Introduction
Many Otonomos clients have been around crypto for a much longer time than tradfin money managers and, solely on this basis, have an edge over them when its comes to investing in crypto.
Access non-US tokens and opportunities
However for many, setting up a fund is often still a bridge too far.
As a result, they deploy proprietary funds or pool capital with friends and family straight out of a wallet held in personal name, with no separation of funds and no clear legal delineation of roles and responsibilities, and often with detrimental tax consequences on capital gains.
In addition, if US-based, many tokens and protocols may not be available to them.
Otonomos has been doctoring on a solution that we believe significantly reduces the threshold and the cost of setting up your proprietary fund to access non-US products, establishes a track record and eventually open up to outside investors.
Read all about it!
In what follows, we continue the line of posts going back to April 2021, when we first wrote about How to Become The Next Michael Burry (of Big Short fame), followed by an extensive Fund Special in our November 2021 issue of The Otonomist, with focus on the Incubator Fund in the British Virgin Islands (BVI).
Since, Otonomos has been helping dozens of budding managers set up their crypto fund and we believe that now is as good a time as any to come back into the markets if you take a longer-term view and believe crypto is irreversible.
In this Part I, we summarize the BVI fund setup.
In Part II, we then share a free updated version of the template term sheet which will be your main terms document, given that a BVI fund does not need a meaty offering memorandum. We share this as an editable Google document which will allow you to start configure your fund terms straight away!
Finally, in our paid Part III section, we dissect the all-important Subscription Agreement which is what your investors, when you’re ready to take outside money, will complete and sign before they send you their funds.
Part I - A pre-packaged fund setup: From legals to launch in 5 days
In this first part, we summarize the ease with which a fund can be launched in the BVI, and the low maintenance even for funds up to US$100MM in Assets Under Management (AUM).
Dual citizenship
Before we dig deeper, it is perhaps helpful for anybody who is slightly intimidated about setting up a fund that a fund, as a legal vehicle, remains in essence a limited company.
That is also why, when the fund is “liquid” i.e. investors can come in and out during its lifetime (vs. having the set lifespan of a Venture Capital or Private Equity fund, which are typically set up as Limited Partnerships), we don’t speak about the “GP” (General Partner) and “LPs" (Limited Partners) but respectively about the “Manager” and the “Investors”.
Both Manager and Investors are shareholder in this fund company. However, because different rights are attached to their different roles, the fund will have two types of shares: the Manager share class (referred to as the “M Shares” in the term sheet) and the Participation shares (referred to as the Class A participation shares in the term sheet as there can be different share classes for different types of investors within the Participation shares to cater for currency denominations, different fee structures, etc.).
The Class M Shares are then issued exclusively to the Directors of the fund (or their affiliates) who will be managing the fund and these Class M Share will be voting shares which are not entitled to the receipt of distributions from the fund.
The reason for this is that by issuing a separate M Class of shares, Managers can retain control over their fund even if investors acquire more than 50% of its capital, since Participation shares do not have voting power.
Such “Class A Participating shares” will be issued to all investors that have contributed capital and are hence entitled to the receipt of distributions our of the fund (“Class A Shares” or “Shares”) but do not give voting rights.
If the Managers invest some of their own money in the fund (as is typically expected by investors so they have “skin in the game”), they will also receive Participation shares and, in their capacity as investors, be treated exactly the same as other investors. That is why we often refer to Managers as “dual citizens”.
Note that at any time the Directors may amend the Memorandum and Articles of Association to create and designate additional classes of shares in the fund without notice to, or the consent of, the existing shareholders of the fund, provided that such classes do not rank higher in priority to the shares already issued as regards participation in the profits or assets of the fund.
Capital structure
One point of confusion with a lot of clients is the capital structure of their fund.
Typically they get alarmed by the limit on the number of authorized shares in the company, which is capped at 50,000. The main reason for this cap is that annual government fees, currently US$550 per year, would be much higher if the company were to authorize a higher number of shares.
However, authorized share capital of 50,000 shares does not mean that the company can only have US$ 50,000 in AUM!
- First, the 50,000 shares are authorized capital, not issued shares. Think about authorized capital as shares held in reserve, ready to be issued when more shareholders come in. If authorized capital would be limited to issued shares, a capital increase would be required each time a new shareholder comes in.
- Second, shares can be fractionalized with the same rights as whole shares so there no risk the Company will be short of shares.
- Third, issued shares can be at a very low (and typically at no) par value. In other words, they have no nominal value, which is different from the actual value the shares will be priced at when the fund launches.
As per the term sheet (“Initial Closing Date” on page 4 of our template), this share price can be set at any level during the Initial Offer Period. If for instance a fund launches with a million dollars after this period closes, and the fixed subscription price is US$1,000 per share, that means an initial 1,000 Participation shares will be issued.
