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Business Formation & Corporate Governance

Fund Formation Essentials: A Comprehensive Guide for Startups and Emerging Fund Managers

Promise Legal Staff

• 4 min read
Fund Formation Essentials: A Comprehensive Guide for Startups and Emerging Fund Managers

1. Introduction to Fund Formation

Startups and early-stage fund managers form investment vehicles to pool capital, diversify risk, and access a broader investor base. Funds enable systematic deployment of capital into a portfolio of assets—ranging from equity stakes in growth-stage companies to special situations—while providing investors with professional management and oversight.

2. Types of Investment Vehicles

When establishing a fund, teams commonly choose among several legal structures, each tailored to specific strategies and investor preferences:

  • Limited Partnerships (LPs): The most prevalent vehicle for private equity and venture capital. Managed by a General Partner (GP) who makes investment decisions, LPs attract capital from Limited Partners (LPs) whose liability is capped at their investment. LPs enjoy pass-through taxation, avoiding double taxation at the fund level. (mondaq.com)
  • Limited Liability Companies (LLCs): Hybrid entities that blend partnership tax treatment with corporate liability protection. LLCs offer flexible management (member- or manager-managed) and tax elections (default pass-through or S/C corporation), making them popular for fund management companies or single-investment vehicles. (library.fiveable.me)
  • Corporate Funds: Taxable entities (C-corporations) that may suit tax-exempt or foreign investors. While they can centralize operations under a single entity, corporate funds face double taxation—at the corporate level and again on dividends. (avisenlegal.com)
  • Special Purpose Vehicles (SPVs): Single-asset or deal-specific entities—typically structured as LLCs or LPs—used to isolate risk for co-investments or carve-outs. SPVs streamline syndication by grouping investors for one transaction without exposing the main fund. (becivil.co.uk)
  • Master-Feeder Structures: A master fund handles investments, while multiple feeder funds—often segregated by geography or tax status—contribute capital. This setup accommodates U.S. and international investors in a tax-efficient manner. (becivil.co.uk)

Selecting the right vehicle impacts liability protection, tax efficiency, and operational flexibility. Align your choice with investor profiles, target returns, and regulatory considerations.

Beyond choosing an LP or LLC, consider domicile:

  • Delaware: The preferred U.S. jurisdiction for funds, offering flexible General Corporation law, a robust case law foundation, and favorable tax treatment for out-of-state and foreign partners. (VC Lab)
  • Cayman Islands: A leading offshore domicile with streamlined fund regulations and tax neutrality. International managers often use Caymans for non-U.S. investors to avoid U.S. withholding and K-1 complexities.
  • Luxembourg: Popular in Europe, offering regulated fund forms (e.g., SICAV) and a comprehensive regulatory regime under the EU’s AIFMD.
  • Limited Partnership Agreement (LPA): Defines GP/LP roles, capital commitments, fees, governance, transfer restrictions, and termination. (capitalfundlaw.com)
  • Private Placement Memorandum (PPM): Detailed disclosure of investment strategy, risks, team bios, fees, and terms, enabling informed LP decisions. (permian.no)
  • Subscription Agreement: Investor’s commitment and representations—accreditation, risk acknowledgment, and payment terms. (dentons.com)
  • Management Agreement: Service levels, fee structure, performance incentives between the fund and management company. (capitalfundlaw.com)
  • Side Letters: Tailored amendments for specific LPs—preferential rights or reporting. Use sparingly to avoid perception of unfairness. (Harvard Law)

5. Regulatory & Compliance Framework

Most funds rely on SEC Rule 506(b)/(c) under Reg D, permitting accredited LPs and, for 506(c), general solicitation if verification procedures are robust. File Form D within 15 days of first sale and monitor state Blue Sky filings. (SEC Form D)

  • Integration Concepts: Stagger closings to avoid triggering integration, maintaining exemption. Understand the 6-month look-back and look-forward windows.
  • General Solicitation Rules: 506(c) allows open marketing but mandates documented investor verification. 506(b) prohibits public advertising but permits up to 35 non-accredited LPs with disclosures.
  • Blue Sky Compliance: Coordinate with specialized counsel to file notice filings in states where LPs reside, minimizing fees via coordinated exemption tactics.

6. Fund Economics & Terms

The industry-standard 2/20 model:

  • Management Fee: 1.5%–2.5% of committed capital (often stepping down after investment period).
  • Carried Interest: 20% of profits after LPs receive their preferred return (8% hurdle is common).
  • Hurdle & Catch-Up: Ensures LPs get minimum return before GP share; 100% catch-up until GP share aligns with 20% of total profits.
  • Waterfall: Sequence: return of capital → preferred return → catch-up → split of remaining profits.

7. Fund Governance & Operations

  • GP vs. LP Rights: GPs manage; LPs vote on major changes (e.g., extension, GP removal).
  • Advisory Boards: LPACs review conflicts, valuations, related-party transactions. (diligent.com)
  • Reporting: Quarterly NAVs, capital account statements, annual audited financials. Transparency builds trust.

8. Tax & Accounting Considerations

Partnerships pass through income; no entity-level tax. Use blocker corporations for U.S. taxable investors or foreign tax-exempt LPs to mitigate UBTI/PFIC issues. Track UBTI triggers for tax-exempt investors. Plan PFIC reporting for foreign portfolio entities. (Investopedia)

9. Launch Process & Timeline

  1. Pre-Launch: Roadshow deck, formation of GP entity, draft LPA/PPM/subscription agreement. Target regulatory window.
  2. Fundraising & Closing: First close to signal momentum, followed by multiple closings. File Form D within 15 days of first sale.
  3. Post-Closing: Capital deployment, ongoing compliance, investor reporting, and IR communications.

10. Best Practices & Common Pitfalls

  • Align Expectations: Ensure LPA terms—fees, hurdle, term—match LP appetite to avoid disputes. 81% of managers report LP conflicts from document misalignment. (ocorian.com)
  • Maintain Compliance: 760 SEC enforcement actions in 2022 highlight risk of waiver of filings or late Form Ds. (eisneramper.com)
  • Lifecycle Management: Structured processes boost target attainment by 25% through disciplined investment pace and exit strategies.

11. Practical Examples & Case Studies

Compliant vs. Non-Compliant Scenarios

Compliant: A GP discloses a carried interest hurdle, includes an 8% preferred return in the PPM, and files Form D on time. Clear waterfall example included in the LPA.

Non-Compliant: A fund misstates the distribution sequence, fails to disclose related-party fees, and misses state Blue Sky filings—leading to remedial filings and penalties.

12. Conclusion & Next Steps

Launching a fund is a complex endeavor, but with diligence in structure, documentation, and compliance, you can create a vehicle that aligns interests, drives returns, and builds lasting LP relationships.

Checklist:

  • Finalize vehicle (LP, LLC, corporate, SPV, or master-feeder).
  • Draft and review key documents (LPA, PPM, subscription, management agreement, side letters).
  • Plan regulatory filings (Form D, state filings) and capital call procedures.
  • Establish governance (advisory board, reporting cadence).
  • Coordinate tax structure (blockers, PFIC planning, UBTI monitoring).

With these essentials in place, you’ll be well on your way to forming and operating a successful fund.