Rainmaker 8: Investment structure strategies

Deal structure shapes outcomes and appeal to single family offices, through share classes, liability limits, fee design and payment order. The episode also covers co-GP agreements and a discount on a later round.

LLC Share Classes and Partner Liability

Deal structure can materially affect how a transaction turns out and how well it appeals to single family offices, a point Richard C. Wilson draws from his years of experience. An operating agreement for an LLC can create several share classes. One class carries control. Another carries a preferred return, a stated return its holders receive before the other classes share in profit. The operating agreement separately states when original capital is returned and when pro rata sharing begins. In a limited partnership, the limited partners typically have liability capped at the amount they invested, while the general partner actively runs the deal and carries more liability. Each document assigns risk to named parties.

The choice between an LLC and a limited partnership shapes the subscription agreement and the exit mechanics that follow. Investors read class terms early. A family office reviewing the operating agreement looks for the preferred return and the point where pro rata sharing begins, and then checks the size of its own exposure. Those answers shape first impressions during the first review of the term sheet.

Sponsor Fees and the Investor Pool

Fee design draws close attention. Some investors prefer that a manager earn more when investments perform well, and they resist large upfront fees. In a hypothetical deal, fees collected on day one and again each year can look like a hedge against the sponsor’s own risk. Investors may read those fees as undermining the sponsor’s claimed contribution of capital at risk, because money collected on day one reduces the exposure the sponsor describes. Fund structures that prohibit side letters and direct deals can limit the pool of potential investors, since an investor that wants a side letter or a direct deal has to look elsewhere.

Minimums affect that pool as well. He notes that some platforms keep a $25,000 minimum, and that some of their strongest investors are smaller investors who told others about the opportunity and brought in more investors. A modest ticket on the subscription agreement keeps the door open to people who later refer others, and referrals build the investor list.

Waterfalls and Downside Recovery

A waterfall sets the order of payment. In preferred equity funds, a preferred return is paid before later investors receive distributions. A co-GP agreement can be struck with someone who sourced the deal or someone who brings all the capital, and a partner who can add value fits the same template. In one described deal, the co-investor of the active controller recovers invested capital first. The controller is repaid afterward, and pro rata sharing follows. That ordering puts the investor’s principal ahead of the controller’s, a feature worth reading closely in the operating agreement. The same template also names who funds the deal and who makes decisions.

Downside protection gets its own language. Some structures seek to recover 60% or 100% of an investor’s money if an investment fails, even when the investor earns no return. On a later round, the largest investor in the current round may negotiate a discount, perhaps a stated percentage off the next round price. Both terms belong in the term sheet before closing.