To Seed or Not to Seed
February 14, 2017
By Jason Grunfeld, Partner - Kleinberg, Kaplan, Wolff & Cohen
It is one of the age-old quandaries in the fund industry: Try and obtain a seed deal or forego that option and try to make a go of it on your own. In today’s ever-changing world, raising capital has become increasingly challenging for start-up fund managers. However, there are now more alternatives than there have been in the past.
For those unable to secure a seed deal, or who are not interested in giving up a substantial portion of their management company and general partner: Do not fear, you now have another tool in your belt to attract Day 1 capital. The introduction of the concept of founders’ class shares/interests in the last 2-3 years has 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 will typically offer discounted fees to investors that 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 investment, but often also includes a certain time period or threshold assets under management (AUM). For example, a fund may offer founders’ class terms to any investor that invests over $1 million so long as that investment is made before the earlier of 6 months from launch or the time that 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 determine 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 some sort of seed arrangement, so entering into a seed deal does not preclude a manager from offering a founders’ class as well.
For managers looking to enter into some sort of seed arrangement, the landscape has changed over the past several years. No longer are managers dependent on chasing the “white whale,” those large seeders that write 9-figure checks. Those seed deals are few and far between. The number of large seeders has decreased over time and those that remain typically only write 2-3 checks a year, so the chances of getting that deal are very slim.
However, a whole new crop of participants have joined the seeding world and they come in all shapes and sizes. We have seen everything from family offices to high net worth individuals seeding managers. Sometimes, a manager will get some sort of seed capital from their prior employer. There are also seeders that will give them capital, but 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 that investment will be locked up for. As a manager, you would typically want to lock that money up for 2-4 years. Without a significant lock-up, it is probably not worth giving up ownership in your management company and General Partner for a Day 1 investment.
A change we have seen recently in the seeding world is that some managers are not looking for investments in their fund, but rather working capital to be invested in the management company. For a manager, this can help ensure stability on Day 1, make sure the lights stay on for several years so they can hire the right people, build the right systems, etc., which are all imperative to making sure the firm is built to succeed and that it can pass institutional due diligence. This working capital can come in the form of a passive investment or from investors who will actually be involved in helping the manager run the business.
Another factor to consider when thinking about a seed arrangement is what else that seeder might provide. Many will just provide capital (either as an investment in the fund or working capital to the manager), but others will provide support in the form of marketing and capital introduction services as well as infrastructure and back-office assistance.
So, 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...
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