maybe it’s not all bad 

The increased scrutiny isn't necessarily bad for emerging managers. The lack of clear guidance for early-stage VC leaves a lot of ambiguity over questions like how management fees can be charged or what constitutes a reasonable amount. SEC guidelines might prove to be a valuable compass for new entrants looking to better understand how to negotiate with LPs. Such rules could help answer questions and prevent abuses, creating safe harbors for legitimate activities. Good business can thrive in a clearer landscape.

And, in the meantime, if you’re looking for guidance on standard fees, check out our recently published report on Standard Terms for Emerging Managers.

What’s next? 

Now that the rules have been passed, the SEC will move forward to publish the final versions in the Federal Register. The date for this publication is still to be determined. Once the final rules are published, the clock will start on a 12-month period for advisers with >$1.5B AUM or an 18-month period for advisers with <$1.5B AUM, which will dictate the applicable compliance date. RIAs have two months to comply with the "Compliance Rule Amendments," which require a written annual review of their compliance policies. TDLR: VCs and other private advisers will not have to comply with these rules until late 2024 or early 2025. 

Importantly, the SEC is also providing legacy status for existing vehicles, meaning that any governing agreements (such as LPAs or side letters) that are executed prior to the compliance date will not be expected to comply with the Preferential Treatment or Restricted Activities Rules.

—

Continued reading:

• From the horse’s mouth: check out the SEC’s own press release about the passage of the new rules. 

• It’s no surprise that the Institutional Limited Partners Association (ILPA) is in favor of the rules. Read their statement and check out the helpful chart on Page 6 of their report.

• What does this mean for emerging VC fund managers? Hear what Nik Talreja, CEO of Sydecar, has to say.

• Emerging Fund Lawyer Chris Harvey breaks down what the rules mean and where the biggest impact will be felt.

• A group of VC, PE, and hedge funds are threatening a lawsuit against the SEC. Among them is VC darling Andreessen Horowitz. Read more about their complaints here, and check out a16z’s specific comments on the SEC’s website.

• The Wall Street Journal calls the proposed rules a complete “overhaul.”

Venture capital (VC) is more than financial backing; it is a lifeline for many venture-backed startups. The rocket fuel propels novel ideas from concepts into tangible, market-altering realities. Yet, to differentiate their firms from the competition, venture capitalists know their role extends beyond writing a check—it involves providing strategic counsel, opening doors, and mentoring entrepreneurs.

Above all, it encompasses building meaningful, enduring relationships with the startups they back. 

We have collaborated with the relationship-building CRM, 4Degrees, to discuss the essentials of building stronger relationships with startups. This comprehensive guide explores how VCs can foster more robust relationships with startups, enhancing their investment outcomes and strengthening the broader entrepreneurial ecosystem and the success of their portfolio companies. 

The Role of a Venture Capitalist

As a VC investor, your role goes beyond investing. You are responsible for assessing and managing risk, providing advice, and offering introductions and networking opportunities. You are a partner on the startup's journey, helping it navigate the complex landscape and achieve its ambitious objectives.

Providing value beyond capital involves leveraging your experience, industry connections, and your firm's institutional resources to support the startup. The goal is to position yourself as more than an investor—you are a valuable partner contributing to the startup's growth and success in multiple, far-reaching ways, from helping entrepreneurs find talent or close key deals to providing them with hands-on operational support. 

Strategies for Communicating With Startups

The best investors communicate openly with their startups, creating a positive relationship built upon respect and mutual growth. These relationships require an ongoing commitment and purposeful strategies, such as:

Empowering and Respecting Autonomy: Despite providing guidance and advice, respecting the founders' autonomy is crucial. They are the visionaries driving the enterprise; your role is to support their vision, not supersede it.

Building Trust and Transparency: Trust forms the bedrock of any relationship. You can build and maintain trust with the founding team by demonstrating honesty, transparency, and consistency in your actions.

Understanding and Navigating Conflicts: Conflicts will inevitably arise. The key is recognizing potential issues early, understanding where people are coming from, and handling disagreements constructively.

Assisting Startups Beyond Capital Investment

The monetary investment is just the tip of the iceberg regarding how venture capitalists support startups. Nowadays, VCs are expected to provide additional value. Strategic guidance, networking opportunities, and mentorship are critical aspects. 

Strategic Guidance: You have deep industry knowledge and experience as a VC, which allows you to provide strategic guidance on market trends, competitive landscape, and growth strategies, helping founders refine their business models, identify target markets, and make informed decisions regarding product development, pricing, distribution, and many other areas. Identify your expertise as this is where you can be the most helpful.

Network and Connections: You have extensive networks of industry experts, potential customers, partners, and other investors that founders need. You can also leverage your firm's network to assist with talent acquisition, helping founders identify and recruit key team members. Using a relationship intelligence platform will allow you to keep tabs on your network so you always have a connection ready. 

Fundraising and Investor Relations: You have expertise in fundraising and can guide in navigating subsequent funding rounds, for example, introducing founders to potential new investors, helping them refine their pitch, preparing for due diligence, etc. Your team may advise on valuation, term sheet negotiation, and structuring deals, areas most first-time founders are unfamiliar with. Additionally, you can assist with investor relations and help founders navigate interactions with existing and prospective investors.

While these are all helpful to a founder, VCs must remember to guide with the company’s best interests in mind and trust the founder’s instincts to avoid overstepping.

Common Pitfalls and How to Avoid Them

Unfortunately, potential pitfalls can strain VC-startup relationships. These issues often include:

Misaligned Expectations: This is perhaps the most common pitfall. Startups might expect more hands-on help from their VC partners than they are willing or able to provide.

Poor Communication: Both parties need to maintain open and transparent lines of communication. If either party feels left in the dark or is surprised by decisions or changes, it can create tension and trust issues.

Lack of Transparency: This can be about finances, company status, or plans. Lack of clarity can breed mistrust, lead to surprises down the line, and damage the relationship significantly.

Overbearing VCs: Sometimes, VCs overstep their bounds and try to exert too much control over the startup, which can lead to conflict. While VCs certainly have a stake and a say in the business, they need to respect the founders' roles as company operators.

Poor Cultural Fit: A VC and a startup need to have compatible cultures for a successful relationship. If the VC's approach is fundamentally at odds with the startup's culture, it can lead to misunderstandings and disagreements.

Early identification and proactive management of these issues are essential to preserving the relationship's health. Regular check-ins, establishing clear communication protocols, and respecting each party's roles can avert these problems from escalating.

Long-term Relationship Management with Startups

Managing long-term relationships with startups involves continuous engagement, support, and communication. It's not about occasional check-ins; it's about being a part of the startup's narrative, sharing in its triumphs and setbacks. It's also about forward-thinking, encompassing discussions about future milestones, exit strategies, etc.

To simultaneously manage your relationships with multiple startups and provide them with high-value mentorship and introductions, your network must work for you while ensuring nothing falls through the cracks. 

Successful VCs have introduced relationship intelligence CRM platforms such as 4Degrees to ensure they make proper introductions and provide the most value to their portfolio companies while maintaining a robust deal pipeline.

There are endless nuances and parameters involved in setting up and managing a venture fund. While often funds have custom provisions or side letters that cater to the needs or preferences of the GP and LPs, certain key terms tend to be similar across funds of similar sizes. Emerging fund managers, who are typically raising from entrepreneurs, high-net worth individuals, and family offices, should be aware of the standard terms that these types of LPs expect to see reflected in a fund’s controlling documents (i.e. LPA or LLCA). Understanding these standard terms will create efficiency for emerging fund managers as they establish their fund documents and structure.

Let's review industry standard terms and trends that fund managers need to know when fundraising.

Standard Fund Terms for Emerging Fund Managers

For the purpose of this article, we’ll define emerging fund managers as those who are managing their first, second, or third venture fund with a fund size under $30M. Based on our research, these funds share the following standard terms:

• Management Fees: 2% or 2.5%

• Carried Interest: 20%

• Hurdle: None

• Investment Period: 2-3 years

• Term of Fund: 10 years

• GP Commitment: ~1%

As mentioned, high net-worth individuals and family offices will largely be familiar with these standard terms, so it is often in the best interest of the fund to adhere to these standards. However, institutional investors such as pension funds, sovereign wealth funds, or foundations may have special requests for the fund’s terms, such as customized management fees or carry. In these cases, fund managers will create side letters to reflect the custom provisions.

Fund Terms Trends for Emerging Fund Managers.

While the industry standard is a helpful starting point, emerging fund managers should also pay attention to trends in fund terms. Since emerging managers tend to have a higher risk tolerance, move faster, and achieve higher returns on investments, investors and fund managers may negotiate terms that deviate from the standard if they allow the fund to execute more effectively on their specific strategy. The most common variations we’ve observed for emerging fund managers pertain to management fees, co-investment, hurdle rate, and warehousing.

Front-loading Management Fees

Typically, the management company charges a 2% annual fee to the fund to cover management services, office, salaries, and other operational expenses. However, emerging fund managers may front-load management fees by increasing the management fee during the investment period (typically the first 2-3 years) and then decreasing it in the post-investment period when the fund focuses on monitoring deals. For example, during the investment period, the management fee could be between 3%-4%. Post-investment period, the fee might be down to 0.5%.

This practice is common for first-time fund managers. Since management fees are proportional to the fund size, first-time fund managers tend to receive less than established fund managers do. Front-loading the management fees allows emerging fund managers to have the capital they need to get started and pay themselves a salary prior to receiving a return (in the form of carried interest) from their investments. Front-loading management fees allows those who do not come from generational wealth to become VCs while still making a living.

Recycled Management Fees

Management fee recycling is a tactic used by fund managers to maximize returns. Since management fees reduce the amount of capital the fund can deploy, fund managers may “recycle”, or re-invest, a portion of the returned proceeds. Recycling gives fund managers more capital to deploy, thereby increasing the amount invested and potential returns to investors. 

Hurdle Rate

In VC, the hurdle rate is the minimum rate of return before the fund manager receives carried interest. The hurdle rate can align incentives so that fund managers aim to overperform.

Typically, fund managers can expect their performance compensation in the form of 20% carried interest with no hurdle rate. 

However, first-time fund managers looking to demonstrate their ability may agree to a hurdle that gives them higher carried interest once the net multiple is above a certain return threshold. For example, if a $10M sets a 2x hurdle rate, the fund would have to return $20M to investors before the manager receives carried interest. 

Co-Investments

Emerging fund managers aim to access the best deals, which may require raising additional money to meet check minimums on occasion. In order to bolster the average check size out of their fund, some managers turn to co-investing. Co-investing allows fund managers to raise capital alongside their funds. Fund managers will set up a co-investment SPV that allows for investment from investors, whether they are investors in the fund itself or not.

Co-investing benefits all parties involved. Investors in the fund enjoy capturing more allocation in companies they love. Additional investors access deals without committing to the fund and build familiarity with the fund manager’s investment style for future opportunities. Fund managers secure deals they otherwise could not access.

Given the increasing popularity of co-investing, Sydecar’s Fund+ product supports this seamlessly. You can read more about how we structure co-investments here.

Warehousing

Before raising a fund, emerging fund managers use syndicates or angel checks to build their track records. For some investors, their existing portfolio is very attractive to potential investors. When this is the case, investors might negotiate warehousing terms.

Warehousing allows emerging investors to “store” or transfer investments that occur before the fund is set up. The investors then acquire an investment interest in these deals. Often, warehousing allows investors to participate in marked-up deals from the fund manager’s portfolio at lower valuations. Through these deals, investors can de-risk the fund. Beyond just seeing the fund manager’s track record, they take part in it.

Summary

The terms that govern your fund are no small matter. Fund terms will impact its whole strategy, including capital deployed, the target rate of return, and deal allocation. While it may be tempting, and ultimately recommended, to stick with the industry standard terms, there may be cases where custom provisions are helpful, especially if you are an emerging fund manager.

Organizing an investing syndicate is the ultimate test of coordination at scale. On top of all the work of finding new investors, managing existing ones, and coordinating their commitments, syndicate leads also have to identify the best deals and negotiate their allocation. 

We’ve teamed up with AngelSchool.vc to create the ultimate syndicate tech stack. AngelSchool.vc gives angel investors everything they need to launch and scale their own syndicate. 

The platforms, providers, and systems you use to run your syndicate can make a world of difference. Hours of collecting signatures becomes sending one link. Days of sending out K-1s becomes an automated process. Removing repetitive and cumbersome tasks allows investors to focus on what matters: analyzing deals and building relationships. 

As you start to build your syndicate tech stack, you should consider the following: 

The size of your syndicate

Communicating with a group of 20 investors is very different from 200. While a smaller group can be handled by a simple document or email list, 200+ investors will likely require a contact management tool that allows you to filter, sort, and view your group in various arrangements. 

User experience

An intuitive interface will not only make your life easier. For any tool that you need to have your LPs use, you want to make sure they have a great experience. This will make you look good and make you the syndicate they will come back to. Consider what the experience is like on both your side and theirs. 

Plans for scale

While you may be concerned with the most budget-friendly option when your syndicate is small, you should look for tools that can grow with your community. Many software tools have variable pricing tiers based on size or usage, which gives you the flexibility to expand functionality as your budget increases. On the flip side, if you plan to keep your syndicate relatively small, you may be okay with the cost efficient option. 

