Provided that they meet certain criteria, venture capital funds are not required to be registered as an “investment company” by the U.S. Securities and Exchange Commission (the “SEC”) under the Investment Company Act of 1940 (the “Investment Company Act”). The Investment Company Act defines “investment company” to include any issuer which is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities. Venture capital funds would typically fall under this definition; however, most venture capital funds are organized in such a manner so as to qualify for at least one of the two primary exemptions from the definition of investment company, and thus registration, under the Investment Company Act: the Section 3(c)(1) exemption and the Section 3(c)(7) exemption.
Non-Public Offering
In order to be exempt from registration under both the Section 3(c)(1) exemption and the Section 3(c)(7) exemption, a venture capital fund must not plan to or make a public offering of its securities. To satisfy this requirement, venture capital funds typically offer and sell interests to investors in accordance with the safe harbor under Rule 506(b) of Regulation D of the Securities Act of 1933. To qualify for such safe-harbor, a venture capital fund must: (i) issue interests to no more than 35 non-accredited purchasers of securities (see below), (ii) not offer or sell securities by any form of a general solicitation or general advertisement (see below), (iii) exercise reasonable care to assure that the purchasers of the securities are not underwriters and that the purchasers are not acquiring the securities for the purpose of resale; and (iv) file certain forms with the SEC at certain times, including notices on Form D.
Although the safe harbor permits a venture capital fund to issue interests to up to 35 non-accredited investors, most venture capital funds avoid taking any non-accredited investors because of the regulatory risk and additional disclosure requirements that would accompany taking in such investors. Thus, Venture capital funds generally offer and sell interests only to accredited investors. Additionally, despite the fact that the safe harbor under Rule 506(b) does not allow the offer and sale of securities by any form of general solicitation, general solicitation is permitted under Regulation Crowdfunding and Rule 506(c) of Regulation D. Venture capital funds, however, typically do not rely on these potential exemptions because of the additional verification requirements (e.g., Rule 506(c) requires a venture capital fund to take reasonable steps to verify that investors are accredited investors, whereas investors in a Rule 506(b) offering typically are able to just self-certify their accredited investor status via completion of an investor questionnaire) and capital raising limits that come along with such exemptions (e.g., Regulation Crowdfunding only permits a venture capital fund to raise up to $5,000,000 in a 12 month period).
If a venture capital fund establishes that it is not making a public offering of its securities, it must also satisfy at least one of the following requirements in order to be exempt from registration under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act: (i) have fewer than 100 beneficial owners (a “3(c)(1) Fund”) or (ii) sell its securities only to qualified purchasers (a “3(c)(7) Fund”).
3(c)(1) Funds
To satisfy the 3(c)(1) exemption under the Investment Company Act and thus be a 3(c)(1) Fund, a venture capital fund must have fewer than 100 beneficial owners. The method for counting beneficial owners of a venture capital fund can be complex and requires an examination of certain look-through rules. For purposes of counting beneficial owners, certain look-through rules apply with respect to investors in the venture capital fund that are (i) “formed for the purpose” of investing in such venture capital fund and/or (ii) themselves registered investment companies or 3(c)(1) Funds or 3(c)(7) Funds exempt from registration and that own more than 10% of the voting securities of such venture capital fund. An investor will generally be treated as “formed for the purpose” of investing in a venture capital fund if (a) the investor (which is an entity and not a natural person) invests more than 40% of its committed capital in such venture capital fund or (b) the investor’s stockholders, partners, members or other beneficial owners have individual discretion as to their participation or non-participation in such investor’s investment in such venture capital fund. The reason for these look-through rules is to prevent venture capital funds and their investors from circumventing the 100 beneficial owner limitation (e.g., by aggregating a number of investors who would otherwise invest directly in a particular venture capital fund into an entity that is formed just for the purpose of investing in such venture capital fund). Venture capital fund managers should pay special attention to these look-through rules to avoid not having more than 100 beneficial owners.
3(c)(7) Funds
To satisfy the 3(c)(7) exemption under the Investment Company Act and thus be a 3(c)(7) Fund, a venture capital fund must sell its securities only to qualified purchasers. Qualified purchasers include: (i) any natural person who owns at least $5 million in investments (as defined by the SEC, but investments generally include cash, stock, bonds and other investment securities), (ii) an entity that is owned by two or more natural, related persons and which was not formed for the purpose of investing in the venture capital fund and which owns at least $5 million in investments and, (iii) a trust not formed for the specific purpose of investing in the venture capital fund, so long as the trustee and each settlor or other person contributing assets to the trust is a qualified purchaser, (iv) an entity which was not formed for the purpose of investing in the venture capital fund and which owns and invests on a discretionary basis at least $25 million in investments, and (v) any entity owned exclusively by qualified purchasers. Unlike a 3(c)(1) Fund, a 3(c)(7) Fund is not subject to a 100 beneficial owner limit.
Parallel Fund Structure
To maximize its potential investor base, venture capital funds may structure themselves as a parallel 3(c)(1) Fund and a parallel 3(c)(7) Fund which are set up to invest side-by-side in portfolio companies pro-rata based on their respective capital commitments. Section 3(c)(7) of the Investment Company Act allows a parallel 3(c)(1) Fund and a parallel 3(c)(7) Fund to co-invest without the risk of integration.
Knowledgeable Employees
A “knowledgeable employee” is defined under the Investment Company Act as (i) an executive officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity of a venture capital fund, the general partner of such fund or the management company of such fund, and (ii) an employee of the management company of a venture capital fund (other than an employee performing solely clerical, secretarial or administrative functions) who, in connection with his or her regular functions or duties, participates in the investment activities managed by such management company or any of its affiliates and has been performing such functions or duties for or on behalf of such fund, the general partner of such fund or the management company of such fund, or substantially similar functions or duties on behalf of another company, for at least the past twelve (12) months. Investors who are “knowledgeable employees” (a) fall withing the definition of, and are thus, accredited investors, (b) do not count towards the 100 beneficial owner limit for purposes of the Section 3(c)(1) exemption, and (c) are permitted to invest in a 3(c)(7) Fund, whether or not they are otherwise qualified purchasers, without jeopardizing a venture capital fund’s Section 3(c)(7) exemption.
Takeaway
Avoiding registration under the Investment Company Act is of critical importance for any venture capital fund. Thus, it is vital to structure a venture capital fund as either a 3(c)(1) Fund or 3(c)(7) Fund. Failure to do so could result in a venture capital fund inadvertently becoming an investment company and hence being subject to substantial regulation by the SEC which, from a practical perspective, would likely make the operation of such fund untenable.
For questions or more information on this topic or any other topic relating to venture capital funds, please contact any of the members of the DLA Piper Pacific Northwest Venture Fund Practice:
Mel Wheaton (mel.wheaton@dlapiper.com)
Chris Thorson (chris.thorson@dlapiper.com)
Lindsey Haythorn (lindsey.haythorn@dlapiper.com)
Luke Postma (luke.postma@dlapiper.com)