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Venture Capital Exemption from Investment Advisor’s Act
Venture capital firms are generally exempt from the onerous registration requirements of the Investment Advisers Act of 1940 (the “Advisers Act”). Specifically, Section 203(l) provides that a manager of a VC firm that meets the requirements of SEC Rule 203(l)-1(a) as a private fund is exempt. The requirements are as follows:
Venture Capital Strategy
The VC firm must pursue a venture capital strategy. This simply means that the prospectus and other disclosure documents must inform any investors (or potential investors) in the VC firm that the company intends to invest the capital for a “qualified investment” in a “portfolio company” or “short-term investments”.
A “qualifying investment” is any of the follow:
I. Equity from the Company – an equity security issued by a “qualifying portfolio company”. This means that the VC firm must purchase some for of stock ownership (or stock equivalent). This would include purchasing a convertible note that converts into equity ownership. It basically limits the purchase of pure debt. The equity must be purchased directly from the target company. It cannot be purchased from another investor or on an exchange.
II. Exchanges of Equity – any equity security that is issued by a qualifying portfolio company in exchange for another equity security of such qualifying portfolio company. This is relevant when there is a corporate reorganization that changes share ownership.
III. Equity of Acquiring Entity – any equity security issued by a parent of a qualifying portfolio company in exchange for an equity security in that qualifying portfolio company. This allows for retention of an ownership interest if the portfolio company is acquired by another private firm or public company.
A “qualifying portfolio company” must meet the following requirements:
I. Not a Publicly Traded – the company cannot be a public company or a reporting company under the Securities Exchange Act of 1934. The company can later go public without any violation. The VC firm cannot acquire additional shares in the company at this point.
II. Limited Debt Obligations – the company cannot be part of a leveraged buyout. That is, the VC firm cannot issue debt in a company at the same time as taking investor capital to purchase ownership in the company.
III. Type of Firm – The company cannot resemble a VC firm, private equity firm, mutual fund, hedge fund, commodity fund, or issuer of asset-backed securities.
VC firms routinely make short-term investments of highly-liquid assets to earn a return while trying to identify companies in which to invest. A “short-term holdings” includes the following:
I. bank deposits, certificates of deposit, bankers acceptances, and similar bank instruments;
II. U.S. Treasuries with a remaining maturity of 60 days or less
III. money market funds
Investments outside of these categories will not be a qualifying investment.
20% Non-qualifying Basket Rule
The rule that all VC firm investments must be in a qualifying investment has one exception. The firm can invest up to 20% of its pledged or committed capital (whether collected yet or no) on non-qualifying assets. The non-qualifying assets purchased is known as the firms, “Non-qualifying Basket”. The 20% rule applies to the value of the assets when they are purchased. It does not matter for exemption purposes if the value of the assets later rises to be more than 20% of the firm’s investment capital. If the value of the basket assets rises beyond 20%, however, this will limit the purchase of future non-qualifying assets. The firm can value the assets at the fair market value or at the historical value (value at the time of issues of the security). This allows the firm to take advantage if the value of the basket drops below the purchase price. It could then purchase more non-qualifying assets, up to the 20% limit. If the firm uses the historical value method, the price fluctuations of the basket assets do not matter.
Limitations on Debt (Leverage)
The VC firm cannot incur debts or guarantee loans in an amount above 15% of the fund committed or pledged capital. Further, the firm can only incur this debt for up to 120 days. The debt cannot be renewable.
Redemption Rights of VC Fund Investors
The VC fund cannot provide redemption rights to the fund investors. The investors can receive a pro-rate distribution from the fund, but no investor can demand to have their interest repurchased by the fund, except in “extraordinary circumstances”. Extraordinary circumstances are situations beyond the control of the VC firm, such as investor bankruptcy. An investor is generally allowed to sell her interest to other investors if the sale qualifies for an exemption from securities registration under Rule 144 for Section 4 of the Securities Act of 1933. In some instances, there may arise an issue when a fund manager seeks to withdraw funds (representing management fees or carried interest) from the fund. This arises when the fund manager’s interest is structured as a limited partnership interest.
Registration under the Investment Company Act
The VC fund cannot be registered under the Investment Company Act of 1940. Also, it cannot be a business development company, which is a publicly traded private equity firm used to invest assets in financially distress businesses. Most VC firms are private companies under the Securities Act of 1933, sections 3(c) and 3(c)(7). These provisionally effectively exempt the VC fund from registration under the Investment Company Act.