Marketing

• LinkedIn

• Beehiiv

• Medium

Investor Relationship Management

• MailerLite

• Affinity

• Airtable

Dealflow and Diligence

• Crunchbase

• SeedScout

• Twitter

Portfolio Management

• Visible VC

• Pulley

Deal Execution

• Traditional Fund Admin: Standish Fund Management, Vector AIS, Juniper Square

• Tech-enabled funds and SPVs: Sydecar 

Education

• AngelSchool.vc 

• Venture Deals

• OpenLP

Thank you to AngelSchool.vc for teaming up on this toolbox! AngelSchool.vc is a Fellowship program dedicated to helping Angel Investors build their own syndicates. We equip Program Fellows with a syndicate blueprint in just 8 weeks. After that, they’re invited to our Investment Committee (IC) to gain real deal experience and earn carried interest. Apply to our next cohort.

Angel School’s syndicate is backed by 1000+ LPs and deploys $MNs annually. Subscribe here for access to our exclusive dealflow.

We’re teaming up with our friends at Junto Law to publish a three-part series on legal (and non-legal) aspects of starting (and running) a venture capital fund. Junto Law supports emerging founders and funders as they form, fund, and scale their ventures. They offer fixed-fee packages and courses that promote communication, efficiency, and transparency. Junto allows you to spend your time growing your business instead of worrying about the bill.

You can read our first post on the  common structures and players, and our second on the key economic and non-economic terms for venture capital funds.

In this post, we will focus on the legal and regulatory aspects of raising and running a venture fund, specifically, the compliance obligations and regulations that impact a VC.

The Securities Act of 1933

The Securities Act of 1933 (the “Securities Act”) governs the offer and sale of securities by the fund to LPs.

Under the Securities Act, “securities” means “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”

The SEC has used “investment contracts” to include a broad range of assets, contracts, instruments, and relationships as securities. Given this definition, an offer and sale of interests in a fund should be considered an offer and sale of securities. 

In order to properly offer and sell securities under the Act, the fund (also known as the “issuer”) must do so under a valid registration statement or pursuant to an exemption from registration. 

Given the regulatory and administrative requirements, registering fund interests is not practicable, so they are offered and sold through the exemptions offered by Reg D–commonly under Rule 506(b) and Rule 506(c). 

Rule 506(b)

Rule 506(b) allows a VC to raise capital from an unlimited number of accredited investors and up to 35 non-accredited investors (more on this later).

Generally, a non-accredited investor must be a sophisticated investor who can evaluate the economic risks and merits of the proposed offering.

What is an Accredited Investor?

The SEC summarizes the definition of an “accredited investors” as:

One of the benefits of Rule 506(b) is the streamlined process of validating an LPs status as an accredited investor.

Under Rule 506(b), an issuer must reasonably believe an LP is an accredited investor, which it often satisfies by conditioning a subscription on receiving an investor suitability questionnaire with a “check the box” providing the basis of an LP’s accreditation.

Despite the ability, many issuers do not allow non-accredited investors to invest in a Rule 506(b) offering because the issuer must provide more detailed disclosures (e.g., two years of financial statements and a more detailed description of the issuer’s business and the risks involved). If an issuer makes these disclosures to non-accredited investors, it will also need to provide such information to its accredited investors. 

The biggest limitation of Rule 506(b), however, is the prohibition on general solicitations and advertisements. In practice, this means the issuer must have a substantive and pre-existing relationship with the prospective investor. There can be a fine line between a substantive and pre-existing relationship and a general solicitation. 

Generally, Rule 506(b) offerings cannot advertise the offering in the general media (e.g., tweet about the offering) or engage in cold outreach campaigns or solicitations (e.g., direct messaging a prospective LP on LinkedIn). 

Rule 506(c)

For many VCs, Rule 506(c) is the more appealing exemption because it allows the VC to advertise that it is raising a fund. This may be particularly important for VCs with large networks that want to leverage those networks to reach a broad base of LPs.

The tradeoff of this benefit is that Rule 506(c) is not available for non-accredited investors, and there are heightened duties on a VC to verify an LPs status as an accredited investor. When using Rule 506(b), most VCs will require LPs to submit a statement from an attorney, CPA, or investment professional verifying the LP's status and/or require the submission of detailed financial information (e.g., tax returns or bank statements). 

Form D and Blue Sky Filings

As part of a Reg D offering, VCs must file a Form D with the SEC within 15 days of the first sale (e.g., the initial closing) or a binding commitment to purchase securities (e.g., an accepted subscription agreement), whichever is earlier.

Form D requires the issuer to disclose certain information about the sale, such as the name of the issuer, the types and amounts of the securities offered for sale, and the number of accredited and non-accredited investors.

Securities offered under Rule 506 are considered "covered securities" under the Securities Act, which means they are exempt from state-level securities laws, also known as Blue Sky laws. However, state regulators may still require issuers to file certain state notices and pay associated fees.

Fortunately, the North American Securities Administrators Association Electronic Filing Depository (NASAA EFD) system offers electronic submission of Form D notice filings to participating state securities regulators.

Investment Company Act of 1940

The Investment Company Act of 1940 (“Investment Company Act”) regulates investment companies, such as those in the business of pooling assets from investors (e.g., mutual funds, private equity funds, hedge funds). 

Similar to the reliance on exemptions under the Securities Act (i.e., Reg D), venture capital and other private equity funds typically rely on an exemption under the Investment Company Act, namely the exemptions under Sections 3(c)(1) and 3(c)(7).

The exemption a fund uses will depend on the nature of the fund and its LPs.

Section 3(c)(1)

Section 3(c)(1) is a common exemption for venture capital funds and exempts issuers that are not making or proposing to make a public offering of their securities and are limited to a certain number of investors. 

For venture funds with less than $10M in aggregate capital contributions and uncalled capital commitments, the fund is limited to 250 “beneficial owners.”

For funds over $10M in aggregate capital contributions and uncalled capital commitments, the fund is limited to 100 “beneficial owners.” 

This 100-investor limit has been questioned by VCs for years as the limit forces funds to focus on LPs that are capable of contributing substantial capital. This limit pushes funds to have higher minimum check sizes, leading to the investment being inaccessible to investors with less available capital.

For instance, in a $50M fund, the 100 limit would impose an average check size of at least $500,000, which is well beyond the means of even those that are otherwise accredited investors.

When counting the number of beneficial owners entities are generally counted as a single investor unless the entity LP (a) was formed for the specific purpose of investing in the fund or (b) is a private investment company and owns 10% or more voting securities of the fund.

Section 3(c)(7)

Section 3(c)(7) is available for issuers whose securities are only owned by persons who are “qualified purchasers.”This allows a private fund to have an unlimited number of investors so long as it does not engage in a public offering and limits its investors to qualified purchasers.

Whether an LP is a qualified purchaser must be evaluated at the initial investment commitment. 

The term “qualified purchaser” includes:

• An individual investor or a family office with at least $5 million in investments.

• The qualified purchaser is an individual or an entity that invests at least $25 million for their own accounts or on behalf of other investors.

• Any entity where all owners are qualified purchasers.

The limits imposed by Section 3(c)(1) (as to the number of investors) and Section 3(c)(7) (as to status as a qualified purchaser) do not apply to a fund’s “knowledgeable employees” (i.e., such employees do not count toward the 100 limit).

These individuals have financial knowledge, expertise, and a close relationship with the fund, and therefore do not need the protection of the Investment Company Act.

Parallel Funds

In Part II, we discussed parallel funds but focused on the use of parallel funds in the context of non-US LPs. 

However, parallel funds are also used to increase the number of LPs eligible to invest in a fund. 

For instance, a GP may establish a Section 3(c)(1) fund and a Section 3(c)(7) fund to invest in parallel. 

Investment Adviser Act of 1940

Unlike the Securities Act and Investment Company Act, which regulate the fund, the Investment Adviser Act of 1940 (the “Adviser Act”) regulates investment advisers, such as the management company providing investment advisory service to the fund.

Similar to the Securities Act and Investment Company Act, the Adviser Act provides paths to registration (i.e., registered investment advisers or IRAs) but is more often triggered by exemption (exempt reporting advisor or ERAs).

Dodd-Frank amended the Adviser Act to exempt investment advisers to venture capital and other private funds–specifically, the Section 203(l) and Section 203(m) exemptions.  

Section 203(l)

Section 203(l) provides that an investment adviser solely to one or more “venture capital funds” is not subject to registration under the Adviser Act.

Generally, a “venture capital fund” is a private fund that:

1. Pursues a venture capital strategy;

2. Invests no more than 20% of the fund's capital contributions in non-qualifying venture capital investments (e.g., at least 80% of the portfolio is equity and convertible equity);

3. Is not significantly leveraged (e.g., does not borrow 15% of fund assets);

4. Only issues illiquid securities, except in extraordinary circumstances (e.g., not redeemable except in extraordinary circumstances);

5. Is not registered under the Investment Company Act and is not a business development company.

Section 203(m)

Fund managers can also claim an exemption under Section 203(m), which exempts an investment adviser of private funds if such adviser acts “solely as an adviser to private funds and has assets under management in the United States less than $150M.”

Form ADV

An investment adviser relying on Section 203(l) or Section 203(m) may operate as an exempt reporting adviser by filing a truncated version of Form ADV with the SEC (a less robust version of those submitted by RIAs).

Form ADV is not an application, and the SEC does not have the authority to deny an eligible adviser’s ability to take advantage of the exemption. 

An ERA must file Form ADV within 60 days of relying on an exemption and file annual amendments within 90 days of the end of each fiscal year.

Part 1A of Form ADV requires information about an ERA’s beneficial ownership, clients, private fund information, employees, disciplinary actions, and certain business practices. 

Notably, ERAs do not file Form ADV Part 2, which is for RIAs and requires a “brochure”–a plain-English narrative of its advisory business. 

Form ADV must be submitted electronically through the Investment Adviser Registration Depository (IARD). 

Like Blue Sky laws, advisers may be required to register or make certain filings under state law. 

Other Notable Regulatory Regimes

CFIUS

The Committee on Foreign Investments in the United States (“CIFIUS”) is an interagency committee that evaluates certain foreign investments into U.S. businesses, and has the authority to mitigate security risks such as by enforcing divestiture. 

Historically, the scope of CFIUS was reserved for defense contractors and controlled technologies under U.S. export laws. However, the 2018 enactment of the Foreign Investment Risk Review Modernational Act (“FIRRMA”) significantly expanded the application of CFIUS. 

CFIUS has the authority to review “covered transactions,” which are transactions (e.g., M&A deals, joint ventures, and non-controlling investments) in which a “foreign person” could be deemed to control, directly or indirectly, a U.S. business engaged in matters concerning critical technology, critical infrastructure, or sensitive personal data or otherwise have access to material non-public technical information.

An entity may be considered a foreign person even if it is a U.S. entity and has its principal place of business in the U.S. if a foreign person is deemed to have control (e.g., board representation), access to “material non-public technical information“ or substantial decision-making authority.

Generally, if a transaction is a covered transaction and not otherwise exempt, it will be subject to CFIUS review. 

CFIUS concerns may impact a VC’s ability to bring on certain GPs or grant increased information or oversight rights to LPs out of concern that such a person may render the fund a foreign person, which could impact the fund’s relationship with a startup (e.g., holding a board seat).

Tax

VC funds are typically taxed as partnerships, and subject to partnership tax laws and reporting obligations.  

However, many VC funds must also satisfy unique tax requirements to accommodate certain LPs (e.g., non-US investors). 

Moreover, most VCs structure their investments to qualify as “qualified small business stock” to receive the tax benefits associated with QSBS. 

Sufficit to say that the legal and compliance obligations related to tax are beyond the scope of this post, but we plan on addressing these considerations later. 

Summary

This concludes our three-part series on starting and operating a venture capital fund. In this last post, we discussed various legal and compliance issues applicable to VCs (and their LPs). Specifically, we discussed the most common Reg D exemptions (i.e., Rule 506(b) and Rule 506(c)), the Investment Company act and the limits on the number of LPs in a fund, and the compliance hurdles of the Investment Adviser Act. 

About the Author

Hey, if you like this article, you should follow Shayn on Twitter or check out what Junto Law is building!

Disclaimer from Shayn: While I am a lawyer who enjoys operating outside the traditional lawyer and law firm “box,” I am not your lawyer.  Nothing in this post should be construed as legal advice, nor does it create an attorney-client relationship.  The material published above is intended for informational, educational, and entertainment purposes only.  Please seek the advice of counsel, and do not apply any of the generalized material above to your facts or circumstances without speaking to an attorney.

If you are raising a fund in the U.S. with foreign investors, you want to be on the lookout for frequently used offshore tax evasion schemes. 

“Round-tripping” is a form of offshore tax evasion by which money earned in the U.S. moves outside the country - usually to visit a tax haven nation, such as the British Virgin Islands or the Cayman Islands. This money is then invested back to the U.S. As the name suggests, the funds make a round trip! The amount invested annually in the U.S. through “round-tripping” is estimated to be between $34 billion and $109 billion.

Let’s explore some of the key concepts of “round-tripping” equity investment and how it affects you as a fund manager.

What is the purpose of “round-tripping” U.S. equity investment?

Investors use “round-tripping” to hide funds and evade ordinary and capital gain tax rates applicable to their securities investments. In order to do so, the investment is disguised as a foreign investment. This allows returns to be taxed as a foreign investment, which has a more favorable tax treatment than a domestic investment. Further, sending funds to a tax haven nation allows for the lowest tax liability.

What is the difference between tax evasion and tax avoidance?

“Round-tripping” is difficult to detect. Because of this, governments have international tax exchange agreements to prevent tax evasion, and investments coming from tax haven nations are under more scrutiny than others.

