You may recall from my prior post here that a number of funds are soon going to become subject to regulation under the Investment Adviser’s Act but that “venture capital funds” will be exempt. On Friday, November 19th, the SEC issued its proposed rules and request for comment on a number of open issues under the Dodd Frank Act, including the proposed definition of “venture capital fund.”
The press release is available here.
I’ve also written on this issue for my law firm here.
See the new “venture capital fund” definition after the jump.
Exemptions from Registration under the Adviser’s Act
The proposed rules would provide three key exemptions for funds:
- Advisers solely to “venture capital funds“
- Advisers with less than $150M in assets under management (“AUM”)
- Foreign advisors with less than $25M AUM attributable to US investors
It’s worth noting here that managers of even 1 fund that does not fall within an exemption would be required to register.
“Venture Capital Fund” Definition
According to the SEC’s proposed rules, which are available on the SEC’s website, a venture capital fund is:
- A “private fund”, meaning a fund that would be an investment advisor but for the exemptions provided in Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940. Generally, 3(c)(1) funds have no more than 100 accredited investors and 3(c)(7) funds may have more than 100 investors but all must be qualified purchasers. The qualification rules for accredited investors and qualified purchasers are detailed but, for purposes of comparision, qualified purchasers must have $5M in investment assets while accredited investors need only $1M (exclusive of net personal residence equity).
- Makes equity investments, as defined in 3(a)(11) of the 34 Act and rule 3a11-1 thereunder, to include common stock, preferred stock, warrants, and convertible securities (including convertible debt).
- Invests in “qualifed portfolio companies” and at least 80% of the fund’s securities were acquired directly from the private companies (i.e., secondary market investors would not qualify and founder liquidity would be limited). A “qualified portfolio company” is a private company (not publicly traded company or a company controlled by a publicly traded company) at the time of each investment. Essentially, this would prohibit the occassional follow-on investments in portfolio companies that went public by VCs that we’ve seen used successfully in recent years.
- Does not incur leverage in connection with the investment. This includes borrowing, issuing non-convertible debt, providing guarantees or other leverage in excess of 15% of the fund’s size, which must be for a non-renewable temr of no longer than 120 days.
- Investments may be in domestic or foreign companies.
- Investments are used by the portfolio comany for operating capital or expansion (and not to redeem interests, for example).
- Other than securities, the fund holds only cash, cash equivalents, or U.S. Treasuries with a maturity of 60 days or less. This is fairly restrictive in terms of short-term investments and imposes a limitation on the types of debt investments the fund may make.
- Provides managerial assistance or controls the portfolio company (presumably, this is equivalent to “management rights” for purposes of ERISA’s venture capital operating company allowance).
- Does not offer investors redemption or similar liquidity rights except in extraordinary circumstances.
- Represents itself to investors as a venture capital fund. This imposes a form over substance issue that will no-doubt elicit comments.
- Is not itself a fund (is not subject to the Investment Company Act and is not a “business development company”).
Now it’s time for the venture capital industry to chime in, during the 45 day comment period, and clarify the rules. Comments on the proposed rules can be made on using the SEC’s online form here or by sending an email to email@example.com with File Number S7-37-10 in the subject line.
One issue immediately apparent is the extent to which funds will still be allowed to engage in debt financings in their portfolio companies. Convertible debt is an “equity” investment, so no issue there; however, most VC funds also engage in non-convertible short-term bridge lending to their portfolio companies. These loans would no longer be allowed, although the SEC appears open to an expansion of the rules.
These rules would also limit founder buyouts (acquiring stock directly from the founder rather than the company), as discussed in more detail by William Carleton here, and would limit secondary market stock investments.
Grandfathering Rules for Existing Funds
For the most part, these proposed rules will not apply to existing funds. Existing Funds are exempt from the new rules if:
- the fund represented to investors and potential investors that it was a venture capital fund at the time such fund offered its securities;
- the fund held a closing on or prior to December 31, 2010; and
- the fund does not hold any additional closings after July 21, 2011.
Record Keeping Requirements for Exempted Funds
Note that the SEC has also provided proposed rules regarding what types of ongoing recordkeeping and reporting requirements for exempted funds:
Under proposed rules, which are available on the SEC’s website here, exempt reporting advisers would nonetheless be required to file, and periodically update, reports with the Commission, using the same registration form as registered advisers. Rather than completing all of items on the form, exempt reporting advisers would fill out a limited subset of items, including:
- Basic identifying information for the adviser and the identity of its owners and affiliates.
- Information about the private funds the adviser manages and about other business activities that the adviser and its affiliates are engaged in that present conflicts of interest that may suggest significant risk to clients.
- The disciplinary history of the adviser and its employees that may reflect on their integrity.
Exempt reporting advisers would file reports on the Commission’s investment adviser electronic filing system (IARD), and these reports would be publicly available on the Commission’s website.
Note that these exemptions would not limit the SEC’s statutory authority to examine the books and records of advisers relying on the exemptions (see Advisors Act 204(a)). This is not something the SEC regularly does and it’s not clear whether this authority applies in this case, where the funds would arguably be exempt under the statute.
For those looking for additional information, the Wall Street Journal’s Venture Dispatch has also written a good post on this issue here.