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The first point to make is that no two seed funding deals are the same, as each deal will be determined by the unique needs and interests of the parties involved. That means each deal comes with a unique structure, fees and terms.
Sometimes seed funding deals will comprise an interest in the management company itself as well as the fund, while others will simply involve an interest in the economics of the fund. Some will be a mix of both.
There is no ‘one-size-fits-all’ when it comes to seed funding, and you should think carefully how accepting any kind of seed-funding will affect the long-term economics of your fund management business.
Getting a new fund off the ground is difficult. In fact, if you’re reading this article, you probably don’t need me to tell you that.
So there are clear attractions of dealing with investors who provide the initial capital to fledgling boutique fund management outfits in order to help them move closer to critical mass.
Allocators often have rules on the minimum AUM they require a fund to have before they take a serious look at it, and once you’ve exhausted the friends and family route the going can get pretty tough. Seed funders can be the helping hand you need to take your fund to the next level.
But seed funders can provide so much more than capital.
Given that seed funders are often highly specialised outfits that are focused on working with emerging managers, they can often come with considerable intangible benefits as well.
For instance, they may also be able to provide invaluable assistance when it comes to distribution and capital raising, especially since they are often very well connected within the emerging manager investing community.
They may also be able to offer all kinds of useful advice regarding the business of running a boutique investment firm, as their experiences will have given them access to the inner workings of many different managers, many of whom will have faced similar challenges and opportunities to your own business.
It’s inevitable that a seed funder will want to extract their pound of flesh from the deal. Again, there is no one-size-fits-all formula here, but here are some of the terms you can probably expect to be floated.
Gross revenue shares (GRS) are probably the simplest form of agreement as it eliminates the need for the seed funder to monitor the expenses side of the business (unlike a profit share agreement). An added attraction of this arrangement is that it is often less demanding on the manager, who can maintain independence and doesn’t have to expend time and energy explaining themselves to a third-party when it comes to decisions that impact the bottom line.
At the opposite end of the spectrum is a deal that involves a share in the net income of the manager or an equity stake. The latter may be attractive if you also require further financing to build out the infrastructure of the company and/or the cash runway to profitability.
However, be aware that professional seed funders will drive a very hard bargain and you may not like the terms that are offered. The again, accepting dilution may be the right decision if it gets you to where you need to be.
One of the main attractions for the manager is that seed funding will almost invariably come with a lock-up clause for the seed-funder (usually at least 18 months but often much longer).
However, there will be several clauses attached to this commitment, such as key person or ‘bad actor’ clauses, or problems with the management company or the fund which could release the seed funder from its commitment. It is also important to bear in mind that the commitment is also binding for both sides, meaning it will be subject to restrictive covenants such as non-compete clauses that will prevent the manager and other key staff from walking away.
It’s also typical for a seeder to insist on the inclusion of consent clauses when it comes major transactions or events that could have a significant impact on the business, such as taking on debt, changing strategy or M&A.
The seed funding of emerging managers and new funds is a very specialised niche, and as such there are relatively few dedicated seed funders of managers.
There are a handful of institutional platforms that act as a kind of incubator for fund houses to take advantage of their in-house admin and back-office capabilities before eventually being spun out. This may or may not suit the manager, which may have to accept less operational flexibility as a result.
Managers should also bear in mind that the people most likely to provide seed-funding probably don’t describe themselves as a seed funder. There are many entities and individuals out there who may be willing to write a large cheque for your fund in exchange for equity/preferential fee arrangements/revenue share agreements. These could include family offices, endowments and even some HNWIs.
Before you commit to a deal with a seed funder, have you considered the alternatives? If you are not in too much of a rush to grow AUM asap, the friends and family approach is often a great way to start moving towards that first twenty million – a size where you can then begin to approach larger investors.
There are many different factors to take into account when evaluating the pros and cons of entering into a seed funding arrangement.
As we mentioned earlier, there is no one-size-fits-all here, and the seed funding market is highly opaque, which can make it difficult to get a handle on what is ‘normal’ in terms of deal structuring etc. What this means is that each deal has to be evaluated on its own terms and whether it fits your vision for the fund and for your business.
Disclaimer: This blog is intended for informational purposes only. This blog is not intended to invite, induce or encourage any persons to engage in any investment activities and is not a solicitation or an offer to buy or sell any stock, investment product or other financial instruments. If in doubt, please seek financial advice from an independent financial adviser. Sarnia Asset Management is licensed by the Guernsey Financial Services Commission (GFSC). Past performance is not an indication of future returns. Investments carry risk, including the risk that you will not recover the sum that you invested.
By James Faulkner
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