However, there may be legitimate reasons to channel investments through vehicles located in a tax haven. For example, it could occur for regulatory or tax avoidance when investing along a foreign trading partner.

Investors must distinguish between tax evasion and tax avoidance. While both may be deliberate, only tax evasion is criminal. The main characteristic of tax evasion is the illegal nature of the scheme chosen to hide funds from the IRS. Tax avoidance is done through reading the law in the most favorable way to reduce tax liabilities (e.g. claiming tax deductions or credits).

When in doubt, it is better to consult with a tax advisor or avoid getting into tax haven territories.

What are guidelines for fund managers?

So, as a fund manager, what can you do to ensure your fund stays in compliance? 

The IRS can come to you to request information about investors suspected of engaging in criminal activities, so you want to be prepared. Failure to comply can lead to civil and criminal liabilities. That said, “round-tripping” is difficult to detect, so the best you can do is to hold yourself to the highest professional standards of fund management by following guidelines:

• Run your investors KYC

• Maintain complete and accurate records of all investments and investors

• Ensure that your investment agreements include standard language about the origin of the funds

• Report suspicious offshore tax evasion activities to the IRS

• Consult with an international tax advisor or avoid getting into tax haven territories if you don’t fully understand the legal complexities and liabilities at stakes

Working with a provider like Sydecar can help you stay on top of compliance matters, as the platform will handle KYC, keep investment records accurate, and provide standard investment agreements that include language about the origin of funds. This will significantly reduce the amount of work you have to spend on compliance and free you to focus on running your fund.

We’re teaming up with our friends at Junto Law to publish a three-part series on legal (and non-legal) aspects of starting (and running) a venture capital fund. Junto Law supports emerging founders and funders as they form, fund, and scale their ventures. They offer fixed-fee packages and courses that promote communication, efficiency, and transparency. Junto allows you to spend your time growing your business instead of worrying about the bill.

In Part I, we discussed the structures, players (GP, LPs, management company), and (some) key terms, including capital commitments, capital calls, and internal rate of return.

In this post, we will focus on all things terms. Particularly two buckets: (1) economic or financial terms and (2) other terms, such as those related to governance, structural, and regulatory terms. 

Economic Terms

Fund Expenses

Starting and running a venture fund can be expensive. Luckily for the GP, many fund expenses are paid out of the capital contributions of the LPs. Fund expenses are the costs incurred for the day-to-day operation of the fund, including organizational expenses (e.g., the costs and expenses in forming the fund) and operational or administrative expenses (e.g., sourcing investments, legal fees), and accounting fees (e.g., tax returns, audits, financial statements). Fund expenses do not ordinarily include expenses related solely to the GP, such as office space or salaries. 

Fund expenses are paid directly out of the LPs’ capital contributions, meaning that a GP does not invest the full amount of capital that they raise. These costs and expenses are separate from the management fees.

Management Fees

Most VCs charge an annual management fee that is calculated as a percentage of the capital commitments of an LP over the life of the fund. Management fees are payable by the LPs to the Management Company out of the capital contributions. The standard management fee in VC is 2% annually. Regardless of how the VC chooses to call capital, the Management Company is entitled to take an annual management fee on the full amount of the capital commitments.

Management fees are ordinarily paid to the Management Company as compensation for its services. The Management Company can use this pool of money to operate the fund and to cover the costs and expenses associated with its services (e.g., compensating employees, travel expenses, and other day-to-day expenses).

Similar to how fund expenses reduce the overall amount of dry powder, or cash available to be deployed into investments, it may not be advantageous for the VC to take the entire management fee. For instance, for a $50M fund with a 10-year life, the aggregate management fees would be $10M–which may drastically cut the amount of dry powder, and thus the number of investments possible.

To address this, the limited partnership agreement (“LPA”) often provides that the management fees may be recycled (e.g., used to make investments)–thereby increasing the capital deployed and increasing the odds of generating a profit. 

Importantly, management fees must be returned to LPs before the GP receives any carry. In a way, the payment of management fees is like an interest-free loan to the GP, which further incentivizes the GP to recycle some of the management fees.

Further, because most of the VC’s activity occurs during the investment period, the management fee may be reduced in later years (e.g., drop by .5% for periods after the investment period or for all times after the investment period, be measured as 2% of the unreturned capital to the LPs).

Carried Interest and Waterfall

Carry or carried interest refers to the portion of the fund's profits that the GP is entitled to keep out of the distributions paid through the waterfall.

The waterfall refers to the tiers of payments to be made through the Fund. Typically, LP capital is returned in its entirety, then profits are returned to LPs (typically 80%), and then carry to the GP (typically 20%). 

When the GP can distribute these profits to itself, however, it is subject to significant negotiations with the LPs and outlined in the LPA. 

To better illustrate the GP’s entitlement to carry and distributions under the waterfall, let's look at an example:

Example: Junto Ventures Fund I, LP is a $50M fund. The Fund invests $5M in a portfolio company (PortCo 1) which exists with a $30M distribution after three years.

In our example, the fund has received $25M in profits for its investment in PortCo 1, Inc.. If the GP can distribute, the LPs will receive $25M ($5M as a return on capital invested and $20M as 80% of the profit) and the GP would receive $5M (being, 20% of the profit).

A fund’s GP is often required to contribute a portion (e.g., 1%) of the total capital commitments (often referred to as the GP commit). For the purposes of returning capital in the first tier of the waterfall, the GP commit would be treated the same as the capital contributions of the LPs – so,  the GP would be entitled to repayment of the GP commit prior to a distribution of profits to LPs).

The key, however, is whether the GP can distribute the $5M to itself, which largely depends on the status of its other investments. 

Let’s look at a few scenarios:

If the investment in PortCo 1, was one of a few exits and the other investments yielded returns of, say, $100M, then it is clear that the GP is entitled to distribute the carry.

Conversely, if all the other investments were marked down to zero, the GP could not take any carry (i.e., the total amount returned was only $30M of a $50M Fund). 

Those are relatively easy, but unlikely situations. 

Instead, what if none of the other investments had matured at the time of the exit of PortCo 1–could the GP take carry? Typically, the LPA dictates that the GP can take carry on the exit from PortCo 1, so long as the portfolio's value on paper would still render the fund “in the money” for the purposes of the GP’s receipt of carry.

There are a few ways that VCs value their portfolio for the purpose of carry calculations. The most common approaches are the (i) Last Round Valuation and (ii) Comparable Company Model. 

The Last Round Valuation model would look at the last round of an investment and mark the value of the investment based on the valuation in that round multiplied by the Fund’s ownership (e.g., if the last round was at a valuation of $100M and the Fund owns 10%, then the value of the investment is $10M (i.e., $100M x 10%). 

Conversely, the Comparable Company Model looks at the key valuation metrics for similar publicly traded companies (e.g., ARR for a SaaS company) to determine a metric to apply to the portfolio company, subject to a discount for lack of marketability (e.g., the portfolio company securities cannot be readily be sold)

If it turns out that those paper marks were incorrect, and the final results were such that the GP would not have been entitled to take $5M as carry, the GP’s would need to give that money back. This is called clawback. 

The GP could also be subject to clawback if the distribution waterfall provided for a hurdle or preferred return, and the final results of the investments did not clear the applicable threshold.

Hurdle Rate: Unless the Fund generates a return over a certain threshold (e.g., 6-8%) the GP is not entitled to take any carry.

Preferred Return: Similar to a hurdle in that it requires the GP to pass a certain annual threshold (6-8%), but also provides that the LPs receive all cash until that preferred return is exceeded, and the GP would only receive any carry over the preferred return.

Similar to the recycling of management fees, GPs are often entitled to re-invest the carry received on early investments. For instance, in our example, the GP could re-invest the $5M it received from the exit of PortCo 1, Inc. in hopes of generating even greater returns. 

Other Terms

Fund Thesis and Strategy

GPs have considerable freedom in managing their fund and selecting investments. However, the LPA does impose certain restrictions on their ability to make investments outside of a specified scope, typically outlined in the "purpose" clause.

Investment limitations can differ in scope. For example, the LPA may broadly state that the fund will invest in "early-stage, privately-held companies," while others may be more specific, mentioning the stage, criteria, or industry (e.g., "venture capital investments in early-stage, privately-held companies focused on the healthcare technology").

The GP pitches LPs and raises the fund by describing its strategy and thesis.  Central to this thesis is the industry (e.g., B2B SaaS), stage (e.g., seed), check sizes ($500k-$1M), and portfolio construction (e.g., 65% initial investment/35% follow-on reserves) strategies.  LPs must evaluate a GP's thesis and strategy to ensure it aligns with their investment goals, as they are signing up for a blind pool of investments.

Side Letters

Side letters are agreements that grant additional rights to specific LPs. These agreements are similar to those received by the VC from a portfolio company. Side letters are usually only given to a select group of investors, such as the lead VC in a startup round or a prospective LP providing a significant investment. Side letters may also be granted to attract certain investors or to manage regulatory constraints on an LP's investment, such as those imposed by the Employee Retirement Income Security Act (ERISA). 

The content of a side letter can vary, but may include:

• Rights to more detailed information about each investment (e.g., its status and size)

• Reduced carry or fees (e.g., a waiver, reduction, or cap on management fees)

• Co-investment rights (e.g., the option for LPs to invest alongside the Fund)

Alternative Investment Vehicles

Certain LPs may be subject to legal, tax, or regulatory issues that make investing in the fund untenable–unless certain special purpose vehicles (“SPVs”) are used. The most common SPVs are parallel funds, feeder funds, alternative investment vehicles, and co-investment vehicles.

Parallel Vehicles

Parallel vehicles are typically established for LPs with a distinct tax status requirement that differs from other LPs.  For example, if a fund has non-US LPs, it may be beneficial to create a parallel fund in an offshore jurisdiction (“Parallel Fund”), such as the Cayman Islands, that is more favorable to these LPs.

Aside from specific legal, tax, and regulatory differences, the Parallel Fund will have the same investment strategy and terms as the main fund.  The Parallel Fund will also invest in the same assets and at the same time as the main fund. The allocation into an investment will be pro rata between the two funds based on their respective portion of the total capital commitments.

Feeder Funds

Another way to accommodate non-US LPS with unique legal, tax, or regulatory concerns is by using feeder funds.  A feeder fund is an investment vehicle organized as a corporate taxpayer. Instead of investing directly into the fund, the LPs invest in the feeder und, which then invests into the fund.  The feeder fund acts as a blocker in the relationship between the LP and the fund. Because the feeder fund is a corporate taxpayer, it will pay taxes on allocations and distributions, relieving the non-US LPs from filing and paying federal taxes in the US.

Alternative Investment Vehicles

Alternative investment vehicles are typically structured to address the legal, tax, and regulatory issues that may arise when certain LPs invest in a particular opportunity.  While a Parallel Fund invests alongside the main fund in each investment, alternative investment vehicles are limited to a single, specific investment.  In this way, alternative investment vehicles can provide a more focused approach for certain LPs, allowing them to tailor the investment to their specific needs and objectives.

Co-Investment Vehicles

Co-Investment vehicles are SPVs created to invest alongside the fund on specific investments.  For example, an SPV may be used when the GP receives an allocation larger than the fund's limits.  In this situation, the VC may establish an SPV to invest the additional amount with one or more LPs or non-LP investors (i.e., investors that are not LPs in the Fund).

Summary

In this post, we provided an in-depth overview of the legal and financial components of starting and running a venture capital fund.  We also shed light on the expenses and management fees associated with the process and explained the concept of carried interest and waterfall. The article further highlighted how the GP's entitlement to carry and distributions are determined through negotiations with the LP and outlined in the LPA.

We’re teaming up with our friends at Junto Law to publish a three-part series on legal (and non-legal) aspects of starting (and running) a venture capital fund. Junto Law supports emerging founders and funders as they form, fund, and scale their ventures. They offer fixed-fee packages and courses that promote communication, efficiency, and transparency. Junto allows you to spend your time growing your business instead of worrying about the bill.

Throughout the series, we will discuss: (1) the legal structures and players, (2) the common and important terms, and (3) the regulatory hurdles.

What Are VC Funds?

Venture Capital funds, or VC funds, are used to pool capital from investors and deploy it into companies identified by the venture capitalist, or VC.

A venture capital fund is a type of private fund that: (i) holds itself out to investors as pursuing a venture capital strategy, (ii) holds at least 80% of its assets in "qualifying investments" (e.g., equity or cash), (iii) does not hold debt of more than 15% of its aggregate capital contributions and commitments, (iv) the interests of the Fund are not readily redeemable, except in extraordinary circumstances, and (v) is not registered under the Investment Company Act of 1940

An investor's investment into the VC fund ("Fund") is known as a capital commitment and is made in exchange for an interest in the Fund.

Investors do not typically pay capital commitments at the outset or all at once. Instead, capital calls are made over the Fund's investment period, which is the period in which the VC is authorized to deploy capital (e.g., 3-5 years).

This allows for investors to avoid having their money lay dormant while the VC identifies investment opportunities.

Capital calls are also helpful to the VC, who does not want to start the clock on its internal rate of return by calling capital before it is ready to be deployed.

Internal Rate of Return ("IRR") is a more accurate metric for evaluatingFund performance than simple multiple calculations, as IRR analysis accounts for the time value of money by (i) starting the clock when the capital is called and (ii) stopping the clock when capital is distributed to the investors.

Structures and Players

As we will discuss throughout this series, there are few technical barriers to becoming a VC.

