Key issues to consider:
- Sources of financing
- For-profit or non-profit
- Tax treatment
- Governance mechanism
- Implementation mechanism
- Liability tolerance of contributors and participants
Sources of Financing
The sponsors of the fund will first need to establish its objectives and the scope of its mission in order to determine which sources of financing may be available to the particular water fund. Once that determination is made, the water fund can reach out to potential funding sources to determine interest level and whether the proposed project is viable.
What are potential funding sources for the Water Fund?
What special requirements do contributors typically impose?
Is the Water Fund’s source of funding expected to change over time?
Prior to approaching prospective funding sources, the water fund should determine whether the projects are expected to be self-funded or partially-funded via revenues over time. For example, if there is an expectation that a project will generate user fees that will offset the need for funding from certain sources, such projections should be shared with potential funding sources as they may be more willing to fund a project that seeks to be self-sustaining in the future.
For-profit or non-profit
Is the Water Fund entity intended to be non-profit or a for-profit enterprise? In most cases, the relevant law under which the water fund will be organized (most often, the national law of the host country, although in some cases it may be a sub-division of the country, as in the United States, where incorporation of new organizations is done under state law) will have a couple of different entities which can be used to form a for-profit or non-profit enterprise. The choice of which entity to use will initially depend on whether the intention is to create a for-profit or non-profit enterprise, and thereafter will depend on other objectives of the sponsors of the entity.
If the entity will be a for-profit enterprise, the sponsors will need to consider whether tax should be paid at the entity level, as well as on distributions of income (such as dividends), if any, to the contributors to the entity, or if the income of the entity should be passed through to its contributors, with tax being paid only by the contributors, but not the entity. In the United States, partnerships, limited liability corporations and S-corporations are typically pass-through entities for which no tax is paid at the entity level – instead, taxes are paid at the contributor level on distributions of entity income to the contributors. C-corporations pay tax on their income at the corporate level and contributors are also taxed at their own income tax rate for income received in the form of dividends from the corporation.
Broadly speaking, water funds are typically governed by one of the following governance structures:
- Multi-stakeholder: Governed by a board consisting of governmental, non-profit and sometimes for-profit organizations, usually those that have made financial contributions to the fund. Significant variety exists in size, structure and powers of these boards. An assembly or advisory committee of non-financially contributing partners is common.
- Government-operated: Decision-making power remains solely within a governmental authority like a municipality or public utility. An advisory committee of non-financially contributing partners is also common.
- Watershed committee: A quasi-governmental river basin committee that includes representatives of the federal government, states, municipalities, water utilities, other water users and other organizations, which may be non-profit or for-profit, concerned with the use and conservation of water resources. They may consider some grey solutions in addition to natural conservation solutions to water resource needs.
What is the governance structure of the entity?
The governance structure of an entity refers to the system of internal rules, practices and processes by which a company is directed and controlled. When forming a water fund, it is important to consider who will have decision-making responsibility for the entity. For example, will one person make decisions and take actions on behalf of the water fund, or will a group of persons make decisions on behalf of the fund? Different entities can be used for different governance preferences. If one person will make the decisions, a partnership that provides that all management responsibility resides with a general partner. One could also form a limited liability company that is manager managed or has a single-member that manages the affairs of the company. Alternatively, one might form a corporation that would be governed by a number of individuals who are appointed to the corporation’s board of directors.
What expectations do the contributors have for the corporate form and governance of the fund?
The sponsors of a water fund should discuss the governance mechanism with prospective funding sources to ensure the proposed structure accords with the requirements and objectives of the funding sources as certain funding sources may prefer one form of entity over another.
What control and voting rights should be considered?
The contributors to a water fund will likely seek the ability to approve certain maters with respect to the operation and structure of the water fund, as well as the specific projects that will be funded and how much funding each project will receive. While the terms over which specific contributors may seek approval or veto rights will vary on a case-by-case basis, set forth below are certain key terms over which the contributors to a water fund may seek approval rights:
● Investments in projects that deviate from the fund’s investment objectives and strategies or the fund’s stated investment guidelines;
● The incurrence of indebtedness by the water fund;
● A change in control of the managing member / general partner of the fund;
● Changes to the fee structure, if any, charged by the fund;
● The ability of the sponsor of the water fund to charge fees to underlying projects;
● The ability of the sponsor to raise a successor water fund;
● The issuance of additional interests in the water fund;
● An extension of the term of the fund; and
● The dissolution and termination of the fund.
What additional rights may contributors seek?
Contributors may also seek additional approval, informational and reporting rights in connection with their investment in the water fund, including, without limitation:
● The ability to terminate the investment period, if any, of the fund;
● The ability to cause the early termination of the fund;
● The formation of an advisory committee comprised of various contributors which will be responsible for approving certain matters for the other contributors to the fund;
● Periodic reporting from the sponsor regarding the performance of the underlying projects and the water fund;
● Annual audited financial statements and quarterly unaudited financial statements;
● Periodic meetings of the contributors; and
● The ability to remove the sponsor (e.g., managing member and or general partner) of the water fund, with or without cause.
What liabilities are the sponsors willing to incur?
Due to the nature of the activities of Water Funds, it is conceivable that a water fund could be subject to claims from land owners or other persons who are injured by such activities. One benefit of using a separate (new or existing) legal entity to carry out the water fund activities is that the owners or contributors to such an entity are more likely to be shielded from liability to such third persons than the participants in a more loosely organized water fund based on contractual relationships (in case which it might be possible to characterize the participants as partners in a joint enterprise).
To the extent the water fund will be investing or sponsoring multiple projects, the sponsors may also wish to consider whether to create separate special purpose entities for the operation and management of each project. Such a structure may insulate the liabilities of one project from the other projects and may facilitate the financing and operation of each project. For example, to the extent one project needs financing, the financial providers may want to ensure that they have a security in the assets of the project and that their investment is not subject to the liabilities of another project. In addition, to the extent that the water fund has any assets that are disproportionately valuable, such assets could be protected from the liabilities associated of projects which may have more potential liabilities. In addition, the separation of such investments into different special purpose entities will facilitate the ability of the contributors to the water fund to participate in different projects. On the other hand, more entities means more expenses for the establishment and maintenance of the entities, and potentially a more complicated human resources structure as well.