Seed agreement

A seed agreement creates the legal framework for partnerships between new hedge fund managers and early seed investor. These detailed contracts establish the formal relationship between fund managers and seed investors. The agreements help funds reach the minimum size needed to operate effectively, build track records, and attract more investors. In exchange, seed investors receive better financial terms than regular investors.

New fund managers often create seed agreements with early investors. They negotiate special terms that fit each situation. Under these arrangements, the seed investor promises to invest money in either the fund itself or the management company that runs the fund. In return, they get favorable treatment such as lower fees, a share of the fund's revenue, or partial ownership of the management business. The seed agreement specifies how much the investor must commit and under what conditions they will actually provide the money.

Seed agreements create different types of financial structures. These may include revenue sharing arrangements that give investors a contractual right to fee income without owning part of the company directly. They might also include special share classesDifferent categories of fund shares with varying fee structures, rights, or redemption terms offered to different investor types. that offer both reduced fees and revenue participation rights. Some arrangements provide direct ownership stakes that give minority ownership in the management company. Others use warrants and options that allow investors to buy equity at preset prices.

Fund managers and seed investors often structure revenue sharing to cover multiple fund launches over time. However, these arrangements typically include negotiated limits such as dollar caps, time restrictions, limits based on the type of investment vehicle, or constraints tied to specific strategies.

Seed investors can choose to participate in either gross fund revenues or net profits. Gross revenues are fees collected before any expenses are deducted. Net profits are fees calculated after expenses have been subtracted. Each approach creates different considerations for expense oversight and risk management.

Seed agreements typically address several categories of special rights for the investor. These commonly include capacity rights, which allow the seed investor to put additional money into the fund on favorable terms. They also usually receive reduced or eliminated management fees Management fee Management fee refers to a recurring fee, typically calculated as a percentage of assets under management, that hedge funds charge investors to cover operational and administrative expenses regardless of fund performance. and performance fees Performance fee A performance fee is compensation paid to a hedge fund manager based on the fund's investment profits, typically calculated as a percentage (commonly 20%) of returns above a specified threshold, subject to high-water marks and potentially hurdle rates. .

Seed investors typically get enhanced transparency and reporting rights. This means they receive frequent and detailed information about the fund's investments and financial performance. Most agreements include "most favored nation Most favored nation (MFN) Most favored nation (MFN) provisions in side letters guarantee that an investor will receive terms at least as favorable as those granted to other investors of the same or smaller size, often organized in tiers based on investment amounts. " protections, which ensure the investor receives terms that are equal to or better than any other investor gets.

Many seed agreements also include tax consultation rights. These give the seed investor input on tax strategy decisions and the right to approve certain tax-related choices that could affect their investment.

Seed agreements generally include provisions that address how the seeding relationship will eventually end. Fund managers typically want to expand their investor base and pursue new opportunities without depending on their initial seed investors. These provisions usually give either the fund manager or seed investor the right to end the arrangement.

Various factors can trigger these termination rights. These include breaches of the seed arrangement terms, departure of key investment personnel, reaching predetermined time limits, or achieving specific performance targets. Notably, both strong fund performance and poor performance can lead to termination. Strong performance means the seed investor has achieved their desired returns. Poor performance means they want to limit further losses.

Two commonly used exit approaches address the natural tension in these relationships. Seed investors prefer extended profitable relationships, while fund managers want to achieve independence from their early backers.

Put/call arrangementsA financial arrangement where one party holds an option to purchase another party's position while that party simultaneously holds the right to force the sale of their position, providing exit flexibility for both parties in agreements. give the fund manager the option to buy out the seed investor's position. At the same time, they give the seed investor the right to force the fund manager to buy them out. The parties often use valuation methodologiesSystematic approaches and frameworks used to determine the fair market value of assets, securities, investments, or business interests using financial analysis, market comparables, and appraisal techniques. or independent appraisers to determine buyout prices.

Phase-out provisionsContractual terms that gradually reduce or eliminate specific rights, financial interests, or ownership stakes over a defined time period rather than terminating or removing them immediately. structure the transition over a longer period instead. The seed investor's financial interest gradually decreases to zero over a negotiated timeframe. The associated buyout costs are paid from future profits rather than requiring the fund manager to arrange immediate financing. These alternatives address the fund manager's limited access to capital and the seed investor's need for clear exit options.

Seed arrangements naturally create potential conflicts of interest. These arise because the seed investor has a special relationship with the fund manager and invests alongside other fund investors who have different rights and benefits.

Some conflicts can be adequately managed through clear disclosure to other fund investors. This disclosure explains the seed investor's preferential terms and enhanced rights. Other conflicts require active measures to prevent the fund manager from breaching their duties to the broader investor group.

Specifically, if the seed investor participates in fund operations or marketing activities, this should be disclosed to other investors. This allows them to understand the seed investor's multiple roles and interests.

The Fifth Circuit Court of AppealsFederal appellate court that reviews decisions from district courts in Texas, Louisiana, and Mississippi. issued a decision on June 5, 2024 that vacated the SEC's Private Fund Adviser RulesSEC regulations that would have imposed additional disclosure and operational requirements on private fund advisers before being overturned by the Fifth Circuit Court of Appeals.. This gives managers and seed investors more flexibility in structuring these arrangements without certain federal disclosure restrictions that were adopted in 2023. However, fiduciary obligationsLegal obligation to act in the best interests of another party, requiring utmost good faith and loyalty. under state law and the Investment Advisers Act of 1940 Investment Advisers Act of 1940 The Investment Advisers Act of 1940 is the primary U.S. legislation regulating investment advisers, including hedge fund managers, establishing registration requirements, fiduciary duties, disclosure obligations, and compliance standards for advisers meeting certain thresholds. continue to apply.