Sidecar funds — an overview

There are several different ways to be an angel investor. In this post we’ll have a deep dive into one: investing through a sidecar fund.

What are sidecar funds?

A sidecar fund is a pooled investment vehicle that makes investments by “riding alongside” another investor.

A pooled investment vehicle means an investor puts their money into a common pool with other people.

Riding alongside means the pool invests in conjunction with some other investor — an angel group, VC or PE fund, or some other investor.

And makes investments is self-explanatory: these funds invest in some kind of assets — in this case, early stage angel investments.

How many sidecar funds are there?

Data on how many sidecar funds there are is not easy to find. Based on some membership data from the Angel Capital Association, my best guess is that around 10% of angel groups that are part of that organization have a sidecar fund. Groups in the ACA tend to be the larger and more established groups, so the proportion of all collective angel efforts is probably lower. So perhaps 5% of angel groups have one, so perhaps around 50–75 in the US?

What about in the southeast? There are several groups in the region with a dedicated sidecar fund. We have one (actually five!), and there are several of the university angel groups in North Carolina have sidecar pools of capital from various university and alumni sources.

How do sidecar funds work?

We’re on firmer ground when speculating about how sidecar funds work!

First, structurally, they’re usually LLCs or Limited Partnerships, so that investors can pool funds while maintain the legal liability protections of corporate entities.

Second, they generally combine some kind of “trigger” of the fund with a level of “match” and some kind of “oversight”.

In general, sidecar funds invest when a certain level of investment is received from the “lead” entity. For example, the angel group invests $50,000, then the fund is “triggered”. The parameters for the trigger, and the threshold amounts of the parameters, will vary — but the idea of some kind of automated catalyst for the fund is standard.

Some level of “match” is also pretty common to sidecar funds. The approach might vary: perhaps investors want a fixed amount like 20 deals at $250,000 each in a $5M fund (ignoring fees); or perhaps they want to flex with the popularity of the investment, investing from the sidecar 1x the amount invested by the lead group? We can have fun debates about which is the best approach, but the common thread is some kind of match.

Lastly, oversight. Funds are generally not totally automatic. It is good to have some oversight, some responsibility, some human element that can help supervise when life’s inevitable complexity impacts the funds. This “management” can vary from very minimal — perhaps a veto on investments that are technically triggers but aren’t in the fund’s mandate — to more discretionary — perhaps an ability to vary the size of the “matching” investment — to almost wholly discretionary.

The particular combination of these three elements will tell you a lot about the fund, and might result in substantially different returns.

How does VentureSouth sidecar funds work again? I need an example

To distill the concepts of the last section into a concrete example: the VentureSouth Angel Fund III.

· It’s a Limited Partnership

· It’s “triggered” to invest when 10 or more VentureSouth members invest, in aggregate, $100,000 or more in an investment. For investments that attract fewer than 10 checks, or 19 x $5,000 checks, do not trigger the fund, so it does not invest.

· Its match is 1:1 of the amount invested by VentureSouth angel group members, up to a maximum investment of $250,000 per company

· And the oversight is the VentureSouth team (as the fund’s General Partner), which could veto investments if, following very clear criteria established in the fund agreements, an otherwise triggering investment didn’t fit the fund’s investment criteria.

Why would someone invest in a sidecar fund?

Beyond the reasons for angel investing in general, the specific reasons for using a sidecar fund for angel investing include:

· Passive: early stage investing can be hard work and time consuming. Sidecar funds are designed to be minimal work for the investor, and are ideal for those without the time

· Automatic diversification:

— A single early stage investment is, on average, going to lose money. Diversification is critical. Sidecar funds are designed to created diversified portfolios.

— For example, VentureSouth’s five sidecar funds invested in 23, 18, and 19 and 20 companies.

· Smaller exposure and per-deal allocation: even though angel investing requires less capital than you might believe, the total allocation might be too much if you are only recently accredited. If 20 deals at $5,000 per deal (total $100,000) is too much exposure, you could significantly reduce that with a $25,000-$50,000 allocation to a sidecar fund.

· Administrative ease: one set of investing documents to sign, one K-1, and you’re not bothered by ongoing consents or all the other minutiae of early stage deal documents.

What should you evaluate when looking at sidecar funds?

