To Seed or Not to Seed: A Fund Manager's Guide to Day 1 Capital Raising

Capital raising for fund managers has become increasingly challenging, especially in light of the geopolitical climate. Even managers with solid pedigrees have more strategic partnership options on Day 1 beyond the traditional seeding arrangement, including work capital, GP stakes, and more. In any of these arrangements, there are a handful of audit and tax considerations to take into account.  

Key Takeaways 

• Capital raising has become increasingly challenging for fund managers due to geopolitical factors, leading to more strategic partnership options beyond traditional seeding, including GP stakes and working capital.
• There are various seed deal options available, such as revenue-sharing agreements, each with specific audit and tax considerations crucial for compliance and optimizing returns.
• Founders’ class shares offer an alternative to seeding for emerging managers by providing discounted fees for early investors meeting certain criteria, reflecting a strategic business decision to attract initial investments without giving up company ownership. 

What Are the Types of Seed Deals? 

Below are the four types of seed deals. 

1. Revenue Sharing Agreements: The seeder receives a negotiated percentage of the manager's gross revenue and/or performance fees for a certain period, in addition to returns on their invested capital.  
2. General Partner (GP) Stakes: Investors take an equity stake in the management company, which provides a share in the firm's overall valuation, including future profits from the management company itself, in addition to the fund. GP stakes have become increasingly popular since they offer non-dilutive capital to scale, fund GP commitments, and provide liquidity for succession planning, giving investors access to diverse revenue streams. 
3. Working Capital: The seeder provides significant capital for the fund launch, covers operating expenses, and often includes support for marketing and back-office functions. Working capital maintains stability for managers on Day 1, increases sustainability and builds the right systems, fostering an environment of success and institutional due diligence. This working capital can come in the form of a passive investment or from investors who will be involved in helping the manager run the business.
4. Hybrid Model: The seeder receives both the revenue sharing and equity stake to maximize their return on capital.   

Seeding Considerations for Fund Managers 

As the industry has seen other types of investors besides the traditional seeding and GP stakes firms deploying Day 1 money, to now include family offices and high net worth individuals seeding or providing capital to managers, there are a handful of considerations managers need to take into account. Although seeders will give them capital, they require it to be in a managed account structure, not a fund. A major issue to consider when taking seed capital is how long the investment will be locked up. As a manager, the typical lockup is 2-4 years. Without a significant lock-up, it is probably not worth giving up ownership of the management company and GP for a Day 1 investment. 

“The seeding options have evolved over the last several years, especially with all the spinouts from the large multi-managers,” said Ari Samuel, Partner, Financial Services, EisnerAmper, and the firm’s hedge fund growth leader. “Despite the challenging fundraising environment, there are various options for solid pedigree managers seeking capital for their launch.”  

Audit Best Practices for Seed Arrangements: Finding Compliance in Revenue Sharing and Equity Stakes 

There are a handful of best practices auditors should consider when it comes to seed deals, including:  

• Reviewing legal documents to understand specific deal terms 
• Performing adequate testing to confirm fees and performance allocations are calculated properly
• Verifying capital was developed on Day 1
• Conducting proper valuation of the portfolio asset, especially for complex or illiquid investments 

These best practices are critical to establishing robust compliance and regulatory controls.  

Tax Considerations for Fund Seeders 

Seeding tax considerations focus on structuring revenue sharing to avoid tax consequences for seeders, particularly Unrelated Business Income Tax (UBIT), for tax-exempt investors seeking to limit "unrelated business income tax." On the other hand, non-U.S. investors prefer not to be engaged in a U.S. trade or business (ETBUS), which can require them to pay U.S. taxes. Revenue or profit-sharing arrangements should be structured using "tax blockers" to protect non-U.S. or tax-exempt investors from unnecessary tax liability. Further, since seeders receive a percentage of carried interest, this income is subject to the time restrictions under IRC. Sec 1061 for preferential long-term capital gains treatment (also known as the carried interest “loophole”). It is important to note that the valuation and timing of the seed deal also impact taxes.  

Founders’ Share Classes: The Alternative to Seeding for Emerging Hedge Fund Managers 

For those unable to secure a seed deal or who are not interested in giving up a substantial portion of their management company, founders’ class shares/interests have given fund managers who do not proceed with seeders a better chance of raising Day 1 capital. 

The concept behind a founders’ class is that the manager typically offers discounted fees to investors who meet certain criteria, sometimes in exchange for a longer lock-up and sometimes just because they were early investors in the fund. The criteria may focus on the size of the investment, but often also include a certain period or a threshold for assets under management (AUM). For example, a fund may offer founders’ class terms to any investor who invests over $1 million, so long as that investment is made before the earlier of 6 months from launch or the time when the fund has $50 million in assets. The beauty of the founders’ class concept is that it is a pure business decision made by the manager. They can determine the size of the check, the time frame, or the AUM threshold in question, which determines eligibility for the founders’ class, all based on what makes sense for their business. It can also be any one of those 3 criteria or a combination of the 3. 

Since the introduction of the founders’ class, most funds have this option built into their offerings, and it is now pretty standard. This can be done whether or not the manager is entering into a seed arrangement, so entering into a seed deal does not preclude a manager from offering a founders’ class as well. 

Finding the Path Forward 

Although raising capital has been extremely difficult in the last several years, there are now more options available to a start-up manager, whether they choose to look for a seed deal from a large seeder or one of the alternatives to trying to raise capital through a founders’ class. However, the question remains and will continue to be debated: to seed or not to seed? EisnerAmper is here to help you answer that difficult question and deliver tailored solutions to help you navigate with confidence. Contact us to learn more.