What is the Venture Capital Exemption from the Investment Advisor's Act?

Lots of regulations surround the sale of securities and management of other people’s money for the purpose of investing in securities. One of the most daunting rules governing the actions of individuals investing the funds of others is the Investment Advisor’s Act of 1940 (“Advisor’s Act). The Advisor’s Act requires that fund managers register the fund with the Securities and Exchange commission. Registration is generally required of large money management funds, such as mutual funds. The registration process is very burdensome. Smaller funds, such as venture capital funds, cannot or, in the least, do not want to go through this onerous process. Luckily, there is an exemption available under Section 203(I)-1(a) of the Advisor’s Act available to venture capital fund managers. This is commonly known as the “Venture Capital Exemption”. To qualify for this exemption, the fund managers must follow specific steps and the fund must meet certain qualification. Let’s review the specific qualifications.

What is a Venture Capital Strategy?

The managers of the investment fund must provide notice to any potential investors that the fund pursues a “venture capital strategy”. Generally, this simply means that all communications with potential investors in the fund must unequivocally state that the fund is pursuing a venture capital strategy. A venture capital strategy is not defined under the rule. Generally, it suffices that the disclosure material provide a brief description of the objectives behind the fund’s capital raise and the intended use of the funds.

The 20% Investment Rule

The next requirement is that the investment fund must make certain any assets purchased with investor funds are a “qualifying investment”. Specifically, the rule says that the fund cannot invest more than 20% of the total fund in non-qualifying assets. The 20% amount is based upon the total amount pledged to the venture fund. Any pledge of capital to the fund must be real. The VC fund cannot solicit promises of capital that are never truly intended to be invested in the fund to affect the 20% calculation. This would be a method of skirting the 20% Investment Rule. A qualifying investment is an investment in shares of a qualifying portfolio company, shares traded for those of another qualifying portfolio company, or shares in the parent company of a qualifying portfolio company. This generally means the company must buy shares of stock or debt convertible to stock (but not just debt) directly from a portfolio company. This leaves the question of, “What is a portfolio company?”

What is a Qualifying Portfolio Company?

A qualifying “portfolio company” is a private company. It cannot be registered with the Securities and Exchange Company as a public company or a reporting company or registered to trade on a public exchange. The company cannot issue debt instruments as part of, or at the same time as, the venture capital investment if any of these funds will go to the investors. The reason for this second requirement is that such a debt offering looks like the venture capital investment is a disguised debt transaction. Lastly, the company cannot be another investment fund, such as a venture capital fund, private equity fund, hedge fund, commodity pool fund, or issuer of asset-backed securities. If a portfolio company becomes a public company after the investment by the VC fund, it does not lose its status for purposes of the Venture Capital Exemption.

What about “Short-Term Holdings?

The rule allows the investment fund to invest in certain assets for cash management purposes. Basically, the fund does not want to let funds sit idle when it is searching for portfolio companies in which to invest. So, the rule allows the company to invest in “short-term holdings”. These include bank deposits, certificates of deposit, banker’s acceptances, US treasuries with a 60-day maturity (or less), and money-market funds.

What is the “Non-Qualifying Basket?

The 20% rule allows for the venture capital fund to invest up to 20% of its holdings in something other than qualifying portfolio companies or short-term holdings. The basket of assets comprising this 20% is known as the “non-qualifying basket”. The value of the non-qualifying assets is calculated either as the fair market value or the historical costs of the assets. The fair market value is a fluid calculation. The historical cost is the value of the asset at the time it was issued. In any event, the value in the basket is measured at the time of purchase. It does not break the 20% rule if the assets later rise in value. However, if the fair market valuation is used to value the non-qualifying assets at purchase, a later decline in value will allow the venture fund to purchase more non-qualifying assets until it reaches the 20% amount. If the historical value is used, changes in the value of the asset or irrelevant. For these reasons, an investor must be aware of the value of the assets in the basket. If the value of the assets are less that 20% at the time of purchase and later rise to 20% or more, it can interfere with any future purchases of non-qualifying assets. Lastly, the same valuation method must be used throughout the life of the fund.

Ability to Incur Debt

The venture capital fund is limited by the VC Investor Exemption on how much debt it can incur or debts it can guarantee. The fund cannot incur debt that exceeds 15% of the total capital pledged to the fund by the investors. Also, any debt cannot exceed a 120-day repayment period and cannot be renewable.

Investor Redemption Rights

Investors in the venture capital fund receive an ownership interest in the fund in exchange for their capital investment. This interest received is generally considered a security for regulation purposes. The venture capital exemption requires that the equity issued to investors have no redemption rights except in “extraordinary circumstances”. That is, the investors in the fund cannot demand repayment or be cashed out from the investment fund prior to the fund dissolution. The investors can, however, receive pro rata distributions from the fund. One scenario that could cause issues are when an investor sells her interest to another investor. Generally, as long as there is an applicable exemption to transfer of securities under the SEC registration exemptions, a transfer of one’s interest in the VC fund is permitted. The company should seek a legal opinion before allowing the investor to sell her interest.

Non-Registration under the Investor Company Act

Lastly, the venture capital fund cannot be previously registered under the Investment Company Act. Also, it cannot be a business development company, which is a publicly-traded private equity company used to provide funds to troubled businesses. This is not an important distinction, as all venture capital funds are “private companies” that seek exclusion from securities registration under the Securities Act of 1933. Statutory exemptions under section 3(c)(1) and 3(a)(7) effectively exempt the VC fund from registration under the Investment Company Act.