Establishing a venture capital (VC) firm is a pivotal endeavour that requires strategic foresight and a deep understanding of the evolving startup ecosystem. This article explores some of key considerations involved in setting up a venture capital fund and structures available.
Options for investment fund structures
Although the limited partnership is the globally favoured structure, there is no standard structure for venture capital or private equity funds. Customised unit trusts, Early Stage Venture Capital Limited Partnerships (ESVCLPs), Venture Capital Limited Partnerships (VCLPs), and Managed Investment Trusts are among the fund structure options available in Australia (MITs).
The best fund structure for a new venture capital or private equity fund will depend on a number of variables, such as the fund’s size, its investment strategy, the sector, industry, and stage of development of the target portfolio entities, as well as the tax residency status and level of sophistication of the intended investor base.
MITs and Unit trusts
A unit trust structure can offer significant flexibility and permit the creation of custom fund structures.
When funds are organized as unit trusts, either the trustee manages the investments or a (frequently affiliated) special purpose investment management entity manages the investments. The unit trust deed governs the rights and obligations of investors who purchase units through a unit trust.
Generic unit trusts are not subject to restrictions on the type of assets the fund may invest in, the amount of such investments, any requirements for the investment portfolio’s diversification, or the size of the entire fund.
A unit trust is typically a tax flow-through vehicle, which means that the trust’s income, profits, gains, and losses are transferred to the unit holders and are then taxed by them based on each party’s individual tax situation.
A unit trust cannot take advantage of certain significant tax breaks that are available to investors and the fund manager of a venture capital or private equity fund structured as an ESVCLP or a VCLP. Furthermore, the ATO recently published rulings that show it will treat income from private equity funds’ asset sales as revenue. However, the trust has the option to treat qualifying assets as capital if it meets the requirements to be an Managed Investment Trust (MIT). MITs can also take advantage of lower withholding tax rates.
In order to promote foreign investment in Australian venture capital, the VCLP was established, and it offers certain foreign partners of the VCLP income tax exemption on profits (capital and revenue) from the sale of eligible investments, and the carried interest of the fund manager is treated as capital account. For Australian residents, the VCLP structure offers no such tax benefits, so they must rely on case law precedents to determine the legal status of any gains or profits they may realize.
Funds with VCLP structures are either managed by the limited partnership’s general partner, or the investment management duties are delegated to a (frequently affiliated) special purpose investment management entity.
Limited partnership interests are obtained by investors in a VCLP, and have obligations and rights governed by the restrictions partnership contract.
The VCLP differs from conventional incorporated limited partnerships in is a tax-through entity that permits distributions to be taxed in the investors’ hands. being able to make a loss claim will depend on the specific circumstances of each investor. One of the limitations of VCLPs are that they can only make investments of venture capital that are generally not investing in companies whose main pursuits include ownership of real estate or land, banking, or providing leasing, factoring, securitisation, insurance, and providing capital to others building new infrastructure or purchasing existing facilities, and investing in a passive manner.
A minimum fund size of $10 million AUD is required for VCLPs. The maximum fund size of a VCLP is unrestricted. In general, mid-market Private Equity is conducted using VCLPs likely to target foreign investors are funds.
With an ESVCLP, both domestic and foreign investors are exempt from paying taxes in Australia on income and capital gains from eligible venture capital investments or from the sale of those investments.
The tax-free treatment is a significant legislative incentive that lowers the risk associated with early-stage venture capital opportunities. It also has the potential to significantly boost an investment fund’s internal rate of return and help it draw in a larger group of investors. Losses do not pass through to the limited partners, just like with VCLPs.
The management of ESVCLP-structured funds is either delegated to a (frequently affiliated) special-purpose investment management entity or the general partner of the limited partnership.
Similar to VCLPs, one restriction on ESVCLPs is that they can only make investments in certain types of venture capital. A focus on early stage venture capital must also be shown in an ESVCLP’s approved investment plan.
The starting point is that an investee’s gross assets at the time an ESVCLP makes its first investment in it cannot exceed AUD$50 million, despite the fact that the legislation does not define the term “early stage.” This relatively high threshold may include investments made during the expansion stage.
The fund must have committed capital of at least AUD$10 million and not more than AUD$100 million, and it must be organized as a limited partnership.
ESVCLPs are typically used for funds with an investment strategy that focuses on early stage, high-growth opportunities and that target Australian resident investors.
For both investors and fund managers, the choice of fund structure has significant implications, including:
- taxation of investor distributions and the fund manager’s carried interest
- obligations for Australian Financial Services Licensing
- the complexity and levels of regulatory compliance, and
- the degree of limitations on the size and investment approach of the fund
Together, these implications may have an effect on a fund’s ultimate investment portfolio’s composition, internal rates of return, and revenue outcomes. Fund managers can increase their competitive advantage and help to ensure a more successful capital-raising campaign with a wise choice in a fund structure.
If you need further assistance with setup or ongoing VC accounting, feel free to contact our team.