The Proposed Rules
One of the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was to require many more financial advisors to register under the Investment Advisers Act of 1940 (the “Advisers Act”). The Dodd-Frank Act exempted advisers that only manage venture capital funds from registration under the Advisers Act, and the Securities and Exchange Commission (the “SEC”) was directed to define the term “venture capital fund.” On November 19, 2010 the SEC proposed a definition of “venture capital fund”. Under the proposed definition, a venture capital fund is a private fund that:
- Public Representation. Represents itself to investors and potential investors that it is a venture capital fund.
- Invests in Qualifying Portfolio Companies. Only invests in equity securities (including convertible notes, warrants and other securities that are convertible into equity securities) of “qualifying portfolio companies” (see below) (and at least eighty percent (80%) of the equity securities of each qualifying portfolio company owned by the fund was acquired directly or indirectly from the qualifying portfolio company) or cash, cash equivalents or U.S. Treasuries with a remaining maturity of sixty (60) days or less.
- Significant Management Guidance. With respect to each qualifying portfolio company, either has an arrangement whereby the fund or the investment adviser offers to provide, and if so accepted, does so provide, significant guidance and counsel concerning the management, operations or business objectives and policies of the qualifying portfolio company.
- No leverage. Does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of fifteen percent (15%) of the fund’s aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 days.
- No redemption rights. Does not offer redemption rights to its investors.
Under the proposed rules, “qualifying portfolio company” means any company that:
- Private company. At the time of any investment by the fund, is not publicly traded and does not control, is not controlled by or under common control with a publicly traded company.
- No borrowing. Does not borrow or issue debt obligations in connection with the fund’s investment in such company.
- No purchase from existing security holders. Does not redeem, exchange or repurchase any securities of the company, or distribute to pre-existing security holders cash or other assets in connection with the fund’s investment in such company.
Under a proposed grandfathering provision, existing funds that make venture capital investments would generally be deemed to meet the proposed definition, as long as they have represented themselves as venture capital funds.
If adopted, the proposed rules raise create significant ambiguity or significant concerns regarding existing practices of venture capital firms.
- What constitutes “significant guidance and counsel concerning the management, operations or business objectives and policies of the qualifying portfolio company”? Is Board representation sufficient? What about board observers? Smaller funds that are more passive nature?
- Public companies sometimes want to spin out very early stage technology that is years from commercialization to affiliated companies and then rely on venture capital funds to fund their growth. The proposed rules would prohibit that practice.
- Many public companies have captive venture capital investment vehicles that invest in emerging companies. The proposed rules would prohibit co-investment by funds if the captive venture capital investment vehicle controls the company.
- Many companies rely on governmental or other low interest loans to fund their growth. The loans often require some matching funds as an independent third-party validation of the company’s prospects. The proposed rules appear to prohibit companies from raising matching debt capital as part of a venture capital investment.
- Occasionally, founders in later stage venture backed companies opt to “take some money off the table” by selling a portion of their equity in connection with later stage rounds. The proposed rules prohibit this practice. Potentially more problematic, the proposed rules could also be interpreted to prohibit repurchases of equity securities from former founders or employees who are no longer active in the company.
While the SEC appears to have made a good faith effort in defining what constitutes an exempt venture capital fund, some of the proposed rules would negatively affect certain common practices in a manner that is hard to explain if the goal is to further investor protection.