An operating agreement is an important legal document that outlines the rights and responsibilities of all members in an investment fund. It provides guidelines on key aspects like fund structure, management, profit sharing, voting rights, etc. When drafting an operating agreement, fund managers need to carefully consider issues around control, economics, exit, and resoluting disputes to protect all parties. This article will provide an example operating agreement and highlight key provisions fund sponsors should focus on.
Fund structure and purpose – Define investment scope and objectives
The operating agreement should clearly lay out the investment fund’s purpose, strategy, and scope of investments. For example, ‘The objective of XYZ Fund LP is to invest in early-stage technology companies in the software sector with high growth potential. The fund will target companies primarily in the SaaS, AI/ML, and cybersecurity spaces.’ Defining the scope sets expectations among investors and also provides guidelines for fund managers.
Management – Specify roles and responsibilities
The operating agreement needs to designate the fund manager/general partner and outline their duties and decision-making powers. It should also mention if there is an independent advisory board or investment committee. For example, ‘John Smith, as General Partner of the fund, will source deals, evaluate investments, manage portfolio companies, and make capital calls/distributions. He will have full discretion on investment decisions, subject to approval from the Advisory Board for deals above $5 million.’
Economics – Explain fee structure and profit sharing
A detailed fee section should provide transparency on costs like management fees, carried interest, transaction fees, etc. along with payment frequency and calculations. Profit sharing/waterfall provisions will specify the distribution schedule – investors get priority return of capital, then catch-up for GP, then 80/20 split of residual profits. Having clear economics aligns incentives between LPs and GP.
Exit – Include redemption terms and liquidation process
The operating agreement should lay out the targeted fund life (e.g. 10 years), extension provisions, and investor redemption rights. It’s key to define the liquidation process detailing the distribution of assets and repayment of liabilities. Standard language includes ‘Upon termination of the Partnership, assets will be liquidated in an orderly fashion, creditors repaid, and remaining proceeds distributed to Partners per their ownership.’
Dispute resolution – Specify arbitration and governing laws
To avoid messy lawsuits, it’s prudent to agree upfront on arbitration for resolving disputes. Typical clause: ‘In case of disputes unrelated to the General Partner’s fraud/misconduct, the issue will first be submitted to JAMS arbitration center in New York City. Proceedings will be confidential under New York governing law.’ This provides a neutral process all parties are obligated to follow.
A solid operating agreement is crucial for alignment and clarity across all investment fund members. Key provisions around structure, management, economics, exit and dispute resolution should be clearly spelled out. With a well-drafted agreement, fund sponsors can prevent misunderstandings and operate smoothly for the fund’s duration.