The Venture Capital Exemption and Startups

If you pay attention to startups and business in general, you know that venture capital plays a key role in bringing new companies and technologies to the public.

This is entirely by legal design:

In 2010, the Dodd-Frank Act was adopted, amending the Investment Advisers Act of 1940 (the “Advisers Act”) to include Section 203(I), which exempts advisers that only manage venture capital funds from the registration requirements set forth in the Advisers Act.

This exemption promotes the proliferation of venture capital funds, which, in turn, helps to fuel the growth of venture capital-backed start-ups because VC funds are generally required by law to focus on direct portfolio investments rather than buying out secondary shareholders.

As the SEC’s Chairman explained:

Our definition [of venture capital funds] distinguishes venture capital funds from hedge funds and private equity funds by focusing on the lack of leverage of venture capital funds and the non-public, start-up nature of the companies in which they invest.  The rule therefore focuses on the provision of capital for the operating and expansion of start-up businesses, rather than buying out prior investors.

See: Speech by SEC Chairman: Opening Statement at SEC Open Meeting: Dodd-Frank Act Amendments to the Investment Advisers Act by: Chairman Mary Shapiro, U.S. Securities and Exchange Commission.  June 22, 2011.

Rule 203(l)-1(a) defines a venture capital fund as a private fund that:

  • represents to investors and potential investors that it pursues a venture capital strategy;
  • holds no more than 20 percent of the fund’s capital commitments in non-qualifying assets (other than short-term holdings);
  • does not borrow or otherwise incur leverage in excess of 15 percent of the fund’s capital commitments […];
  • does not offer its investors redemption or certain other liquidity rights except in extraordinary circumstances; and
  • is not registered under the Investment Company Act and has not elected to be treated as a business development company.

A qualifying investment consists of any equity security issued by a qualifying portfolio company that is directly acquired by a qualifying fund, and certain equity securities exchanged for the directly acquired securities.  A “qualifying portfolio company” is defined as a company that (i) is not a reporting or foreign traded company and does not have a control relationship with a reporting or foreign traded company; (ii) does not incur leverage in connection with the investment by the private fund and distribute the proceeds of any such borrowing to the private fund in exchange for the private fund investment; and (iii) is not itself a fund (i.e., is an operating company).  See Rule 203(l)(1)(c)(4).

In effect, these rules limit a venture capital fund’s ability to acquire secondary shares and encourages, instead, a focus on direct portfolio investments (i.e., start-ups).

Fund formation and structuring is a complex legal area that involves various legal and regulatory considerations. Contact our firm today for a consultation on what type of fund works best for your desired structure.