People create or participate in funds for diverse reasons.   Our focus in this article is on those who want to invest and the options that are open to them.  We have written a separate article about entrepreneurs who want to set up a fund to support their new business or project over here.

A family might set up an education fund for their children’s education. A couple might establish or participate in an established retirement fund so that they receive income on their retirement. People can choose to establish funds themselves or invest into existing managed funds.

A person might invest money into a mutual fund, also known as a managed fund, managed by fund managers. A benefit of such funds is that investors can access a wider range of investments that they would be able to if investing as an individual. These can be passive, meaning they follow the market automatically, for example following the S&P or NZX Top 50 companies. Active managed funds, as the name suggests, involve a manager actively watching the market to identify opportunities for better returns and taking the opportunities. There is typically higher risk and higher fees attached to active manged funds.

Investors seeking low-risk investment might choose to invest in government bond funds. The investment supports government speeding and obligations. The flip side of low-risk is also typically lower yield on the investment.

Other investors (often high-net-worth individuals) might choose to invest in hedge funds. These aim to maximise returns, but also expose investors to greater risk by using strategies such as derivates and short selling.

Many investment funds invest in publicly listed assets; private equity is the term applied when investors’ money is pooled together and invested into private companies. Private equity investors often involve more than just funding. Some private equity funds purchase stakes in private companies so that the investors effectively become partners with the private company owners with a view to maximising its success.

An increasingly popular type of investment fund are those offering investors more than a purely financial return.  Impact investment funds use investor funds to support endeavours with social and environmental purposes. Investors receive a financial return as well as knowing they have contributed to other important societal causes. Find out more about impacting investing.

What do you need to know before investing in or founding a fund?

There is no one-size-fits all when it comes to funds, with different options providing advantages and disadvantages. Whether you are considering investing in or founding a fund, consider the following questions first to help choose the approach that best suits your circumstances:

  • What is the purpose of the fund?
  • How many people will be involved?
  • Do you want to manage the funds or have someone manage them for you?
  • What type of return do you want; purely financial, or financial + social?
  • Do you want to derive income or capital gains from the fund?
  • When and how often do you want to access any returns from the fund?
  • What is your risk appetite?

When creating a fund, the founder may want to ensure that the purpose it is being set up for is recognised and continues. We sometimes work to ensure this by setting up special share types or setting up “Kaitiaki” entities to hold some of the ownership and be involved in key decisions. We describe this in more detail in this paper on Steward Ownership.

We have helped many people who have questions about funds and are happy to discuss further.  Feel free to contact us on 03 348 8480 or by email to Steven Moe – stevenmoe@parryfield.com or Kris Morrison – krismorrison@parryfield.com Please note that this is not a substitute for legal advice.

 

What is a fund?

In essence, a fund is a pool of money set aside for a particular purpose. Typically, multiple investors will introduce money into a fund for a common purpose.

People create or participate in funds for diverse reasons. Our focus in this article is on those who are creating funds for the purpose of kick starting an entrepreneurial idea and giving it life.  There are other contexts where a fund may be relevant that we will save for another day – for example, a family might set up an education fund for their children’s education. A couple might establish or participate in an established retirement fund so that they receive income on their retirement. We have written another article on those contexts, over here.

So how can funds be set up to be used to back a new idea / business?

Investment funds are pools of money set aside by people seeking a return on their investment. The  investors’ funds provide equity that can be used by others and then redeemed according to the terms of the fund. The targeted return might be purely financial, or financial + societal or environmental or cultural.  Increasingly such a broader conception of investment funds result in the term “Impact Investing” which we have written about separately here.

What structure might be used?

You might be able to get investors involved via debt – that is, they provide secured lending to you to undertake the project.   Another option is via equity which is where investors have an ongoing ownership stake.

Typically a project that needs funding will be structured so that there is financial return for investors and this is often done with one of the following methods:

  • Limited Partnerships – in this model for a fund there are those with money who invest but have little say in the project (limited partners) and there is an entity which guides the project (the general partner). This type of legal vehicle is useful when there is a distinct one off project, such as a housing development.  There are often tax reasons why investors prefer this option as well.   We go into more detail on this option here.  An LP might also make loans to another entity which undertakes the project (so a combination of debt/equity structures).
  • Companies – this is a traditional vehicle used to have investment and sees the money flow into the entity from shareholders who will then get return from the dividends that get issued when it is profitable. There will be directors of the company who make the key decisions for the project / business.
  • Unincorporated Joint Ventures – another legal vehicle we see used from time to time is to have different parties involved in a joint venture which is set up for a specific project or purpose. While this is an option in terms of setting up a fund we would typically see that being overseen by an LP or company, mentioned earlier.

Other options may be worth considering, and we talk about different structures in this article here.

Ensuring you comply with fundraising rules

Whichever structure is chosen compliance with the rules set by the Financial Markets Conduct Act is critical – it sets out who you can solicit investment from.  For example, if you only ask for investment from wealthy people (who are ‘wholesale investors’ as defined in the legislation) then you do not have as many compliance requirements in terms of the information provided to them.  Depending on what the fund will do there may be other compliance which is needed, for example if financial services will be provided.