While there are plenty of regulatory hurdles to becoming a VC, there are no required licenses, specific education, or testing requirements. A VC isn't even required to be an accredited investor independently. In fact, the VC may qualify as an accredited investor simply by raising a Fund above $5M or being a knowledgeable employee of the Fund (more on this in Part III).

So far, we've used the term VC generically, but many different people and entities contribute within VC.”

General Partners ("GP")

The founders of the VC firm are often considered the "VC," but the more precise title for the founders of a VC firm is general partner or GP. The GPs usually wrap themselves in a legal entity–most commonly, an LLC (e.g., Junto GP I, LLC), to limit liability and operate through a corporate existence.The GP designation also denotes its role in the traditional fund structure–as the general partner of a limited partnership.

In the traditional fund model, the Fund is organized as a Delaware limited partnership, which is structured to include a general partner (e.g., GP entity) and one or more limited partners (i.e., the investors).

In a Fund that is formed as a limited partnership, the GP has the power and authority to manage and act on behalf of the Fund, making investment decisions, signing contracts (e.g., the Investment Management Agreement with the Management Company), filing tax and regulatory filings on behalf of the fund, and deploying the Fund property.

The Fund investors grant broad discretion and authority to the GP in managing the Fund, however, the Fund's governing documents (in a limited partnership, the Limited Partnership Agreement) do include important restrictions on GP authority without the investors' consent. For instance, the GP may be limited to making investments consistent with a particular Fund thesis, which may be based on stage (e.g., seed, growth, late-stage), industry sector (e.g., enterprise SaaS, biotechnology, blockchain, clean-tech), or philosophy (e.g., geographic-based).

Limited Partners ("LPs")

The most important players in a Fund are the limited partners or LPs, which are the Fund's investors.

Just as the existence of a startup may depend (at least to some extent) on the involvement of a VC, the VC is as much reliant on its LPs.

Typically, LPs are wealthy individuals, family offices, endowments, funds of funds, pensions, etc.

Many LPs look at VC investments as a piece of their overall investment portfolio (e.g., along with public stocks or bonds). They expect that the VC investment will generate outsized returns with the tradeoff of higher risk. Along with these expectations, LPs will have certain expectations related to the GP. For instance, the LPs will expect that the GP has some “skin in the game” by requiring the GP to contribute at least 1% of the Fund's capital contributions.This is particularly true for first-time fund managers who may not be able to point to a significant track record to garner LP trust.

Just because someone is a first-time fund manager does not necessarily mean they don't have a significant track record. For instance, many fund managers start by making angel investments, syndicating smaller deals through special purpose vehicles ("SPVs") within a small network, or working as an associate or venture partner at an established firm.

Despite contributing almost all of the capital (e.g., 97-99%), LPs do not receive (and do not expect) substantial governance rights. Instead, the predominant rights of the LPs are economic in nature (e.g., the top tier of the distribution waterfall), which we will discuss in more detail in Part II.

Put simply, LPs rely on the GP and its team to handle the day-to-day operations of the Fund.

Management Company

In addition to the GPs, the Fund (directly and indirectly) relies on the individuals employed or hired by the GP to carry out and manage the Fund and VC firm.

For instance, VC firms often employ  analysts, associates, and principals that identify and evaluate investments. A VC firm may also employ (or outsource) back-office support teams, including accountants, lawyers, and other administrative personnel.Some of these individuals may be granted a portion of the carried interest or carry paid to the GP (e.g., 20% of the profits generated from the Fund after returning capital to LPs (plus any preferred return), more on this in Part II). This right is usually subject to vesting (more on vesting in other contexts here).

Instead of housing these individuals within the GP entity, the VC often forms a management company (e.g., Junto Manager, LLC) to compensate and employ these individuals.The GP and the Fund often enter into an "Investment Management Agreement" with the Management Company. In this agreement, the Management Company is delegated to sourcing investments and is entitled to the Fund's management fees (more on this in Part II) and reimbursement of the costs and expenses of each Fund.A traditional (i.e., closed-end) structure is shown below:

The above image represents a traditional fund structure. In recent years, a variety of other structures have emerged with their own nuances, such as rolling funds, evergreen funds, syndicates, and DAO Investment Clubs.

Conclusion

A VC Fund is used to pool capital from LPs, which is then called over the investment period by the GP to be deployed into startups.

Although the term VC is often used generically, there are various players under that umbrella, including the GP, the Management Company, and the other stakeholders of the GP or Management Company (e.g., principals, associates, advisors, back office)–each with a unique role.  

In Part II, we will dig deeper into some key terms related to starting and running a venture capital fund.

If you like this article, you can follow Shayn Fernandez on Twitter (I tweet about venture, web3, and sports (with plenty of dad jokes)), check out Junto Law, or set a time to chat.

Disclaimer: While I am a lawyer who enjoys operating outside the traditional lawyer and law firm “box,” I am not your lawyer.  Nothing in this post should be construed as legal advice, nor does it create an attorney-client relationship.  The material published above is intended for informational, educational, and entertainment purposes only.  Please seek the advice of counsel, and do not apply any of the generalized material above to your facts or circumstances without speaking to an attorney.

Have you ever wondered why the majority of venture capital SPVs and funds use the Delaware LLC structure? While it may seem like an arbitrary choice, careful consideration has gone into the use of this structure in VC.

Using a Delaware LLC to structure your investments does not require you to be located in Delaware or to be investing within Delaware. While conventional businesses generally have to register and pay taxes in whichever states they “do business,” investing entities have more flexibility. Investing entities are largely exempt from the  idea of “doing business,” which allows them to choose their state of formation.

To understand why most investors and service providers choose the Delaware LLC, we’ll dive into the cost, formation, tax, and legislative implications of the structure below.  

Cost

On the surface, Delaware is not the cheapest state to register an LLC. Delaware charges $300 annually to create an LLC, while Arizona only charges $50.   However, the Delaware structure may actually be cheaper in the long run for those who are establishing a high volume of investment vehicles. This is because Delaware allows for the creation of series LLCs at no additional cost. While other states require a separate operating agreement be filed for each series LLC, Delaware simply requires the Master LLC operating agreement to mention the formation of series LLCs. This removes the need for additional filings. Delaware remains one of very few states that makes it easy to form series LLCs. Delaware series LLCs are also bankruptcy remote, can enter into contracts, and hold title to assets. All these characteristics make the Delaware series LLC an attractive structure for SPVs. 

Formation 

Delaware has one of the most straightforward processes to form an LLC. The process requires that you have a registered agent (a person designated to receive the business’s official papers) and file a cover memo and a Certificate of Formation with the Division of Corporations. You are not required to have a written operating agreement (although advisable), and you do not have to hold and record board meetings. 

Because Delaware is committed to being business-friendly, filings are processed quickly, and their office is open until midnight on Monday - Thursday and 10:30pm on Fridays.

Tax Benefits

Delaware does not impose income tax on LLCs that do not conduct business within the state. Because investing does not fall into the category of “doing business,” investors typically do not have to worry about Delaware tax liability. Additionally, you are not required to register with the Delaware Division of Revenue or hold a business license.

Legislation

To settle business disputes, Delaware formed a special court called the Court of Chancery. This means that  entities registered in Delaware benefit from  the following:

• A robust body of case law, which provides predictability and guidance.

• Specialized corporate law judges who give prompt expert attention to disputes.

• Typically, the court will side with decisions made by company leaders so long as those decisions are determined to be in the best interest of members.

  
  

Summary 

Since different jurisdictions provide different benefits, finding the right combination of benefits for your specific use case is key. In venture investing, for now, Delaware offers just that. However, this may change as other states attempt to attract more business. Sydecar is constantly exploring cost, structural, and tax benefits across jurisdiction  so that we’re able to offer the optimal entity set up for our customers. If there is a specific jurisdiction that you would like to see added to our roadmap, don’t hesitate to reach out! 

When starting to invest, emerging investors must decide if they will create a management company for their investments. Rather than taking on the management responsibilities as an individual, an investor can form a management company to keep their investment activity in a separate entity. While it may sound intimidating to create an entity, the process is straightforward, allows cleaner record keeping, and protects investors from many liabilities. 

What is a management company?

A management company is an entity (typically an LLC) that is created for the purpose of managing the operations of a venture capital fund. This includes collecting management fees, paying out and accounting for operational expenses (i.e., marketing or business travel), organizing employment or other business agreements, and handling regulatory filings. 

Facilitating these activities through a management company protects fund managers from complete liability when it comes to the fund’s activities.

How does a management company operate?

The management company is typically owned by one or multiple partners of a venture capital fund. This is referred to as a single-member or multi-member LLC. A venture capital fund typically charges a management fee to fund investors, which covers the cost of operating the fund. This includes employee salaries, office space, administrative expenses, marketing and business-related travel, and other ad hoc costs of running a business. 

A standard management fee is 2% of the fund’s assets under management (AUM) annually. In some cases, a fund manager will choose to front-load management fees in order to cover some of the upfront costs of running a fund, so they may charge 2.5% for the first half of the fund’s life and 1.5% for the second half. This is particularly common for first-time fund managers who have not experienced many exits and therefore rely on management fees as their primary form of income. More tenured investors who have already received carried interest on their investments may be less concerned with front-loading management fees. 

Why should a fund manager create a management company?

Having a management company is not a legal requirement for managing a venture capital fund. A solo fund manager may choose to take on the advisory and management responsibilities of the fund individually. However, many fund managers prefer the legal protections and separations of using an LLC. It may also be easier to use a separate LLC to manage the many operating expenses of a fund and keep records cleaner for tax and accounting purposes. Finally, if you are not a solo fund manager, setting up a management company allows for more than one member to have rights and benefits of the fund. 

How do you create a management company?

Setting up a management company is a fairly straightforward process that can be completed online using a variety of different services, such as the Delaware Registered Agent website, you can create a management company and pay out annual registration fees. If you take this route, you'll need to set up a separate bank account for your management company as well.

We recommend consulting with a legal, tax, and/or accounting professional to understand all of the nuances of running a management company.

It seems like everyone is becoming a Venture Capitalist. With everyone from influencers to industry veterans flocking to VC, the rise of emerging investors presents fierce competition to access the best deals and LPs.

Unlike established VC funds, syndicate leads and emerging managers can’t necessarily compete by writing the largest checks, offering an expansive network, or providing comprehensive portfolio support. So how are new investors expected to compete for capital and deals? 

Some of the smartest managers have decided to invest in brand building in order to stand out from the crowd.

From building an engaged following on Twitter to publishing a newsletter to writing thought leadership pieces for traditional media outlets, brand-building activities allow investors to distinguish themselves. A strong brand offers social proof, establishes you as an expert, and puts your name top of mind for founders and other VCs. As capital is increasingly commoditized, it is more important than ever to build a brand alongside a portfolio.

Raising Capital 

Having a strong brand attracts capital. This is particularly relevant with the rise in popularity of 506(c) funds. Rule 506(c) allows “general solicitation,” which means that a VC can publicly market their fundraising efforts through channels like social media. Over the past few years 506(c) has become more popular. There have been a number of examples of emerging VCs who have raised significant capital through platforms like Twitter. Mac Conwell claims to have raised “most of his [$10 million] fund off of Twitter.” And perhaps even more impressive, Minal Hasan raised $25 million for her second fund based on cold inbound on Twitter. 

As you start to build your LP network, you’re competing for investor attention as well as dollars. Building trust and truly owning the relationship with your LPs can be a huge competitive advantage. This is why Sydecar has chosen to keep our customers’ deals and syndicates private, rather than creating a marketplace that draws your investors away to other opportunities. 

Winning Deals 

Building a brand around your investment thesis, and sharing details of that thesis through public channels, will increase your inbound deal flow. You’ll become the first investor others think of when meeting a company that matches your thesis. This increases both the quantity and quality of your deal flow. A strong brand will also help to secure allocation in the most competitive deals as founders will have an understanding of the value you bring. 

Some investors create incentives around helping them with deals. Sahil Lavigna, an entrepreneur and investor with over 260k Twitter followers, created a scout program that incentivizes members of his network to share deal flow and investment memos that support the due diligence process. Julia Lipton, who made a name for herself in the crypto/venture ecosystem, parlayed her engaged Twitter following and newsletter subscribers into a “bounty board” which she uses to crowdsource help on tasks like deal sourcing, due diligence, and content creation.

Supporting Founders 

Your brand immediately demonstrates how you support your portfolio founders. In positioning yourself as an expert in an area, such as growth, product, or fundraising, your founders know they can turn to you for resources and connections on that topic. They can also ask you to utilize your reach for further advice. Lolita Taub, a VC who recently launched her own fund, frequently tweets questions on behalf of founders to crowdsource advice, creating a concise resource for founders to turn to. 

How to Build your brand 

How can emerging VCs start building their brand? The lowest barrier to entry is social media. Experiment with the LinkedIn, Twitter, or even TikTok content to find where you can shine. As you engage with others, you may find podcasts, newsletters, events, or blogs are valuable for building your brand. Here are some low-cost, high-value brand building activities that new investors can focus on: 

• Identify your voice and who you want to connect with

• Use your areas of expertise to create educational content

• Launch a newsletter for LPs to demonstrate your investment thesis and portfolio wins

• Ask questions or run polls on Twitter to get a better understanding of your audience

• Personify your brand by including pictures of yourself or telling stories in investor updates

• “Build in public” by using social media to share updates on your fundraising journey

• Host networking events in collaboration with other emerging VCs 

• Record conversations you have with founders, LPs, or investors and turn them into a podcast 

  
  

If you are looking for some inspiration, we suggest that you check out:

Elizabeth Yin

Maggie Sellers 

Nik Milanovic

Neil Devani

Michael Friedman (Reflect Ventures)

One of the first steps to creating an SPV is establishing a Limited Liability Company (LLC). The LLC is a distinct company formed solely for the purpose of aggregating capital to invest into another company. An LLC is not the only structure that can be used for this purpose, but it’s the structure used by all Sydecar SPVs and funds for a number of reasons.

