BY WENDY HEILBUT, PARTNER
We love getting the call from an emerging company or startup client who is ready to embark on a fundraising round: this step shows growth, proof of concept, and drive toward expansion. Similarly, when we work with a new venture capital fund in its capital raising efforts, we enjoy fantasizing with the fund managers on how they will utilize the new capital to bring about the fund’s thesis or mission. While we relish celebrating these moments, we’ve seen first-hand that unfortunately, minority founders and fund managers historically recoup a disproportionately small amount of private capital from venture capital firms, angel investors, and even friends and family. While speculation about the why of this abounds, (most VC firms are headed by white men and they tend to invest in founders like them, while minority groups typically have less access to capital and therefore less wealthy networks to tap, etc.) the purpose of this article is to walk through the how of investing in early stage companies and emerging funds, as well as show how fund managers oversee your invested capital to help educate and entice new investors.
Who Can Invest
in Private Offerings (Regulation D)?
Under federal securities laws, any offer to sell a security (think selling stock or shares of a private company for purposes of this article) must either be registered with the Securities and Exchange Commission (the SEC) or meet one of the limited number of delineated exemptions to registration. Registering with the SEC is a very onerous process that would take small start-ups and emerging VC funds tremendous time and the cost would overwhelm the enterprise’s ability to be successful. Enter the exemption called Regulation D (Reg D), under which applicable entities can simply file a Form D electronically and avoid registration. To avail itself of Reg D, the enterprise must follow a few rules: (1) it may not offer its securities for sale via “general solicitation” and (2) all investors (those buying the securities) must be accredited.
The first requirement, while a bit vague, is easy to follow. The company or VC fund cannot solicit investors via broad advertisements on social media or in publications; email blasts should be limited, and outreach should only be made to friends or through direct introductions. Founders should prohibit early investors from blasting their platforms about a company’s fund-raising round.
Constraining the investor pool to only accredited investors, however, can be more difficult and limiting, especially to minority and underrepresented founders and fund managers.
Currently, accredited investors are those individuals who have either (a) a net worth of over $1,000,000 excluding their primary home or (b) a historic and expected annual income of $200,000, or $300,000 for couples (please note that there are a few other ways to qualify as an accredited investor for individuals in the investment industry or those employed by the enterprise offering the securities for sale, but these are not relevant for this article).
At present, the SEC is considering further restricting the accredited investor definition to require a net worth of over $10,000,000. We anticipate the agency to pick this conversation back up this year with a request for public comment. President Biden’s commitment to a broader focus on diversity and equity be damned, as his SEC Chairman Gary Gensler has emphasized pushing for regulatory changes that generally aim to enhance investor protection but limit new investors. It is likely that such a modification to the definition of accredited investor will not impact the general EC/VC capital pool, though it will greatly limit the ability of new, and diverse, investors into the asset class.
In February, an advisory committee of the commission, however, pushed to expand the definition of an accredited investor, not further limit it. The thinking, and we agree here, is that the current definition of an accredited investor disenfranchises most of the population simply due to the belief that the government can better determine whom you should back and whom you should avoid. We will be watching closely this spring; stay tuned!
Investing in Emerging Companies and Venture Capital (EC/VC)
If you meet the accredited investor definition and have the assets and interest in investing in an Emerging Company (a startup) or becoming an investor in a Venture Capital Fund (usually becoming an “LP”), the following guideposts will shed a bit of light on the process.
Emerging-companies, startups, and growth-stage companies, which wish to become venture-backed, will typically offer potential investors a pitch deck that lays out the company’s goals, its direction and current growth, and introduces the founding team. The company will further set fundraising goals and identify how much equity (stock, ownership) one could purchase in the company for a dollar amount. The welcoming of outside investor’s capital squarely puts the company on a growth trajectory as it is now expected to reach the goals it laid out to seduce its investors.
Investors typically have an easier time understanding the mission of a company than that of a venture capital fund. However, becoming an LP (otherwise an investor) in a venture capital fund can be another way to enter the private capital space without the need to understand the ins and outs of a number of companies. Each VC fund will have a thesis (i.e., to invest in female-founded technology companies; to invest in Web3 consumer experiences; to invest in CPG targeting minority communities, etc.) that outlines its investment goals. Potential LPs should understand the fund’s thesis and review its investment documents to understand how it will raise, use, and return an investor’s money. Investors should also consider their compatriots as only 26% of VCs in the US have a woman on their board.
How EC and VC Use Your Money
Investors who have made a direct investment into a company should expect quarterly or annual reports from the founder and key management teams outlining the company’s growth, KPIs, and future goals. Sometimes the company may ask investors for support with hiring or critical introductions in these investor communications. Other than signing a few documents from time to time, most investor’s roles are relatively passive, and an EC investor can wait for the company to get acquired, IPO or fold: hoping for one of the former two!
However, investors in a VC fund might want to understand a bit more about how their money is being used and importantly—who—are the individuals running the fund, typically called the General Partner (the GP to your Limited Partner or LP role). LP investments typically have three types of fees (i) fund organizational and administrative expenses, (ii) carried interest, and (iii) fund management fees.
Fund organizational and administrative expenses such as legal fees related to the set-up of the fund, ongoing legal fees for negotiations on investments and revisions to fund documents as well as tax and filing expenses, are usually paid pro rata by the LPs out of the capital they contributed to the fund. Meaning, investors are not separately or additionally billed for these expenses outside of their investment. Relatedly, remember that carried interest is the percentage of the fund’s profits that go to the GP. This is often 20%. What this means is that when the fund recoups any profit, first each LP will get its principal returned and then the GP will retain 20% of the profit distributing the remaining 80% to the LPs.
Fund management fees are an annual fee usually paid to the GP(s) to compensate them for their time and expenses managing the fund. This is usually 2% of committed capital paid proportionally either on a straight-line basis over the fund’s life (typically 10 years) or on a step-down basis since the GP’s work will likely diminish after the capital has been deployed (after a couple of years). Again, LPs are not separately or directly billed for the management fees, it is merely paid by the fund out of the LP’s invested capital.
More investors make for more diversity of voices, perspective, and opinions; we think that’s always a good thing. By doing your homework beforehand, and then sharing that knowledge with your lawyer and investment advisor, you will set yourself up for the best return possible: knowing that your money is in forward-thinking, capable, and diligent hands.