SUCCESSFUL FORMATION OF A PE FUND IN 2009

C. Craig Lilly600 Hansen Way

Palo Alto, California 94304-1043650.843.3232

This presentation is intended only as a general discussion and should not be regarded as legal advice. For more information, please contact Craig Lilly at

650.843.3232.

U.S. Fundraising Declines in 2008Commitments to Venture Capital Funds

$24.7

$32.2$30.0$25.6

$17.3

$10.1$12.5

$50.7

$83.8

$57.5

$26.9

$17.5

$0

$20

$40

$60

$80

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: Dow Jones VentureSource

2009 Fund Themes

• VC firms will be more specialized.

• Future investments will be smaller, healthier and less leveraged.

• Increased dialogue with LPs will continue; liquidity constraints will still be a concern.

2009 Fund Themes

• Liquidity constraints will continue to be sources of concern for fund sponsors. Alternatives to consider to address LPs' allocation and liquidity concerns include: (a) raising a co-investment fund to invest with the existing fund, (b) obtaining a bridge or capital commitment loan with a lender to defer capital calls, (c) assisting LPs with transfers of fund interests, (d) deferring or reducing capital calls, commitments or fees, and (e) amending the fund's organizational to allow deal-by-deal investments.

• The secondary market will see more opportunities.

• The current economic climate will create more distressed debt and asset investment opportunities.

2009 Fund Themes

• Reduced equity and asset prices will yield greater fund opportunities and returns.

• Fund managers will need to address higher taxes if the current proposed budget is passed.

• Increased disclosure/ regulation is forthcoming.

• Venture and private equity will stabilize and be a part of the solution.

Fund Legal Structure - Basics

• Private equity funds (“Fund”) in the United States are generally formed as Delaware limited partnership (with a new limited liability company serving as the general partner).

• Investors will contribute capital to the limited partnership and receive partnership interests and a capital account in the partnership in return.

• The gains and losses attributable to the Fund’s performance are passed through to the investor’s capital accounts on a pro rata basis.

• Fund Term is generally 10 to 12 years (note: extensions).

• Commitment Term is generally 3 - 5 years (note: extensions); generally, GP contributes 1% or less, and LPs commit the remaining 99% plus.

General Partner, LLC(Delaware LLC) Limited Partners

Fund Limited Partnership(Delaware)

Portfolio Investment #2Portfolio Investment #1

99% Capital

80% of Profits

1% Capital20% Carried Interest

Management Advisor (Delaware LLC)

~2% Management Fee (Management Services Agreement)

Fund Structure

General Partner and Investment Management Entities - Legal Structure

• A separate limited liability company generally serves as the general partner (and as the investment manager).

• Note there are liabilities under the securities laws for which an individual can be held to be personally liable irrespective of the legal form of the entity which serves as the general partner.

• A limited liability company or limited partnership is advantageous for tax and estate planning purposes.

• For tax and other reasons, managers frequently use two separate entities at the management level:– (a) serving as the general partner of the Fund, or

– (b) serving under contract as the investment manager of the Fund

General Partner Compensation -2 and 20 Generally Plus More

• Carried Interest: The general partner typically is entitled to an incentive allocation generally equal to 20% of the net profits (depending on industry/ fund type, some funds pay a preferred return prior to carried interest).

• Management Fee: Generally, 2% of the capital commitments to the Fund and paid quarterly in advance (note: fee conversion techniques).

• Transaction Fees: Fee income from portfolio companies including (a) investment banking fees, (b) break-up fees, (c) monitoring fees, and (d) consulting fees.

Note The type and amount of transaction fees vary per industry and fund type.

Applicable Laws

• SECURITIES ACT OF 1933 – Securities of Funds are typically offered in private

placement transactions which rely on the private placement “safe harbor” provisions of Rule 506 of Regulation D (or the safe harbor for offerings outside the United States contained in Regulation S).

– Form D filings with SEC within 15 days of closing.

– States are still permitted to require “blue sky”notice filings and collect filing fees (generally file within 15 days of closing).

Applicable Laws

• THE INVESTMENT ADVISERS ACT OF 1940– Most Fund managers or general partners choose

not to register under as an advisor as a result of an exemption from registration because they have fewer than 15 clients.

– This is because the Fund is generally deemed, under certain circumstances, to be one client and do not hold themselves out to the public as investment advisors.

The Investment Company Act - Two Applicable Exemptions

• 3(c)(1) Fund Exemption– The reference to “3(c)(1)” is to an exclusion from

registration as an investment company pursuant to Section 3(c)(1) of the Investment Company Act (the purpose of this Act is to generally regulates mutual fund).

– A Fund will not have to register under the Investment Company Act if its outstanding securities are not owned by more than 100 persons.

• Counting to 100 is not as straightforward as it might seem.

• Sometimes the rules force a fund to “look through” an entity investor and count each of the underlying beneficial owners of the entity based on certain percentage tests which may increase the number of investors which count against the 100 investor limit.

3(c)(7) Fund Exemption

• The reference to “3(c)(7)” is to an exclusion from registration as an investment company pursuant to Section 3(c)(7) of the Investment Company Act.

• This exclusion is available for a Fund which limits its limited partners to individual investors (“Qualified Purchasers”) who own not less than $5,000,000 in investments, and to entities which own not less than $25,000,000 in investments, as defined by the SEC.

• An entity that has less than $25,000,000, but which is beneficially owned by persons who are Qualified Purchasers may also be considered a Qualified Purchaser.

• A 3(c)(7) Fund is limited to under 500 investors.

Securities Act of 1934

• Funds with 500 investors and $10,000,000 in equity must register.

ERISA

• If 25% or more of in a Fund are held by “benefit plan investors”, the Fund is subject to undesirable ERISA constraints unless it qualifies as a “venture capital operating company” or as a “real estate operating company”.

Fund Documentation

• Private Placement Memorandum.

• Limited Partnership Agreement.

• Subscription Agreement - Investor Suitability Questionnaire.

• Secondary Documents:– Asset/ Investment Management Agreement

– Side Letters

– GP Operating Agreement

– Third Party Administrator/Back Office Agreements

Accredited Investors

• $1 million in net worth or $200k single in last 2 years ($300k if married in last 2 years).

• Generally, only accredited investors are offered LP interests and admitted as a LP. The traditional wisdom is that accredited investors are less likely to sue than non-accredited investors and juries are less sympathetic to accredited investors than they are to nonaccredited investors.

Summary - Launching a Private Equity Fund

• Create term sheet and fund documentation.

• Meet with prospective LPs to explain opportunity/strategy and communicate terms of offering.

• Identify lead anchor LPs and pre-negotiate final offering terms.

• Circulate final documentation.

C. Craig Lilly600 Hansen Way

Palo Alto, California 94304-1043650.843.3232

This presentation is intended only as a general discussion and should not be regarded as legal advice. For more information, please contact Craig Lilly at 650.843.3232.