Understanding the LLC 

An LLC is a flexible business structure allowed by state statute, meaning that each state has different rules and regulations that govern their LLC structure. Fun fact: The first state to establish an LLC structure was Wyoming in 1977. LLC owners are referred to as “members,” and each member is afforded exactly what the name suggests: limited liability. Prior to the LLC, the most common alternatives were general partnerships or limited partnerships. In these structures, at least one partner is required to have unlimited liability, meaning that they could be held personally liable for the debts of the company. On the other hand, limited liability dictates that a member can only be liable for the debts/obligations of the company up to the amount they invested.

Because an LLC is a state designation, it allows flexibility in how the company is treated for tax purposes. Most LLC members elect to be taxed as partnerships. You may have heard LLCs referred to as “flow-through entities,” which means that all income and expense items flow directly through to the members, thereby maintaining their unique tax attributes. Each member then reports and pays tax (or deducts loss) on their share personally. Therefore, LLCs allow a unique combination of limited liability with the tax advantages of a flow-through entity.

Let’s explore the flexibility of an LLC a bit further…

Any type of entity can be a member of an LLC, including other LLCs, C-Corps, S-Corps, qualified accounts (IRAs) and more. This gives SPV investors the flexibility to register their membership in a variety of different ways. However, investors should be mindful of the tax treatment of an LLC. If the LLC elects to be treated as an S-Corp for tax, it will be subject to the shareholder restrictions imposed by S-Corp status. For example, in an S-Corp, only individuals or certain trusts/estates may be shareholders with a maximum of 100.

In some cases, you may want an LLC to elect to be treated as an S-Corp for tax purposes. For example, if a VC’s management company wants to payroll its owners, treating the LLC as an S-Corp for tax purposes may be advantageous. This is because paying the LLC members as employees allows for appropriate taxes – like Social Security & Medicare (FICA taxes) – to be withheld throughout the year while the S-Corp pays the employer half. This allows the LLC owners to avoid having to pay FICA taxes through their individual returns often referred to as “Self Employment Tax”.

Another benefit for the LLC structure is that it can assign management functions. For instance, an SPV or fund that is structured as an LLC can assign management functions to another LLC. This other LLC (often referred to as a management company) can be assigned as the manager of multiple funds or SPVs, thus centralizing management functions to one company. Now, as discussed earlier, the management LLC can elect for tax purposes however it wishes.

Last but certainly not least, certain states (specifically Delaware, Iowa, Nevada, Illinois, Texas, and Tennessee) allow for the creation of a special type of LLC called “Series LLCs.” Under this unique structure, there is a single “Master LLC” that is registered with the state and pays the appropriate taxes/fees on an annual basis. An unlimited number of distinct Series LLCs can be created under the Master LLC. Each Series LLC is protected from any adverse judgements against any other. This structure is particularly cost efficient for investors who are using LLCs to invest in startups on a deal by deal basis using SPVs.

LLCs and SPVs

LLCs are a powerful way to customize any business structure that can be particularly beneficial in the context of venture investing. Sydecar uses the Series LLC structure to establish our SPVs and funds because of the time and cost efficiency that it affords our customers. This powerful structure, combined with our game-changing infrastructure, makes it possible for anyone to spin up an SPV in minutes with a reasonable cost ratio. 

Conclusion

The Benefits of the Series LLC Cost Efficiency

Under this unique structure, there is a single “Master LLC” that is registered with the state and pays the appropriate taxes and fees on an annual basis. An unlimited number of distinct Series LLCs can be created under the Master LLC. Each Series LLC is protected from any adverse judgements against any other. This structure is particularly cost efficient for investors who are using LLCs to invest in startups on a deal by deal basis using SPVs.

Limited Liability: In an LLC, a member can only be held liable for the debts and obligations of the fund up to the amount they invested. In contrast, the general or limited partnership structure which has historically been used in venture capital requires at least one partner to have unlimited liability, meaning that they could be held personally liable for the debts of the fund.

Tax Flexibility: Because an LLC is a state designation, it allows flexibility in how the company is treated for tax purposes. Most LLC members elect to be taxed as partnerships. LLCs are “low-through entities, which means that all income and expense items flow directly through to the members, thereby maintaining their unique tax attributes.

Assignment of Management: The Series LLC allows you to assign management functions to another person or entity. An entity can be assigned as the manager of multiple funds or SPVs, thus centralizing management functions to one company.

Membership: Any type of entity can be a member of an LLC, including other LLCs, C-Corps, S-Corps, qualified accounts (IRAs) and more. This gives SPV investors the flexibility to register their membership in a variety of different ways.

How A Little Knowledge of Tax Law Can Accelerate Funding

There are a multitude of factors to take into account when investing into startups: industry, market, size, company stage, and location. Depending on certain factors, an early stage startup may be qualified as a “small business” in the eyes of the IRS. Equity shares of these companies are referred to as Qualifying Small Business Stock (QSBS). The tax benefits for certain investors in QSBS can be magnificent, however special conditions apply. In 1993, in an attempt to stimulate investment into startups and small businesses, the IRS enacted Section 1202 of the Internal Revenue Code to exclude some of the gain realized from the sale of QSBS.

What is QSBS?

QSBS (originating from Section 1202 of the Internal Revenue Code) excludes tax on gains from the sale of stock in qualified small businesses (QSB). A QSB is defined as a business organized as a U.S. C-corporation with less than $50M in gross assets before and after that company receives cash from an equity funding round. Although convertible debt and other promissory notes do not qualify as QSBS, the YC SAFE contains explicit language that qualifies it as an “equity” investment. The company must not be on the list of excluded business types (which includes SaaS businesses).

How does QSBS apply to SPV investments?

All of the SPVs administered by Sydecar are LLCs (pass-through entities). SPV investors qualify for QSBS benefits if they held the interest on the date the SPV acquired the QSB stock and at all times thereafter until the stock was sold.

How do I know if my SPV investment qualifies as QSBS?

Besides the qualifications mentioned above, the SPV qualifies for QSBS only if the SPV acquires original issue shares (i.e. not purchased on the secondary market) and if the stock has been held for at least five years. The company in which you or the SPV invested will know if the shares sold are eligible to be treated as QSBS. Frequently, QSBS is assessed at the time of a 409A valuation. If the stock has been qualified as QSBS, the benefit cannot be taken away until it is sold.

What are the tax benefits of QSBS?

If an SPV (or angel investor) sells shares of QSB after the five-year mark, they may exclude up to 100% of capital gains (depending on the date of purchase) of up to $10M or 10x the cost basis, whichever is greater. It’s important to note that tax laws change frequently so it’s important to check with your tax advisor on the latest developments or changes in the tax code.

What happens if I buy or sell an interest in an SPV that has purchased QSBS?

Since purchasing interest in an SPV does not qualify as selling stock directly, the stock retains its QSBS eligibility within the SPV interest that is purchased. Further, an investor who purchases interest in an SPV (i.e. via a secondary sale) actually inherits the SPV’s holding period. For example, if you purchased interest in an SPV that held QSBS for five years already, that holding period would be applied to your interest (even though you did not own it for the full five years). Conversely, if you sell an interest in a QSBS holding SPV, you are not entitled to exclude any gain on the sale, as you are not actually selling the underlying stock but rather your partnership interest. You as the seller would want to factor the benefits to the buyer into the sales price.

What else should I know?

If the business in which the SPV invested is incorporated in one of the locations below, you won’t be eligible for QSBS exclusion at the state level:

1. California

2. Mississippi

3. Alabama

4. Pennsylvania

5. New Jersey

6. Puerto Rico

Where can I go for more information?

• Section 1202 regulations

• Qualified Small Business Stock definition

• U.S. Small Business Administration QSBS discussion

• This post from Lowenstein Sandler explains the complexity and vagueness of the QSBS laws as it relates to SAFE notes.

Recent updates in technology and regulation contributed to a rise in participation in private markets, particularly for individuals investing as a group. While group investments are typically led by a single “sponsor,” there are often multiple individuals that contribute to assessing and managing a deal. Depending on their level and type of contribution, these individuals may deserve, and receive, a portion of the deal sponsor’s carry as compensation. This is known as “carry sharing.”

What is carried interest?

Carried interest is a share of any profits that the deal sponsor receives as compensation for managing the deal. In venture capital, it’s common for the sponsor of an SPV or fund (the “GP”) to receive a standard 20% carry of the profits made from their investments. Carried interest is only paid after investors’ initial capital has been returned. In the case of a fund making multiple investments, the fund manager will only receive carry once each investor, or limited partner, has received a return on their initial investment. As a result, the manager typically has to wait until they have enough capital to return to initial investors and will not receive any profit from a fund’s early liquidity events.

Many investors have turned to SPVs as a faster, more efficient way to deploy capital and see returns. Deal sponsors are able to receive carry on a deal-by-deal basis when they invest this way. Since SPVs are generally limited to a single investment, the lead only needs to return capital on a successful investment once before receiving carried interest on those profits. If the return to an SPV is less than the initial investment, the deal sponsor does not typically receive any portion of the return.

How does carry sharing work?

A deal sponsor will share carried interest, or carry share, with another individual who contributed to managing an investment, or helped the sponsor in ways that contributed to the success of the deal.

Generally, a carry share is executed using a “side letter,” which is a secondary agreement used to create bespoke terms between a deal sponsor and an investor, in addition to the terms of the SPV that all other investors receive. The side letter agreement, which is signed by both parties as well as the fund administrator, outlines the percentage of carry that the carry share recipient will receive at a liquidity event. Similarly to the deal sponsor, the carry share recipient will only receive their portion of the carry once the investment has returned at least 1x to its investors.

What are the benefits of carry sharing?

Carry sharing can be especially powerful for groups of investors working together and contributing to each other’s success, generally referred to as syndicates. Syndicates typically have a primary “deal lead” who is responsible for bringing deals to the group, performing due diligence, and supporting the portfolio companies. But it’s near impossible for an individual to do all this work on their own. They are often supported in various ways by other participating members of the group based on individual areas of expertise. For instance, one syndicate member may pitch in on due diligence given their specific domain knowledge, and another may support a portfolio founder on hiring for a specific role or building out their go-to-market strategy. The syndicate lead may choose to share a portion of their potential 20% carry from a specific deal with members of the group to compensate them for their contribution, without violating specific requirements around securities brokers and dealers.While participation in venture deals is generally limited to Accredited Investors, you do not have to be accredited in order to receive shared carry on a deal. This creates an opportunity for just about anyone to participate (albeit indirectly) in venture investing. By contributing to sourcing, evaluating, and managing a deal, a non-Accredited Investor can build their own track record while simultaneously generating wealth. This expands and benefits the entire ecosystem.

What are some of the challenges of carry sharing?

For emerging VCs, carry sharing can be a powerful way to expand your network. Offering someone a share of your carry may incentivize them to share the opportunity with members of their network and thereby drive capital to the deal. But it’s important to be mindful of the regulation that governs the use of carry sharing.Per the SEC, any individual receiving compensation (through carry, cash, or any other form) as part of a VC deal must have contributed to sourcing, diligencing, or negotiating the terms of the deal. An individual cannot be compensated solely for influencing others to invest in a deal. This means that it’s fair game to share carry with someone who introduced you to a founder, helped you write an investment memo, contributed subject matter expertise to the diligence process, or supported the deal execution from an operational perspective. However, if an individual drove capital to a deal (i.e. made introductions to other investors or shared an investment opportunity with their network) but did none of the above, then receiving compensation (via a carry share) would put them in broker-dealer territory in the eyes of the SEC. A broker-dealer is a person or organization that buys and sells securities on behalf of someone else (typically a paying client). Generally, VC investors want to avoid this activity as broker-dealers are required to register with the SEC and FINRA. This registration process, and the regular requirements of registered broker-dealers, is complicated, time-intensive, and costly. Ultimately, the majority of venture investors can leverage carry sharing while avoiding these requirements – so long as they are intentional about operating your investor network.

Using carry sharing to expand your network – compliantly

As mentioned above, carry sharing can be a powerful tool for venture investors who are looking to expand their network. If you’ve recently launched a syndicate and are looking to grow your group, incentivizing syndicate members to share investment opportunities with their networks seems like an obvious choice. Luckily, there are ways to leverage this approach in a compliant manner by involving syndicate members in the process of evaluating or managing a deal. This could mean introducing an individual to a founder to better understand their business model, asking them to contribute to a deal memo to share with the syndicate, or having them actively manage the deal after the investment has been made. So long as an individual has participated in one of these activities, they can help drive capital to a deal and receive carry without being considered a broker-dealer.

Hear from some members of the Sydecar community about how they (compliantly) using carry sharing to build community:

“At Pearl Influential Capital, we work with deal co-leads on many of our investments. Bringing co-leads in to provide additional support to deal management and execution has allowed us to scale our community effectively while driving more investments for our portfolio.” - Alyssa Arnold, Co-Founder of Pearl Influential Capital

“Sydecar’s carry share feature enhanced our scout program, making it easy to assign carry to individuals contributing in scouting and conducting due diligence on a deal without all the back and forth we experienced before.”- Michele Schueli, Managing Partner at ARMYN Capital

Time for a pop quiz! 