Once the fund trades, the Share price will reflect the Fund’s Net Asset Value per Share which, simplified, is the aggregate value of the assets in the fund (after deduction of all expenses, including the Manager’s management and performance fees) divided by the total number of Shares outstanding at the time the NAV is calculated.
A DIY fund
Up to US$20MM in AUM, a BVI Incubator fund does not need to appoint a fund administrator. Such administrator, in addition to managing the subscription and redemption process, also calculates the NAV of the fund.
Without an outside fund admin, it will be up to the fund Managers themselves to manage the subscription and redemption process, and calculate the number of shares allocated to new investors once the initial Offering Period expires.
This is done by way of the Subscription Agreement which we will look at more closely in Part III of this post.
This “Do-It-Yourself” approach is in many ways one of the key attractions of the BVI Incubator fund: it essentially means that below AUM of US$20MM, the subscription and redemption process can be entirely controlled by the Managers to the fund themselves, under the policies they establish internally, including Know-Your-Customer requirements.
This becomes particularly relevant if such subscriptions/redemptions are made in crypto (typically stablecoins) as it circumvents the need for fiat banking at the fund level: during a subscription window, investors can simply send stable into the fund’s wallet for the amount they wish to invest, and get the corresponding number of shares at the then NAV per share back as documented in their Subscription Agreement.
From a Manager point of view too, the BVI Incubator Fund can launch with its two (the statutory minimum) Directors, without the need for a separate Manager entity.
Such Directors do however have to be independent from each other and at least one Director has to be a physical person (but not necessarily a BVI resident) and not an entity.
In practice, this means that it is unlikely that an entity acting as second Director to the fund that has the same Director as the physical person who is the first Director of the fund will meet regulatory approval.
In this context, we have seen that credible biographies (to be included in the term sheet under its “Directors” section on page 3 of the Otonomos template) are an area we recommend clients to pay particular attention to, as this section receives a higher degree of scrutiny in the regulatory approval process.
Such regulatory approval, which comes from the BVIs Financial Services Commission (FSC) is not in itself an application, rather a notification, and provided the above requirements are met and the notification is done properly (which is something Otonomos takes care for its clients), your fund will be able to start trading within only 5 days of filing.
A separate investment manager
The alternative to the fund being managed by its two Managers is to appoint a separate investment manager or investment advisor (IA), a right the term sheet reserves to the Directors in their absolute discretion and which they can exercise at any time.
The Fund contracts directly with the IA under an Investment Advisory Agreement (IMA), essentially a power given to the IA to take the investment decisions over the fund’s assets.
The IA is generally based where the principals are based, e.g. as an LLC in the United States for US-based managers, but can also be a separate BVI entity which would then put a sub-advisory agreement in place with individual managers (or their entity). Such managers can then be based anywhere as sub-advisors to the main IA.
What clients too often overlook and/or underestimate is that the IA will typically need a local license to manage money, at least if the fund manages money on behalf of third-party investors and is not just looking after proprietary capital.
In most jurisdictions, managing money is a regulated activity and getting licensed or registering as an investment advisor may be expensive and may take a long time.
Note that since licensing is a particular area of expertise and depends very much on the chosen jurisdiction, licensing work and advice related to how the investment in your fund can be offered and marketed are *not* part of our fund setup scope.
However we do plug in special counsel at negotiated rates our clients can benefit from if you need help in this area.
Hire a license
Note also that not all IA will need to register or need a license from day one. In some places e.g. the U.K., a license can be borrowed for an initial period from another licensed entity until the IA acquires its own.
In other places, such as certain U.S. States (Florida in particular) you can start managing money up to a certain maximum AUM whilst registering as an investment advisor with the SEC.
Finally on the point of licensing, in the context of a BVI setup, there is as such no check if the appointed IA, when based outside of the BVI, has all necessary licenses or benefits from regulatory exemptions at the moment the notification for the Fund is submitted to the FSC.
In practice this means the launch of your fund should not be held hostage to its IA being regulated in its home country.
Only occasionally, a ”comfort letter” from legal counsel where the IA is based or an extract of the register of authorized firms e.g. the Financial Conduct Authority in the U.K. is asked.
Minimum stack
In case an IA is appointed, the minimum entity stack would therefore be:
- The Fund as a special kind of BVI limited company, as we have seen;
- Its Investment Advisor, which can be another BVI company or a local entity where (most) of the managers are based, typically an LLC for US-based managers, a UK LLP, a Singapore Pte. Ltd. or a Hong Kong Limited company.
- If the Fund is accepting US investors, there would also be the need for a separate “feeder”, typically in the form of a Delaware LLC, that bundles all US subscriptions, which together will form one entry on the captable of the BVI fund. We have posted in more detail on the use of feeders in Part I of our November 2021 Fund Special.
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