Venturing Smart: Essential Practices and Precautions of the Venture Capital Advisers Exemption
Generally, an investment adviser must register (either at the federal or state level) unless an exemption from registering applies. In connection with the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Securities and Exchange Commission (SEC) enacted rules that exempt from registration advisers that solely advise venture capital funds (the “Venture Capital Adviser Exemption”).[1] The Venture Capital Adviser Exemption provides significant regulatory relief for investment managers that solely advise venture capital funds and can significantly decrease an investment adviser’s regulatory burdens, including by allowing them to avoid a comprehensive and costly federal or state registration process and the compliance program needed to comply with the Investment Advisers Act of 1940, as amended (the “Advisers Act”) or applicable state law.
In order to qualify for and benefit from the Venture Capital Adviser Exemption, an adviser must solely advise “venture capital funds.” The SEC has set forth five (5) criteria for a fund to qualify as a venture capital fund—one of those five is that it must limit its investments that are not “qualifying investments” in “qualifying portfolio companies.” Specifically, no more than 20% of the fund’s aggregate capital contributions (plus uncalled capital commitments) can be allocated to “non-qualifying investments.”
Generally speaking, “qualified investments” are usually direct equity stakes (i.e., preferred or common stock) in startups and other private businesses in their initial or growth stages, but explicitly exclude items like non-convertible debt securities, publicly traded securities and leveraged investments.
For emerging growth companies seeking venture capital financing, it’s strategic to structure their financial offerings such that they are offering “qualifying investments.” This makes them more attractive to venture capital funds, which are limited in the amount of non-qualifying investments that can make. Structuring their offerings as “qualified investments” allows venture capital funds to invest without concern in either breaching their allowed basket for non-qualifying investments or potentially turning down an opportunity to invest in a different non-qualifying investment.
Additionally, investment managers who are relying or seek to rely on the Venture Capital Adviser Exemption that form Special Purpose Vehicles (SPVs) designed to invest in a single portfolio company must avoid non-qualifying investments in such SPVs altogether. Because of the single-asset nature of such an SPV, its investments are very likely an “all or nothing” and thus a non-qualifying investment would likely prevent such SPV from being a “venture capital fund” as defined in the rules. The Venture Capital Adviser Exemption will not apply if even a single investment vehicle does not meet the required definition, and it would subject the investment adviser’s entire business to registration, unless a separate exemption applied.
The Venture Capital Adviser Exemption is crucial for the venture capital sector as it benefits both investment managers and emerging growth companies. It grants investment managers of private venture capital funds the agility and flexibility to operate with lower administrative costs and regulatory burdens than full registrants—which is particularly important for emerging managers that are often cash-strapped in their operations. By doing so, it enables many managers, including some who would not otherwise have the resources to operate, to focus on growth and building businesses with an eye toward the future.
In order to qualify for and benefit from the Venture Capital Adviser Exemption, an adviser must solely advise “venture capital funds.” The SEC has set forth five (5) criteria for a fund to qualify as a venture capital fund—one of those five is that it must limit its investments that are not “qualifying investments” in “qualifying portfolio companies.” Specifically, no more than 20% of the fund’s aggregate capital contributions (plus uncalled capital commitments) can be allocated to “non-qualifying investments.”
Generally speaking, “qualified investments” are usually direct equity stakes (i.e., preferred or common stock) in startups and other private businesses in their initial or growth stages, but explicitly exclude items like non-convertible debt securities, publicly traded securities and leveraged investments.
For emerging growth companies seeking venture capital financing, it’s strategic to structure their financial offerings such that they are offering “qualifying investments.” This makes them more attractive to venture capital funds, which are limited in the amount of non-qualifying investments that can make. Structuring their offerings as “qualified investments” allows venture capital funds to invest without concern in either breaching their allowed basket for non-qualifying investments or potentially turning down an opportunity to invest in a different non-qualifying investment.
Additionally, investment managers who are relying or seek to rely on the Venture Capital Adviser Exemption that form Special Purpose Vehicles (SPVs) designed to invest in a single portfolio company must avoid non-qualifying investments in such SPVs altogether. Because of the single-asset nature of such an SPV, its investments are very likely an “all or nothing” and thus a non-qualifying investment would likely prevent such SPV from being a “venture capital fund” as defined in the rules. The Venture Capital Adviser Exemption will not apply if even a single investment vehicle does not meet the required definition, and it would subject the investment adviser’s entire business to registration, unless a separate exemption applied.
The Venture Capital Adviser Exemption is crucial for the venture capital sector as it benefits both investment managers and emerging growth companies. It grants investment managers of private venture capital funds the agility and flexibility to operate with lower administrative costs and regulatory burdens than full registrants—which is particularly important for emerging managers that are often cash-strapped in their operations. By doing so, it enables many managers, including some who would not otherwise have the resources to operate, to focus on growth and building businesses with an eye toward the future.
[1] Note: This article solely addresses federal rules. Investment advisers may be subject to state requirements, and although many states have adopted similar rules, it is important for an investment adviser to comply with all applicable rules. For example, the definition of “venture capital company” in California is different from a “venture capital fund” as described in this article.