3. Legal structure

3.1. Strategy

According to Peter Drucker, companies have two main functions: marketing and innovation.

  • Marketing is what gives the company information from the market – the opposite of the commercial service whose purpose is to bring the company’s products or services to the market. Marketing will try to understand the need coming from the market.
  • Innovation is the function that gives the company a differentiating way to meet the needs of the market. If the company has a marketing defect, it does not understand the market demand and will not respond adequately. If the company lacks innovation, it will be overtaken by competition, either with a cheaper but equivalent product or by meeting better demand and maintaining the equivalent price.

Hvac

Companies that have traditionally innovated through research and development are moving to a new paradigm: recruiting the best talent is becoming more and more difficult and having the chance to achieve the disruption of startups is a difficult task. This is where funds have played a major role throughout history: for the first time, DuPont invested in General Motors in the hope that its financial success would necessarily lead to the success of DuPont, being the leading supplier of products chemicals and plastics from the car maker. GM has grown exponentially, outpacing anything DuPont could predict. And today, companies like Microsoft, Google, Sony and P-G are creating their own venture capital funds (Corporate Venture Capital or CVC) to invest in startups in the early stages.

Venture capital funds

CVCs are identical to VC funds, with the difference that they are founded by companies, with additional objectives that add to a simple financial return on investment: such as keeping abreast of market and technological trends in the industry concerned; Have a “first glimpse” of new technologies “outsourcing” research and development to start-ups; secure opportunities to establish business/strategic relationships with, or acquire, innovative start-ups and/or their technologies and/or staff. However, companies that make the investments for the sole purpose of acquiring the technologies are alerted that the holding of a certain number of shares does not give any right to a commercial secret of the company, and that any type of future license or trade agreement to be concluded with the startup must be processed before the investment.

The basic structure of a CVC is similar to that of a private equity fund. The main difference lies in its objective: for venture capital, it is a matter of investing at an early stage of the business (start-up), while private equity focuses on mature companies, partially or buying entire companies in order to develop them before the exit.

Investment funds

The main objective of an investment fund is the purchase and sale: for a traditional company, the idea is to assess the added value of a specific department and/or an affiliate in the Group. Large companies tend to focus on highly profitable activities and forget about loss-making activities, leaving a responsibility for the entire company. Selling low-performing businesses, when they have reached their maximum profitability, may be the best decision within the Group to reduce the financial pressure they would create. In addition, it would be the ideal operation of another company that could make it a better asset. This is where the selling company can trade higher values for activities that have not performed in a certain environment, but which could outperform elsewhere. A well-prepared and well-explained sales decision is not considered a bad management decision (Felix Barber, Michael Goold, HBR). For example, GE implements the group’s cost discipline and quality methods in each new acquisition and ensures that major trends such as offshoring in India are exploited, without integrating the new business; conversely, P-G will first seek to buy and influence with a long-term goal to create synergies with new acquisitions. Private equity funds contribute to the “buy-sell” strategy through heavy investments to boost finances and achieve the most efficient results of acquired companies, allowing them to sell to securities as well. when their portfolios are liquidated.

Other methods include pushing executives to invest their own money to ensure that they are doing their best to stimulate the business and setting short- and medium-term goals in their area of expertise (not in the creation of synergies). Focusing on synergies can lead to intrinsic inefficiencies in companies, which must achieve intrinsic performance before being called upon for big changes.

3.2. Structure

When it comes to developing the company’s business and strengthening its financial performance through the creation of a fund, the question is how to structure it.

A holding company deals with these issues since it acquires and sells subsidiaries. However, it does so as direct investments, without going through a specific entity or a defined fund. This has several drawbacks, one of which is that the teams involved in these investments are generally not entirely dedicated to fundraising activities, which can lead to some difficulties and is incompatible with the rapid growth needed by startups.

In addition, the situation becomes more complicated when it comes to taking advantage of the acquisition with other investors who wish to join the transaction, and above all, the leveraged buyback activity (contracting low-interest debt from banks to process a higher value acquisition) is a complex transaction carried out through the fund.

Private equity fund structure

Investment in a Private Equity fund can be made as a sponsor in an independent fund, which means investing an amount of money in a common fundraising pot, which is made and decided by a General Partner in the Anglo-Saxon system). The sponsor is usually an SARL (or even an SAS) that has the power to make the investments on its own, in accordance with the fund’s original objective. This solution does not give any power to the investor (the sponsor is also called a passive shareholder).

The diagram below represents the overall structure of an EP fund. It involves a number of players: the fund as a legal entity, investors as sponsors, the general partner, the fund’s sponsor, the investment advisor and the portfolio companies ( portfolio company).