We hope you learned something from this article - now it’s time to put your new knowledge to the test! 

Jamie runs a community-driven syndicate where she leads investments into pre-seed and seed stage fintech companies in the US. In the following scenarios, can Jamie share a portion of her carry with a syndicate member (who is not a broker-dealer) in exchange for participation in the deal?

1. John, a syndicate member, introduces Jamie to a founder, and Jamie decides to invest into their company. John has never met the founder in real life and does not contribute to due diligence. Can John receive carry?

2. Margaret has a background working in fintech startups. Jamie calls Margaret because she is doing diligence on a deal and wants to get Margaret’s perspective on the space. Can Margaret receive carry?

3. Julie is super excited about a new company that the syndicate is investing into, so she emails a couple investor friends to ask if they want to participate. One of them ends up investing in the deal through Jamie’s syndicate. Can Julie receive carry?

4. Jamie has brought on her friend, Robert, to support the syndicate in a part time capacity. He is responsible for setting up deal pages in Sydecar, adding investors to the deals, and coordinating with portfolio companies when they have updates to share. Robert also occasionally shares the investment opportunities with individuals in his network that Jamie doesn’t know directly. Can Robert receive carry?  

Answer key: Yes! Even though John hasn't met the founder in person, his introduction still counts as deal sourcing.Yes! Since Margaret contributed to due diligence, she is eligible to receive carry.No! Julie’s excitement about the deal doesn’t qualify as identifying, evaluating, or managing the deal, so she cannot receive carry solely for driving capital to the opportunity.Yes! Since Robert helped actively manage the deal in addition to sharing it with his network, he can be compensated for his involvement. 

When making investment decisions, venture investors typically focus on companies with high growth potential. However, some investors seek out tax-efficient investments that generate passive income outside the US. In 1986, in an attempt to close a loophole that created certain tax advantages, the IRS created a designation of passive income investments called PFICs, or Passive Foreign Investment Companies.

What are PFICs?

PFICs are non-U.S. based companies that either (i) generate 75% of gross income from “passive income” sources or (ii) use 50% of the company’s assets to generate “passive income.” Generally, passive income is income generated from sources that are not related to the company’s regular business operations. Principal forms of passive income as they relate to PFICs include interest, rents, royalties, capital gains, currency gains, and dividends. In general, most investors want to avoid PFICs because the IRS taxes gains from these investments at the ordinary income tax rate, as opposed to the lower capital gains tax rate.

How do PFICs apply to venture investments?

When investing outside of the US, VCs should be aware that some companies can inadvertently fall under the definition of a PFIC. Most commonly, PFIC designation may arise when an early-stage company is in a research and development stage and is therefore not generating any revenue from their regular business operations. For example, let’s say a company has raised millions from outside investors on a promising new product or service. The company generally will not spend all the money immediately, so excess cash is put into interest-bearing accounts until needed. Since the only income being generated is from interest on the deposits, this would fall into the first condition “generating 75% of gross income from passive income.” Further, it could fall into the second condition where 50% of the assets (most likely only cash raised) are generating passive income. Fortunately, the IRS has since created exceptions that help alleviate some of the traps that could catch non-US companies in PFIC classification.

What to look out for?

While it’s typically pretty easy to avoid PFIC restrictions when investing directly via an SPV or fund, an SPV investment into a fund (“fund of funds”) has the potential to trigger PFIC. SPVs are considered “look-through” vehicles for tax purposes, so it’s important to look at the underlying investment (especially if it is a foreign fund). If the company receiving the investment is a PFIC, investors must determine whether they are direct or indirect shareholders of the PFIC. In general, investors using Sydecar’s platform would not be “direct” shareholders of any PFIC since shareholders only own interests in SPVs. That said, a final determination is typically made by speaking directly with the company receiving investment.

How are PFICs treated for tax purposes?

If it is determined that an investment is a Passive Foreign Investment Company, there are three different ways a taxpayer can elect:

1. The Excess Distribution Regime: This is the default tax treatment and usually results in a larger tax burden. Generally, this election allows you to defer taxes (pay them later), but when taxes are due, they are very steep and include interest charges.

2. Qualified electing fund: A taxpayer must elect into this treatment. This method more closely follows US tax treatment of passive income with long-term capital gains retaining their favorable treatment. This is the most common PFIC election.

3. Mark to Market for Marketable Stocks: If a taxpayer’s holdings are regularly traded, they can elect this method. Basically, the taxpayer adds up all their gains and losses (realized & unrealized) each year and the result is taxed at higher ordinary income rates. Losses can only reduce gain to zero. This method is perhaps the most difficult to assess favorability.

What is Sydecar doing to avoid PFIC investment issues?

At this time, Sydecar has made a policy to not support SPV investments into PFICs, but we are here to help you find the resources that can help with the PFIC rules. If you indicate the target company is a PFIC, it’s important to understand the IRS Form 8261 filing requirement.

Where can I go for more information?

• Cornell Law School: Passive foreign investment company

• IRS: Instructions for Form 8621

• PFICs: How do I know if I have it?

• Golding Lawyers: Common Examples of PFIC Investments

Over the past few years, tech entrepreneurs and investors alike have flocked toward web3. Innovating and investing in blockchain projects is seen as a way to increase ownership, access, transparency, and efficiency – what’s not to like, right? On top of those promises, investors celebrate web3’s promises of early liquidity via token warrants (as opposed to traditional venture capital investments, which can take a minimum of 5-10 to become liquid).

While much of web3 still occupies a regulatory gray area (look no further than the recent Coinbase litigation), venture investors who dabble in web3 investing are still held to the same expectations (and limitations) of venture capital regulation. At the center of that regulation is Section 203(l) of the Investment Advisers Act of 1940 (known as the Venture Capital Adviser Exemption). Investors who pursue a “qualifying VC strategy” benefit from certain regulatory exemptions. A “qualifying VC strategy” means that more than 80% of the capital that it raises must be used to acquire equity securities from a private company directly. Read more on what it means to pursue a qualifying VC strategy.

Why this matters for web3

The determination of 1) who can invest in an SPV or fund, 2) what filings are required, and 3) the obligations of the sponsor comes down to two simple questions:

1. Is the GP receiving compensation (carried interest or management fees) in exchange for organizing the transaction?

2. Does the transaction involve contributing >20% to anything other than equity securities acquired directly from a private company?

Web3 investments typically occur via a SAFT or a direct purchase of cryptocurrency tokens, both assets which are not equity securities issued by a private company directly. If more than 20% of a fund or SPV’s assets are SAFTs or tokens, the fund is not considered a qualifying VC fund. The sponsors of these vehicles would no longer benefit from VC exemptions and they may be subject to additional requirements (reporting and filings) and restrictions (only raising funds from qualified clients). Finally (and perhaps most significantly), if the deal sponsor accepts capital from accredited investors (or non-accredited investors) and wants to avoid these restrictions, the sponsor may not be permitted to receive any compensation (carry) for organizing a deal. There has to be another way…

A proposed middle-ground for web3 investments

Can web3 VCs have their cake and eat it too? Perhaps!

 As summarized above, structuring transactions through an SPV/fund that pursues a “VC” strategy permits the broadest base of investors and reduces overhead and complexity for the deal sponsor. By conforming web3 investments to the requirements of a qualified VC fund, deal sponsors may be able to avoid some of the requirements put on non-VC private funds.

Wait, what? 

Let’s start with SPVs. A key requirement of a “good” VC is that more than 80% of the capital it raises is directed to the acquisition of a private company’s equity securities from the company directly. In a traditional web3 investment, a company issues a SAFT or tokens directly, which are not equity securities. So, in order to comply with the 80% requirement, the company must issue an equity security together with tokens (or an instrument that can later be exercised to acquire tokens). It is key, however, that at least 80% of the capital raised by an SPV be used to acquire the equity security, and that the exercise price for the tokens is less than 20% of the capital raised by the SPV. 

A new standard for compliant web3 SPVs

VC investors can remain compliant and benefit from the relevant exemptions if web3 investments are structured in the following manner: 

1. Standard stock, SAFE or convertible note sale in an original issue amount that equals or exceeds 80% of the capital raised in the SPV.

2. Standardized token warrant to acquire tokens for an issue price and aggregate exercise price that sums to an amount equal to or less than 20% of the capital raised by the SPV. Any cash that isn’t funded to acquire the equity (#1 above) or warrant at the SPV’s closing will be parked and utilized to fund the warrant’s exercise.

3. Bonus: Side letter between the web3 company and the SPV that ensures that if for any reason the SPV cannot exercise the Token Warrant in full to comply with regulatory hurdles (e.g. the value of the tokens underlying the warrant is deemed higher than 20% of the SPV’s value), then the SPV may assign a portion of the warrant rights to the SPV’s members pro rata. 

It’s generally expected that the tokens purchased via a Token Warrant exercise (#2 above) will ultimately have a market value that far exceeds their exercise (strike) price. This could potentially occur as early as the expiration of the warrant lock-up. 

So, how does this impact the 80% requirement? Well, under applicable law, the SPV sponsor (GP) generally determines how to value private assets and as long as the determination around fund reporting is consistent, then the GP can determine that both the value of the warrant and the value of the assets (tokens) being acquired (at purchase and exercise respectively) are equal to the original issue prices. 

To bring it all home, an SPV sponsor can leverage an SPV to acquire web3 assets and stay within the VC fund exemption by: (a) packaging any non-equity assets (tokens) together with an equity investment (e.g. a SAFE); (b) ensuring that the value of the qualifying equity investment is at least 80% of the SPV’s raise; and (c) remaining consistent on how the assets are valued for accounting purposes and reflecting all SPV assets at their original issue/exercise price. 

A new standard for compliant multi-asset funds 

Multi-asset funds generally have more flexibility than SPVs as the 80% requirement applies across the entire fund. This means that up to 20% of the fund’s total capital raise can be contributed to non-VC qualifying assets, such as SAFTs or tokens. A multi-asset fund can generally acquire a SAFT or a Token Warrant without having to package the transaction with a qualifying equity issuance (...as long as the sum of all of its non-VC qualifying assets represent less than 20% of the fund’s capital raise). 

That said, web3-focused funds might want to consider the strategy laid out above for SPVs when executing investments in order to avoid having to register as an RIA. If a web3-focused fund embraces a standard protocol of packaging a (sometimes nominal) SAFE/equity purchase with a SAFT/Token Warrant, then even web3-focused funds can remain qualified VC funds and enjoy all of the benefits of a VC fund while investing primarily in web3 assets (e.g. continuing to work with accredited investors, avoidance of RIA status and the onerous audit/compliance obligations it presents). By standardizing this process at the fund level, web3 investors have a better chance of maintaining their VC status even as web3 and crypto regulations evolve.

Over the past decade, group investing has risen in popularity, typically occurring in the form of sponsor-led investments. Deal sponsors (typically referred to as GPs in the context of a fund, or deal leads in the context of an SPV) are responsible for obtaining an allocation, running diligence on a deal, and garnering interest in an investment. A deal sponsor leads investments on behalf of passive co-investors, who decide to invest in deals on the recommendation of the sponsor and are not actively involved in the vetting and sharing of the investment opportunity. Deal sponsors are typically compensated for their involvement via carried interest – upside in the investment after investors in the deal are returned the amount they originally invested. This structure results in the vehicle being considered an investment fund, and the deal sponsor an investment adviser. While these terms may sound scary, there are certain exemptions for VC investors that make it possible for almost anyone to syndicate VC investments. 

If VCs are regulated, how can almost anyone be a VC? 

The regulation governing investment funds (including SPVs) and the individuals that organize them is, at its core, the same regulation that governs private equity, hedge, and real estate funds. But funds and fund advisers (or sponsors) who pursue a “qualifying VC strategy” benefit from certain regulatory exemptions. As we’ve previously highlighted, a “qualifying VC strategy” means that more than 80% of the capital that it raises must be used to acquire equity securities from a private company directly. 

The federal compliance requirements for funds that meet this qualification are:

1. A Form D, which is a very simple form that has to be filed with the SEC anytime a company raises money (since the fund is a company), and

2. A short-form version of a Form ADV, which is a form that an investment adviser should file with FINRA and the SEC within sixty days of first engaging in advisory activity – e.g. structuring an SPV where the adviser receives carried interest as compensation (note, an adviser to “qualifying VC” funds that registers with FINRA & the SEC using the short-form Form ADV is referred to as an “Exempt Reporting Adviser,” or ERA).

These requirements apply to every VC SPV and fund out there, regardless of whether the investments are structured through a law firm, a fund admin, or SPV platform. Advisers to qualified VC funds are generally permitted to accept “accredited investors” as investors in addition to “qualified clients” or “qualified purchasers”, which each present significantly higher wealth thresholds for participation. 

Wait, I thought you said VCs are exempt from requirements?

While the above requirements for a qualified VC fund may seem onerous, they’re relatively straightforward as compared to those that apply to other types of (non-qualifying) private funds. Private (non-VC) funds include those that purchase shares in a secondary transaction, funds that syndicate debt investments (other than convertible notes), funds that acquire cryptocurrency assets, or funds that invest in other SPVs or funds. Any private fund that pursues a non-qualifying VC strategy opens Pandora’s box of state regulations. Such regulations create additional restrictions and requirements for funds and advisers; for example, they may be limited to accepting capital only from “qualified clients” or “qualified purchasers,” and require audited financials, elevated compliance obligations, and the completion of lengthy forms. 