If you want to know more about this area, we suggest looking over our Capital Raising Guide here.

Please note that this is not a substitute for legal advice. We’d be delighted to discuss your situation with you, so feel free to contact us on 03 348 8480 or by email to Steven Moe – stevenmoe@parryfield.com or Kris Morrison – krismorrison@parryfield.com

 

 

We both spend most of our days with start-ups and have realised we often get asked the same questions – what does this legal word actually mean?  Sometimes legal terminology becomes its own language and so we want to demystify that and make it clear.

We are starting with 10 words that we often explain to people when we are involved in legal transactions for start-ups raising capital.  Let’s dive in!

  1. Vesting – this is a mechanism which means that the founders and key people of a start-up don’t get all of their shares at once, but instead receive a little bit every month or year. A “vesting schedule” sets out the timeframe over which their ownership rights to shares are earned.  Also, if they leave prior to their shares vesting, they forfeit a portion of their ownership rights and if they don’t contribute in the way agreed, they might not get their shares.  Vesting is used as a way to keep the founders and key people committed to the start-up’s success.

 

  1. SAFE – an acronym for: ‘Simple Agreement for Future Equity’ this is a financing tool which allows early-stage investors to provide funding to start-ups in exchange for the promise of future equity in the company, but without determining the exact ownership stake at the time of investment. This offers start-ups a way to access early-stage capital without having to immediately determine the value of the company, while investors get the promise of future equity on potentially more favourable terms compared to later investors.

 

  1. Tag & Drag – Drag-Along rights allow a majority of shareholders to compel a minority of shareholders to participate in the sale of the start-up. This prevents minority shareholders from blocking a beneficial exit and ensures that if a favourable sale opportunity arises all shareholders can participate. Tag-Along rights are designed to protect minority shareholders and mean that if a majority shareholders intends to sell their shares to a third party, then a minority shareholder has the option to include their shares in the same transaction.

 

  1. Indemnity –A “legal promise” where one party agrees to compensate another party for any loss, damages, or liabilities coming from a specific event or circumstances. In venture capital deals, the legal promise is by the start-up to compensate the investor for any losses, damages, or liabilities arising from certain events. This is typically included in the investment documents and relates to unforeseen matters such as legal disputes, IP issues, tax or undisclosed obligations. Generally the indemnity is limited to the investment amount which the investor has made.

 

  1. Warranty –A legal statement by the start-up regarding the accuracy and truthfulness of information and representations made about the business. Warranties typically cover areas like the company’s financial statements, IP, and legal compliance. Warranties provide a level of protection in case the start-up’s provided information is incorrect or misleading.

 

  1. Liquidation Preference – specifies the terms under which preferred shareholders will be paid if the start-up is sold, dissolved, or undergoes any other form of liquidation. Liquidation preferences are designed to protect the investors’ downside risk and ensure that they have a certain level of financial security in the event of a less-than-ideal exit for the start-up.  These can be “non-participating preferred” or or “participating preferred” (the difference relates to whether after being preferred they also have rights to participate as shareholders after getting their preference amount).

 

  1. Anti-Dilution– a start-up might issue new shares at a lower price per share than what the investor paid, so anti-dilution protection adjusts the investor’s share price or conversion rate, ensuring they maintain their ownership level and are less likely to be diluted. Dilution refers to the reduction in the ownership percentage of existing shareholders when a company issues additional shares, often during subsequent financing rounds as more shares being issued means the number you hold amounts to a lower percentage.

 

  1. Valuation – The price used to determine the start-ups market value, which is critical for setting investment terms like the share price and conversion rate. Investors use valuation to assess the equity they will receive for their investment, a higher valuation typically means investors will get a smaller ownership stake in the company for their investment, while a lower valuation offers them a larger stake. Accurate valuation is essential to strike a fair deal for both the start-up and investors.

 

  1. Due Diligence – this is usually undertaken by the lead investor and involves the investor thoroughly investigating a start-ups financial, legal and operational aspects of their business to assess any risks before investing. The depth and scope of due diligence can vary depending on the specific deal and the investors risk tolerance.

 

  1. Term Sheet – a document outlining the key terms and conditions of the proposed investment deal. It is a preliminary (but non-binding) agreement that creates the base for further negotiations, it is also used for the drafting of the final investment documents. It’s the ‘getting to know you’ stage in the relationship.  The term sheet helps both parties to understand the key terms and expectations of the investment and includes matters including (but not limited to) the investment amount, valuation, investors rights, conditions, governance and decision making, board structure and confidentiality requirements.

 

We hope this initial list of 10 key terms is helpful and would like to create another list in the future– what terms or concepts have confused you that we should unpack next time?  Drop us a line…

 

This article is general in nature and is not a substitute for legal advice. You should talk to a lawyer about your specific situation. Reproduction is permitted with prior approval and credit being given back to the source. 

 

Elise O’Halloran, Senior Legal Counsel at Icehouse Ventures – elise@icehouseventures.co.nz

Steven Moe, Partner at Parry Field Lawyers and host of Seeds Podcast– stevenmoe@parryfield.com

 

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