Whenever you are investing, you should do your due diligence. We’ll skip here all the general diligence you should do whenever investing — team, investment thesis, differentiation, track records, etc. — and focus again on the diligence checklist items you particularly should consider when evaluating sidecar funds.

· Investment decision making: who is making the investment decisions — both according to the legal documents and in practice?

· Follow-on decisions: ditto. These are often different, but also where great potential for personal agendas, conflicts of interest, or just simply emotional decision-making lies. How does the sidecar address them?

· Fit of investment thesis and sidecar size: does the “lead vehicle” have activity level, scope, capability, and stability to make the investments must to deploy the sidecar? Can it get diversified enough in a reasonable timeframe?

· Size: while we would all like to see hundreds of local, small funds focused on specific areas, the reality is the costs of setting these funds up is not trivial. Is the fund large enough to cover these costs without unduly affecting net returns to investors?

· Liquidity: what happens when a portfolio company is sold (generally you should get the proceeds immediately); and what happens when you want to exit your position (generally you cannot).

· What are the “economics” of the fund?

— Does the “oversight” have commensurate skin in the game (in the form of their own money)?

— Does the annual management fee seem big enough to cover the costs of the fund, but small enough to remain reasonable and not reduce too much the net return to investors?

— Does the carry fit the general market norms (usually 15–20%) and is it appropriate given the relative contribution to the success of the fund given by the “oversight” team relative to the passive investors?

— Do the startup costs seem reasonable? They are not free, but it shouldn’t be that expensive to pay for the creation of the fund documents.

— Do the fund documents allow for lots of extra ongoing costs to be put on investors (D&O insurance, tax prep costs, …)?

Anything else I should be aware of?

A pet peeve is seeing funds being raised while blatantly ignoring the rules on general solicitations.

As a quick primer, most of this type of private capital is raised by using the 506(b) exemption to the Securities Act. The details are arcane, but the key is that these funds may not advertise the fund. They cannot put on their public facing website anything that advertises a new fund or reveals it is fundraising.

But you see funds advertised everywhere. This ranges from the blatant websites to more-subtle techniques. A common one the “we’re proud to announce the first closing of the fund” approach. Check out the search results for “first close” on Techcrunch or Google News and you’ll see even big funds doing this; small, regional, “under the radar” funds do it all the time, and it is not OK.

(This is not just for funds. Private companies raising capital must not publicly disclose they are fundraising either, if they want to keep their 506(b) exemption.)

So if the fund you are evaluating is “publicly soliciting” you should deeply consider the risks for when the SEC comes knocking.

And more widely, remaining compliant with Securities Act rules, Adviser Act rules, state-level equivalents, and more — not to mention taxes! — is not trivial, and the consequences can be significant. As an investor, you need to be sure the sidecar fund follows the rules — because ultimately if they don’t you pay the price.

*Descends soap box*

How should entrepreneurs evaluate sidecar funds?

As we wrap up this article, a quick aside for entrepreneurs to tackle the question: should I care about whether an angel group has a sidecar fund?

As an entrepreneur, you should be completing diligence on your investors in the same way they are completing diligence on you. Working with investors is likely a long journey, and one filled (especially now) with more than the occasional challenges, stress, disagreement, and disappointment. This diligence is again wider than sidecars, but we’ll skip for now the things to look out for in investors in general.

Specifically on sidecars, here are a couple of considerations:

· Firepower: The VentureSouth Angel Fund III essentially doubles VentureSouth’s firepower. If you can get a $250,000 investment from our members, your check is for $500,000 if the sidecar matches. Double the firepower for the same amount of effort.

· Signing authority: Pooled investing means delegating some authority to the fund managers. Are you confident that these managers (a) have the authority to make decisions you need them to make; and (b) will be around to make those decisions?

· Compliance: Back to my soap box, if your investor is not compliant, the downstream cascade can impact you, even if no fault of yours. For example, if the fund has a bunch on unaccredited investors that are, ultimately, your investors, you need to know that!

Where can I learn more?

Here are a few places where you can learn more about sidecar funds. As we said before, information is not easy to come by here, so if you have any better sources we would love to know about them.

· VentureSouth Angel Fund web pages

· The Angel Capital Association has additional material on sidecar funds, mainly from the perspective of helping angel groups understand the benefits of creating their own

· Side car funds introduction from Foley Hoag (link here, downloads)

· Mid Atlantic Bio Angels sidecar fund (link here)