These onerous requirements are triggered at a certain threshold of assets under management (AUM). An adviser that syndicates any non-VC private fund (even a single SPV), and manages a total of over $150M in assets (based on current value), is required to register with FINRA and the SEC as a registered investment adviser (RIA). Registering as an RIA is no simple feat, and requires a long-form registration on Form ADV, adherence to strict fiduciary duties, the appointment of a Chief Compliance Officer, maintenance of books and records related to market transactions, audited financial statements, a formal custodian for fund securities, and notably, limits the adviser to raise capital from qualified clients (individuals with net worth over $2.2M). In addition to these SEC federal requirements, they also may be subject to additional restrictions and requirements under their individual state law. As mentioned, this is potentially in addition to more restrictive and onerous state law.

What does it all mean?

So, that was all pretty complicated. Let’s go through a few specific examples of investment vehicles and identify whether they would qualify for the VC fund exemption.

Example 1: Preferred or common stock purchased directly from a private company

• Qualifying VC? Yes

• Who can invest: Accredited Investors+

• ERA or RIA? ERA

Example 2: SAFE issued by a private company directly

• Qualifying VC? Yes

• Who can invest: Accredited Investors+

• ERA or RIA? ERA

Example 3: Convertible Promissory Note issued by a private company directly

• Qualifying VC? Yes

• Who can invest: Accredited Investors+

• ERA or RIA? ERA

Example 4: Promissory Note not convertible for company equity issued by a company directly

• Qualifying VC? No

• Who can invest: Qualified Clients+

• ERA or RIA? ERA until AUM exceeds $150M, then RIA

Example 5: YC SAFE and a Warrant to acquire governance tokens (a “Token Warrant”), all issued by a private company directly

• Qualifying VC? Yes, but only if the SAFE’s value at the time of every fund investment is >80% of the value of fund assets (all cash committed and contributed to the SPV/fund)

• Who can invest: Accredited Investors+

• ERA or RIA? ERA

Example 6: Preferred/Common Stock and a Token Warrant, all issued by a private company directly

• Qualifying VC? Yes, but only if the Preferred/Common Stock’s value at the time of every fund investment is >80% of the value of fund assets (all cash committed and contributed to the SPV/fund)

• Who can invest: Accredited Investors+

• ERA or RIA? ERA

Example 7: Common Stock or Preferred Stock acquired from anyone other than a private company directly (e.g. acquired from a founder, another investor, etc.); typically referred to as a “secondary” transaction

• Qualifying VC? No

• Who can invest: Qualified Clients+

• ERA or RIA? ERA until AUM exceeds $150M, then RIA

Example 8: SPV interests or another Fund’s LP interests

• Qualifying VC? No

• Who can invest: Qualified Clients+

• ERA or RIA? ERA until AUM exceeds $150M, then RIA

Example 9: Any assets other than equity securities issued by a company directly that: (a) are >80% of the SPV/fund’s total assets and (b) that also results in the total value of funds/SPVs managed by the sponsor exceeding $150M.

• Qualifying VC? No

• Who can invest: Qualified Clients+

• ERA or RIA? RIA

TLDR: as long as at least 80% of the cash committed across all of the SPVs or funds you organize is used to purchase equity securities from a company directly, then you can generally raise capital from accredited investors and avoid limits around your AUM.

Want to learn more about the VC fund exemption? Check out this article.

This post was written in collaboration with Doug Dyer, CFO at Chapter One. Chapter One is a full-stack crypto fund built for early-stage founders, that strives to be the first check-in powerful stories they want to co-write alongside incredible founders.

What is accounting and why it matters 

Generally speaking, accounting is the process of measuring and communicating the value of different financial assets and dates back to the year 1494. While accounting is primarily backward-looking and based on past transactions, strategic finance professionals can use it to understand the present and predict the future. 

What role does accounting play in venture capital?

Venture capital (VC) is defined as a form of investment for early-stage, innovative businesses with strong growth potential. VC accounting helps stakeholders keep track of the money and understand the value of their investments. VC requires lots of money movement as deals are struck. Given this money movement, regularly changing valuations, and the increasing role of regulation, VC fund accounting can get confusing pretty quickly (Doug has written about this previously here, where he shares notable fund administration firms dedicated to helping VCs manage this on an ongoing basis).

One of the primary ways VC differs from traditional company accounting is that a VC firm is investing other peoples’ money, which brings additional reporting requirements for transactions and investment values to stakeholders. On top of that, each investor that participates in a venture fund (or other investment vehicle) can contribute a different amount of capital, meaning they each own a different percentage of the fund’s investments expense obligations. A fund accountant is responsible for keeping track of these varying percentages and reporting changes to each fund investor. 

How does fund accounting work?

Fund accounting revolves around a ledger, which is used to track any instance in which money moves in or out of the fund. This includes capital calls, fees and expenses, investments, and distributions. The ledger “ties” to the bank accounts or other “sources of truth” for cash movements.

When an LP (“limited partner”) signs a contract to invest in a fund, they don’t transfer the full amount of money they commit (their “commitment”) at the get-go. In most cases, funds are transferred over a predetermined period of time using what are referred to as capital calls. A fund accountant is responsible for tracking capital calls as LPs fulfill their commitments over time.

Fund accountants also manage valuation reporting, or the process of tracking, updating, and communicating changes in value of the fund’s investments. For a venture fund that is investing in early-stage companies, valuations typically change when a portfolio company raises a subsequent financing round, although that is up for debate (see Fred Wilson’s latest, Valuing a Venture Capital Portfolio). 

An accountant will use the details of the financing round (such as company valuation and price per share) to determine how the financing event has increased (or decreased) the value of the fund’s previous investment. These reports are delivered to the fund’s LPs on a predetermined cadence (usually quarterly) that is set by the fund’s Limited Partnership Agreement (LPA).

How does accounting work for SPVs?

SPVs are vehicles typically formed by VCs or individual investors to make a single investment into a single company (vs. a traditional VC fund, which invests in a portfolio of companies in one fund vehicle). Because SPVs there is only one company in the vehicle, the accounting and reporting requirements are much simpler than those of a fund. 

Typically, money moves into the investment vehicle when the initial investment is made and out of the investment vehicle when an “exit” or distribution occurs. Additionally, since the SPV investors fund their entire commitment upfront, there are no capital calls to keep track of going forward. 

Given the simplicity of an SPV, accounting values (e.g. each investor’s ownership % and the value of an asset) can typically be tracked without the hands-on involvement of a fund accountant.

Why does it all matter?

VC fund and SPV investors are judged on their investment performance but this can take years! Along the way, both VC funds and SPVs are required by their investors to accurately account for and present their investments, expenses, and financial transactions. Doing this in an accurate and clear manner inspires confidence from investors, which can only help VC fund and SPV managers as they grow.

Thanks for reading! If you’re interested in learning more about fund accounting,here are a few resources we recommend:

• NVCA’s Accounting Auditing Standards

• ILPA’s Best Practices: Quarterly Reporting Standards

• Fred Wilson’s VC Investor Relations

A few months ago, we published an article unpacking some of the proposed updates in the JOBS Act 4.0, which could have massive implications for emerging VC and many of the investors we talk to everyday at Sydecar. We were thrilled with the response to our article and hopeful about the many productive conversations it has spurred with organizations like the Senate Banking Committee and the NVCA, other emerging technology companies, and – perhaps most importantly – many of our customers. In order to keep these conversations going within our community, we wanted to share a letter that our founder & CEO, Nik Talreja, submitted to Congress expressing our support for the proposed updates.

I write this letter in support of the JOBS Act 4.0, which in large part addresses systemic issues that prevent widespread participation at the intersection of wealth creation and innovation: venture capital (“VC”).

While the Jumpstart Our Business Startups (JOBS) Act of 2012 enacted a number of modifications to securities law that have increased retail participation in early-stage venture investing, it left significant areas of the venture capital landscape untouched. In the past decade, the landscape for venture investing has changed dramatically. Notably, participation in venture capital has increased substantially, but the regulatory environment that governs this channel of capital allocation has left many participants at the wayside.

The Emerging Venture Capitalist’s Vantage Point

I hope to present a vantage point for your consideration: that of the early-stage venture capitalist. I feel well-prepared to do so, being an early-stage investor myself as well as the founder and CEO of Sydecar, Inc. (“Sydecar”), a platform built for this specific segment. In addition to professional investors, this group includes individuals in professional services, leaders of technology companies, and industry thought leaders, all who have access to investment opportunities in early-stage companies. It is often these individuals – the solo capitalists, angel syndicates and emerging managers (collectively, “emerging VCs”) – who are the most helpful to, most interested in, and most diligent and passionate about companies that will shape our future. While emerging VCs might have the most coveted access to investment opportunities, they are not as prepared to understand and navigate the nuanced regulatory landscape created by the Securities Act of 1933, the Investment Company Act of 1940, and the Investment Advisers Act of 1940.

As you know, professional counsel is cost prohibitive, and it is only through counsel that many nuances of the law can be translated. For example, an emerging VC today may have an opportunity to invest in an early-stage company’s offering of securities directly (e.g. “Preferred Stock”), as well as acquire an equal value of a very similar security (e.g “Common Stock”) from early employees of the same company. If an emerging VC structures even the simplest investment vehicle to acquire these securities (a special purpose vehicle that is set up to acquire just this company’s securities, and where participating investors have discretion over whether or not to deploy capital behind this investment opportunity (an “SPV”)), the emerging VC may come up against restrictions set by  the Investment Advisers Act and related rules. In this example, because the SPV acquired both “primary” securities from the company, and more notably, “secondary” securities from early employees, this SPV is no longer a “qualifying VC fund.” This emerging VC has now set itself on a path of: (1) complying with complex and varying state rules and regulations (since the benefits of a federally qualified VC fund may not apply to this SPV across all states), and (2) potentially having to formally register as an Investment Adviser (an “RIA”), as the benefits of being an “exempt reporting adviser” may evaporate if this emerging VC is successful and the value of assets that it manages exceeds $150,000,000. While this may seem like a very high threshold, the value of an emerging company investment on paper may multiply quickly even though the realizable value of these investments may still be distant. 

The above issues – whether an SPV or fund is a “qualifying VC fund” or an exempt “private fund” – would apply to any SPV or Fund with substantial exposure to anything other than a direct acquisition of equity securities from a private company. On the surface, this seems benign. In practice, this limits a number of fund (SPV) transactions that present massive opportunities for positive impact and wealth creation, including: 

1. acquisitions of securities in “secondary” transactions (above example),

2. investments in venture capital funds or SPVs, and

3.  investments in non-equity securities, such as private debt and blockchain-based “tokens.”

How the JOBS Act 4.0 Decreases Complexity 

The updates proposed in the JOBS Act 4.0 address many of the material limitations currently facing emerging VCs. The JOBS Act 4.0 proposal notably:

• Expands the definition of a “qualifying VC” investment to include secondaries and fund-of-fund investments, meaning that VCs employing these strategies can avoid having to register as an RIA.

• Allows any American to invest up to 10% of their income in private assets (as opposed to the current requirement of being an accredited investor).

• Increases the investor cap to 500 LPs for exempt private funds under $50M (as opposed to the current cap of 250 investors for a fund <$10M).

• Shifts the burden of verifying accreditation under Rule 506(c) “general solicitation” from the fund manager to the individual LPs. This would allow LPs participating in 506(c) deals to self-attest their accredited status (similar to the current 506(b) process), rather than require the GP to verify each investor’s status.

Why This Matters

The updates proposed in the JOBS Acts 4.0 are timely, given recent shifts in the venture capital landscape. VC is no longer preserved for institutional GPs and LPs. At Sydecar, we believe the future of VC — and in many ways, the future of innovation — will be defined by a new generation of capital allocators, from solo-capitalists to emerging funds to individual angel investors. Regulation changes, along with proper tooling, is a necessary first step to empower private investors from a wider variety of backgrounds.

Sydecar aims to streamline venture capital transactions through the creation of new standards. As a former securities attorney, I understand that proposals such as the JOBS Act 4.0 and SEC rulemaking are instrumental in supporting the proliferation of compliant venture capital transactions. Clarity in the interpretation and application of sensible legislation enables compliance and much-needed transparency in otherwise opaque and illiquid markets. The JOBS Act 4.0 is a framework that will decrease unnecessary friction among market participants, FINRA, and the SEC, and we are excited to contribute to its adoption. 

Our team is well-versed on the various rules that affect exempt offerings and fundraising by VC market participants today and is available to discuss the impact of the JOBS Act 4.0 and related legislative proposals on your constituents. 

Sincerely,

Nik Talreja

CEO, Sydecar, Inc.

Side letters have become increasingly popular in venture capital over recent years. But despite their recent popularity, they remain a complex and often misunderstood topic. Today, we’re bringing you a guide to side (or should we say, Syde) letters in hopes of continuing to educate and empower new and aspiring venture investors.   

A side letter is essentially a secondary agreement used to create bespoke terms between two parties. Side letters can exist between venture capitalists (including fund managers/GPs and deal leads) and their limited partners (LPs), as well as between startup companies and their VCs.  The primary purpose of a side letter is to give an investor (either a VC or LP) some special or additional rights that are not granted to all of the other investors involved in a transaction. In almost all cases, these additional rights are advantageous to the investor. 

Side Letters for LPs

Side letters between VCs and LPs allow both parties to agree to terms that may not be applicable to all investors, such as preferential treatment on returns or fees. LPs also use side letters to build in flexibility or leniency around defaulting repercussions, transfer rights, liquidity terms or indemnification. They also allow managers to pre-approve terms for LPs when raising new funds.

