This is the third installment in our series on making a private secondary investments (Part I is available here
and Part II is available here
). This week, we'll discuss Investment Structure.
It's an exciting time for accredited investors, with increasing access to private secondary investments. But, as Shri Bhashyam, our in-house lawyer, always reminds me, the devil is in the details. Before you invest, be sure to understand what you’re investing in and how that investment is made.
Direct vs. Fund Structure
In its simplest construction, an accredited investor will be the direct owner of the shares that are the subject of the investment. In the case of a share purchase, the investor will be listed on the company's cap table
and get direct updates from the company, should the share class they own be privy to any.
At the time of acquisition or IPO
, the investor will be contacted directly by the company's Equity Administration team or Transfer Agent.
Unfortunately, direct share transfers for each investor heavily burdens a company's Legal and Equity Administration teams (if they even have one). Why? Let's consider a transaction where an employee shareholder sells $1 million worth of stock to 50 investors, each investing $20,000:
For one, the company would need to process 50 separate transfer notices (the transfer notice is a required document that sets out the terms of the proposed share sale).
Additionally, the company would need to determine if it should exercise its Right of First Refusal
(ROFR) for each of the 50 purchases. Should they opt not to exercise their ROFR, they would now add 50 new investors to their cap table.
As a comparison, when a company goes through a large Venture Financing, they may only add 2 or 3 new investors to the cap table. So adding 50 people is a ton of work!
In direct investments, the investor typically pays an upfront commission on the transaction.
The solution to the aforementioned problem is a fund structure. In this type of investment, investors are purchasing an ownership interest in a fund (usually a partnership or an LLC
), which will hold the private shares as an investment. In the case of a share transfer, this means that the fund, rather than the specific investors, is purchasing the shares from the shareholder. As a result, only one transfer notice needs to be submitted to the company, and the company will only need to add one name to the cap table (the name of the fund).
At the time of acquisition or IPO, the Fund will be contacted by the company's Equity Admin team or Transfer Agent, and the Fund will be responsible for any distributions of shares or cash.
With a Fund Structure, investors can be charged in various ways: an upfront sales fee, an annual management fee and expense fee, and carried interest (where the Fund's manager will keep a percentage of any profits).
The benefits of the fund structure are that you have access to more deals at a lower minimum investment amount, and also are part of a fund that's being actively managed on your behalf. The consequences are that you have less control compared to a direct investment.
Qualified investors can invest in late-stage private companies either directly or through a fund structure, and it's important to know the difference. In each case, understand how the share transfer will take place: a physical share transfer, or a derivative. If it's a derivative, is it company-approved? If not, beware of the risks involved.