Recently, the Securities and Exchange Commission (“SEC”) issued a no-action letter in response to a request for clarification of the Venture Capital Exemption (“Exemption”) to Section 203 of the Investment Advisers Act of 1940. Section 203 specifically addresses the registration of investment advisers and any applicable exemptions firms may rely on.
Under the Exemption, any firm that acts as an investment adviser solely to one or more venture capital funds is not required to register with the SEC. This is subject to the requirement that the investments must be made in qualifying portfolio companies (“Qualifying Companies“). Qualifying Companies must not be any of the following:
- A publicly-traded company, U.S. or foreign;
- Have a control relationship with a publicly-traded company;
- Incur leverage in connection with the investment by the private fund and distribute such borrowing to the private fund in exchange for investment; or
- A fund.
The examples below address two issues these restrictions place on venture capital firms, significantly because they must be met on the date of the initial investment. A fund or manager may invest in a Qualifying Company that later becomes publicly-traded without hindering the fund or manager’s reliance on the Exemption. If this occurs, however, the fund or manager would be said to have a control relationship with a publicly-traded company. As a result of this control relationship, the fund or manager would not be able to invest in further Qualifying Companies while continuing to rely on the Exemption, as seen in Example 1.
The second example below highlights the same restriction, under slightly different circumstances. A fund or manager (“Unaffiliated Manager”), not relying on the Exemption, has a controlling interest in a Qualifying Company and a publicly-traded company. Additional funds or managers, relying on the Exemption, would then be prohibited from investing in that particular Qualifying Company because of Unaffiliated Manager’s control relationship with a publicly-traded company.
Per the above examples, the restriction disallowing Qualifying Companies from being under common control with a publicly-traded company creates issues for venture capital firms. Specifically, the issues are:
- When a fund or manager invests in a Qualifying Company that later becomes publicly-traded, it is deemed to have a control relationship with that company and prohibited from investing in further Qualifying Companies;
- Any fund or manager (not relying on the Exemption) that is invested in a Qualifying Company and a publicly-traded company has a control relationship with both companies. As a result of this relationship, additional funds or managers relying on the Exemption may not invest in that Qualifying Company.
This not only poses problems for initial investments in Qualifying Companies, but also for follow-on investments. These follow-on investments are often critical for companies receiving funding from firms relying on the Exemption. The SEC agreed that under these circumstances, the literal wording of the rule appears to have unintended consequences of preventing investments in Qualifying Companies. Accordingly, the SEC confirmed that it would not recommend enforcement action given similar circumstances. Firms that intend to rely on the Exemption should read the no-action letter in its entirety and consider documenting all supporting information so it is available in an examination. Any concerns about the applicability of the no-action relief should be addressed to outside counsel and/or a firm’s compliance consultant.