Private equity fund structure

Management

Investors (Limited Partners, LPs or sponsors) enter into agreements when the fund is created, which give them limited liability to the amount of capital committed and limit their ability to control decisions investment stake that are the responsibility of the sponsor.

The general partner (GP) is the real investor, who decides where and when to invest the amounts, following the guidelines given by investors in the objectives of the fund. For limited partnership investment funds, the general partner is normally a specific legal entity (Special purpose vehicle or SPV) that protects the sponsor from unlimited liability for claims against the fund. That is why there is a sponsor, who will act as a general partner, but legally separate from the sponsor. The management company acts on behalf of the general partner to manage the fund and advise on the investments to be made, a service for which it receives a management fee (usually 2% of the invested capital). The general partner enters into a consulting agreement with the management company. The general partner is rewarded on accrued interest, which is the profits generated by the fund after the management company has recovered its initial capital. The general partner receives 20% of the deferred interest (in most cases), with the remainder distributed among investors.

However, as a general rule, to ensure a minimum deferred interest, the sponsor is not rewarded until (1) investors receive all of their investments and (2) an additional percentage equivalent to a minimum interest called “hurdle” of 7 to 9% is granted to them. In a fund, excess cash is often distributed as it is generated. Once these two steps have been completed, the GP “catch-up” (in most cases) and receives the profits generated up to 20% of the profits. After catching up, subsequent profits are split between investors and the GP at the agreed rate (20/80 or other). This is called “distribution waterfalls.” Management fees do not follow the same distribution pattern as the management company must perform ongoing expenses in consulting, salaries and other services required for the day-to-day management of the fund.

Contracts

The table below summarizes the main legal documents needed to create a fund. The Private Placement Memorandum (PPM) is the main document produced for the fund’s marketing period. The PM usually assigns an investment agent who will make individual presentations (to people in his network and his relationships) to explain the objectives of the fund, detailing the team concerned (the GP is the main profile whose experience and background often guides the investor’s decision) and the fund’s strategy. A GP who invests a significant share of the fund will not only give investors more confidence, because he not only asks other investors the risk of his own return with the interest he holds, but he understands the risks of losing his own capital.

The investor agreement and questionnaire often arrive at the same time as the PPM. The agreement sets out the investor’s commitment to the fund, requesting certain statements and guarantees as to its ability to invest and the regulation.

The Limited Partnership Agreement is the main contract that creates the legal structure of the fund. It includes investment objectives, duration (usually between 10 and 12 years), GP and sponsor responsibilities (investors), waterfall distribution and other legal terms.

ContractsPeriod
PpmConstitution
Subscription agreementLifting
LpaAcquisition

The life of the fund will be divided into two main periods: the investment period and the liquidation period. Each of these periods lasts between 4 and 6 years.

The investment period is made exclusively by the acquisition of shares of companies or by the purchase of companies, the liquidation period applies exit strategies through IPOs or divestitures (M-As), disposals in our case.

Slp

The Free Partnership Society (SLP) is inspired by the anglo-Saxon limited partnerships explained above. It does not require approval from the AMF. Investing in SLP entitles you to a tax reduction of 18% if at least 70% of the fund is invested in startups. On the other hand, a management company approved by the AMF is mandatory.

This is the most interesting structure in France to receive foreign funds because international investors are familiar with Anglo-Saxon LPs.

Structure LFA

Thus we end up with a legal structure for the LFA fund that brings together the main elements of private equity’s investment fund and whose particularity is found in the general partner. The general partner is the founding partner of the fund, which carries with it the risk of the financial investment, which is legally unlimited risk. That’s why we create an SPV in the form of an SAS holding company that raises the funds of entrepreneurs at equal height. The holding company will be the sponsor of the fund.”

The entrepreneurs have equal shares in the holding company, itself a general company, or GP of the fund. During the period of the fund’s implementation of the startup structure, entrepreneurs are the sole representatives of the fund as partners of the general partner.

As soon as the fund is established, it will be able to welcome investors as sponsors. Entrepreneurs can then re-invest in the form of sponsors. (They are then considered investors for their share of sponsors.)

The final structure of the LFA fund takes the form below:

Structure LFA

Distribution of founders’ shares

When the fund was formed, the founders were brought together in a special purpose vehicle in the legal form of Holding SAS.

Upon its inception, the fund is created by the holding company. The fund is therefore 100% owned by the founders’ holding company, at its inception and before the first raising.

The (5) startups are created in the legal form of SAS. They are 100% owned by the fund.

After the fund is established, investors will be able to invest in the fund as limited partners.

LFA