Side Letters for VCs

Side letters are also used to establish similar agreements between founders and their VCs. In this case, a side letter might be used to grant a lead or significant investor what are referred to as “advanced rights.” This includes pro rata rights, information rights, or right of first refusal. Side letters can also be used when negotiating a provision that may otherwise not be possible within the scope of only one funding round (for example: "The Company has 15 days after giving notice hereunder during which it may provide information relating to any proposed new financing transaction").

Flexibility

The use of side letters has increased in recent years as both VCs and LPs have looked to make their subscription documents more flexible and relevant to individual investors. This flexibility can make venture investing more feasible or attractive to a greater number of investors, especially as it relates to things like lower minimum investments, investment thesis, and fee structures. But establishing and managing side letters can often be a pain for VCs. They create operational burden, require time (and money) spent on legal counsel, and may create additional obligations or restrictions for the manager. 

This begs the question: why not just create flexible agreements to begin with?

At Sydecar, we’re dedicated to creating standards for deal execution that build in flexibility where it really matters. Our product allows you to create signature-ready subscription agreements with variable economics (fees and carry) for each of your LPs without having to create individual side letters. We understand that our customers care more about efficient, reliable, and cost-effective deal execution than about negotiating every little term of an agreement with their LPs. But we also acknowledge the importance of flexibility. Our customers use Sydecar’s variable fees to: 

• Present higher carry to investors who are not part of their existing investor community

• Offer reduced carry to an individual investor who introduced them to a founder 

• Offer reduced carry to fund LPs who chose to come into a sidecar deal

If you’re looking for an easier way to create flexibility for your investors without the hassle of side letters, we’d love to hear from you. Reach out at hello@sydecar.io 

Starting a VC fund, syndicate, or investing group is almost entirely about building trust and overcoming inertia. I first realized this in 2019 while starting a micro-fund with my co-founder, Nik.

We initially thought we wanted to raise a traditional fund. Having committed capital on hand meant we’d be able to consistently back the founders we were most excited about, and the ability to take management fees meant that investing could be a viable career path. But successfully raising a fund requires a strong track record — or at the very least, a perceived brand and differentiated strategy.

Fund LPs are typically focused on one thing: returns. As brand new fund managers, we didn’t have returns to show… but we did have something else: the ability to spot great opportunities and a proven approach to vetting investment opportunities. Our challenge was to convince LPs to invest with us, and we found that making a smaller ask opened up many doors.

We shifted our focus to promoting specific companies on a deal-by-deal basis, which allowed us to garner enthusiasm around each deal. We could promote founders, their technology, and their market opportunity — and largely leave ourselves out of the conversation. Instead of asking to be stewards of capital, we were granting access to coveted allocations.

SPVs were the ‘right place, right time’ vehicle for us, allowing us to move quickly and deploy capital. Our conversations with LPs shifted from “let’s have another call in a month” to “I’ve just sent the wire.” This was a meaningful shift in momentum, and led to our ‘aha’ moment. If the pivot to SPV’s helped unlock funding for us, it could also do the same for every other aspiring VC out there.

“Should I raise a fund or start with SPVs?”

If you are even asking this question, it probably makes sense to start with SPVs. Raising a first traditional fund is almost always a longer process than expected, and there are fiduciary responsibilities and legal technicalities in most fund documentation that might take you by surprise.

On the other hand, SPVs come with the following benefits:

• Simple, explainable, tangible

• Create a bias towards action

• SPV LPs feel more in control as they are making the ultimate decision with each investment

• More control leads to more capital to being deployed

• Value-add investors tend to want to be hands-on in supporting portfolio companies

• You can take a “breather” from doing deals without LPs getting frustrated that you are getting a management fee without active deployment

Of course, nothing great is without its downsides. Some additional things to consider if you are exploring SPVs as your investment vehicle of choice:

• You have to ask your LPs “permission” to do a deal

• Getting the deal together can take time

• Certain investors want portfolio theory

• Management fees can be tricky to ask for at first

At the end of the day, there’s no one size fits all solution for new investors. But if you’re looking to dip your toe in the water of venture investing in a way that is more flexible and straightforward, SPVs are probably the right fit for you.

Want to continue the conversation? Give me a shout at david@sydecar.io.

This piece was written in collaboration with Winter Mead of Coolwater Capital.

Emerging venture investors are expected to do it all when it comes to building their firm. In addition to the obvious functions of fundraising, deal sourcing, and portfolio support, many new VCs are surprised to find themselves taking on the roles of lawyer, accountant, CFO, marketer, HR, and more.

Say it ain’t so!

At Sydecar, we hope to take some of that burden off of your plate. We’ve turned our years of experience as investors, lawyers, tax professionals, and fund accountants into a product that guides new investors down intentionally built paths, so that you never lack confidence or transparency into the decisions you make.

We built this product because we observed a white space in the market. As emerging fund managers, we sought out a platform that would allow us to highlight our differentiated brand, without compromising on efficiency, credibility, or compliance. And when we couldn’t find one, we built it ourselves. In the process, we consulted with fellow investors and tried out countless tools and services ourselves. So rather than leave you go down that path yourself, we’ve aggregated our findings in the “Emerging VC Toolbox.”

Choosing tools is not a one-size-fits-all exercise. Your investing stack should align with your strategy as an investor, with a few driving considerations:

• Which tools work best for your specific investment strategy and structure

• How pricing can change over time from first-time customer to repeat customer

• How do your founders interact with these tools, and is it a good user experience for them

• How well do the service providers get along

• How well do the software tools integrate e.g. accounting + fund admin, or billing + accounting, etc.

As a new investor building a track record with SPVs, your toolbox may look different from someone who is managing a fund. Today, there are more ways than ever before to participate in private investing: angel investing, syndicating deals, crowdfunding, general solicitation, or raising a traditional GP/LP fund.

These investor types have risen on the back of several market trends, including:

• A new generation of investors who view autonomy and business-building as something more important than a “steady” paycheck

• Founders who want value-added investors, especially at the earliest stages of company growth

• Founders wanting emerging managers on their cap tables because they offer empathy and diversity

• Emerging managers, including solo capitalists, securing competitive allocations versus institutional investors to lead rounds

• Traditional and new LPs investing in emerging managers and becoming more integrated with the investment process, demanding more transparency, and seeking flexibility in what they invest in across VCs’ portfolios

• Disintermediation of the traditional “lead VC” — meaning the traditional role of “lead investors” has transformed into an investor managing networks of scouts, deal partners, and value-add LPs

As new participants flood the venture ecosystem, innovation and new infrastructure is required to support new modes of portfolio and brand-building. Emerging VCs need tools that help them understand and leverage their investors, investments, and networks to optimize their investment strategies. If you are a “solo capitalist” who’s just starting to build your track record, here are the tools you should consider as part of your stack:

Education:

• First Round Angel Track

• Hustle Fund Angel Squad

• On Deck Angels

• Coolwater Angels

Deal Flow:

• Stonks

• Knightley

• Twitter

Research and Diligence

• Pitchbook for data on past deals

• CB Insights for market maps and trend insight

• Aumni for investment analytics

CRM:

• Hubspot

• Airtable

• Streak

Marketing & Brand:

• Notion, Super or Webflow for hosting your website

• Sendgrid for sending group emails and tracking analytics

• Docsend for sharing important documents and tracking views

Investor Relations & Portfolio Support:

• Visible VC for automating portfolio data collection and sharing updates with your LPs

• Google Alerts to set up alerts to stay on top of news about portfolio companies

• Pulley for equity management & 409A valuations

Fund Closing & Admin:

• Passthrough to automate fund closing and contracts

• Standish Fund Management, Vector AIS, or Juniper Square for traditional fund admin

• And last but not least, we’d throw our own hat in the ring for SPVs. We think we do a pretty good job

Given the myriad number of resources, tools, and services available to emerging venture investors, it’s important to have a strategy for building a toolbox that will deliver the most value to you and your unique strategy. We know that the process requires an up-front investment of time and requires ongoing management — as you embark on that journey, please don’t hesitate to reach out to us for guidance. Adopting the tools, programs, and services that are right for your strategy is a heavy lift to start, and an ongoing management exercise. If we can be helpful in guiding you in the right direction, please don’t hesitate to reach out!

The JOBS Act, originally passed in 2012, is regularly cited as one of the most significant regulation changes in the history of private investing. Now, almost a decade later, Congress is assessing an update to this legislation — referred to as JOBS Act 4.0 — which has huge implications for both emerging and aspiring venture investors.

The 2012 Act notably increased access to private markets, specifically through Regulation Crowdfunding, which allowed private companies to raise money from non-accredited investors, and the addition of Rule 506(c), which allowed general solicitation of fund offerings. While the 2012 Act (Reg CF specifically) gave retail investors the opportunity to invest in startups for the first time, it did little to meaningfully advance opportunities for venture capitalists.

Today, VCs have to navigate a regulatory minefield to ensure compliance with the Investment Company Act, Investment Adviser Act and Broker-Dealer regulation. The current regulatory regime limits VCs in the following ways:

• Only “accredited investors,” representing ~2% of the US population, are permitted to invest in startup companies.

• The majority of VCs abstain from secondary, “fund-of-fund” (FoF), and crypto investments altogether due to the risk of having to register as an investment adviser (RIA). Investors participating in these types of deals must either keep AUM under $150M or become an RIA (which comes with an abundance of restrictions and requirements).

• VC funds are capped at a maximum of 99 or 249 (accredited) investors (depending on how much they raise), or must create a second “parallel” fund structure which is costly and can only accept qualified purchasers.

• If leveraging Rule 506(c) “general solicitation” (noted above), VCs must actively verify the accreditation status of all participating investors.

  
  

  

Overview of JOBS Act 4.0 updates

So, why is this new JOBS Act update so exciting? Well, it addresses all of those material limitations described above — and more. Here’s a summary of the regulatory changes proposed by the JOBS Act 4.0:

• An expanded definition of a qualifying “VC” investment to include secondaries and fund-of-fund investments, meaning that VCs employing these strategies can avoid registering as an RIA.

• A shift in the burden of verifying accreditation under Rule 506(c) “general solicitation” from the fund manager to the individual LPs. This would allow LPs participating in 506(c) deals to self-attest their accredited status (similar to the current 506(b) process), rather than the GP needing to verify for each investor.

• Any American would be able to invest up to 10% of their income in private assets (as opposed to the current requirement of being an accredited investor).

• The investor cap would be increased to 500 LPs for funds under $50M (as opposed to the current cap of 250 investors for a fund <$10M).

Implications for emerging VCs

The updates proposed in the Jobs Act 4.0 are timely given recent shifts in the venture capital landscape. VC is no longer preserved for institutional GPs and LPs. Today, some of the most promising investment opportunities are sourced by new entrants, from solo-capitalists to emerging funds to individual angel investors. At Sydecar, we believe the future of VC — and in many ways, the future of innovation — will be defined by this new generation of capital allocators. Regulation changes, along with proper tooling, is a necessary first step to empower private investors from a wider variety of backgrounds.

Raising via 506(c) is a huge unlock for new entrants to VC, particularly those that do not come from generational wealth or high socio-economic status. It allows anyone who has built an engaged following online, for example, to market their fund publicly rather than having to rely on the closed-door networks that have historically dominated the industry. However, the current requirement to verify accreditation status in a 506(c) fund can be expensive and time-consuming, as it requires manual document verification. If this responsibility is shifted to the investor, 506(c) becomes more viable for emerging fund managers who don’t come from wealth.

The JOBS Act 4.0 also proposes expanding the definition of qualifying VC investments to include secondaries and fund-of-funds. Historically, only direct investments in private companies were considered “qualifying,” while acquiring private equities from founders, startup employees, or other funds was considered “non-qualifying.” Loosening this definition would allow VCs to participate in secondary and FoF investments without limiting the type of investors they can raise from or worrying about becoming an RIA. In addition to allowing more flexibility for VCs, this would also benefit founders and early startup employees by creating opportunities for liquidity.

Permitting all Americans to invest in private companies, regardless of their income or wealth, would help to level the playing field for wealth creation. Over the past several years, venture as an asset class has outperformed public markets — and, as public market stocks look increasingly uncertain, exposure to private assets held over a longer period looks more enticing. At the same time, this would create a greater pool of possible LPs for new fund managers to raise from, which aligns with the current trend of micro-VC funds. Gone are the days where a fund needs to be in the tens of millions to make fundraising cost-effective. Platforms like Sydecar make it possible to pool and deploy funds within hours, and at a fraction of the cost. All of this means that a VC can cost-effectively do smaller deals, comprised of smaller checks, from a wider pool of investors.

Source: Pitchbook

What’s missing?

So what about web3.0? The proposal avoids any explicit reference to crypto/token issuances in the JOBS Act 4.0. That said, in their current form, the proposed changes would allow VCs to invest in tokenized offerings with far more flexibility.

What’s next?

The JOBS Act 4.0 was proposed on April 4, 2022 and still needs to make its way through Congress before being signed into law. The act is widely expected to undergo major changes, so it’s too early to celebrate some of the proposals summarized above. We will be keeping a close eye on this bill and other advancements to the current state of VC regulation, so stay tuned!

Visit sydecar.io to get in touch or subscribe to our newsletter.

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LEGAL: The information provided herein does not, and is not intended to, constitute legal advice. Sydecar, Inc. and Sydecar LLC (collectively, “Sydecar”) does not represent or warrant that the information disclosed here is truthful or accurate. Please consult legal counsel before making any decisions based on the information provided herein.

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