venture capitalists strategizing

Section 203(l), also known as the “Advisers Act”, provides that only advisers to venture capital funds are exempted from registration under the Advisers Act. The Advisers Act does not define the term “venture capital funds”. Instead, SEC Rule 203(l),-1(a), defines the term as a private fund that meets specific conditions. This article will examine each condition and explain what you need to do in order to fulfill them.

Venture Capital Strategy

A fund must first meet the criteria to be considered a venture capital fund. This means that the fund must “[represent] itself to investors and potential investors as it pursues a strategy for venture capital.” It is subjective to determine whether a fund is actually pursuing a strategy for venture capital. The name of a fund does not have to include the word “venture capital”. The SEC examines the statements made by private fund advisers to potential investors and investors in general. However, to be able to give reasonable assurance that an investment adviser is exempted from registration, the offering materials for the fund must clearly and unambiguously declare that the strategy is venture capital.

Investment Holdings Limitation

The second condition is that the fund must meet:

Immediately following the acquisition of any asset (other than qualifying investments or short term holdings), no more than 20% of the fund’s aggregate capital contributions and uncalled capital in assets (other short-termholdings) that aren’t qualifying investments, valued either at cost or fair price, consistent applied by the fund.

The regulation defines the terms “qualifying investments” and “short-term holdings” in other words.

Qualifying Investments

A “qualifying investment” can be defined as one of the following: (i), equity security issued to a “qualifying company” by which an investor is directly acquired from that company; (ii), any equity security that is issued to a qualifying company in return for another equity security; and (iii). any equity security issued in exchange by a parent company of a qualified portfolio company for an equity stock in that portfolio company. The fund can retain its interest after a corporate restructuring or other exchange of equity interests. The fund can retain its interest after a qualifying portfolio business is acquired by another company, even a publicly-traded one. The qualifying portfolio company would then become a majority-owned subsidiary to the new parent company.

This definition has two major consequences. The first is that qualifying investments must not be debt but equity. The term equity security can be defined, thankfully, to include warrants, preferred stock, common stock convertible into common stock, and limited partnership interests. Bridge loans that aren’t convertible would not be considered qualifying investments.

They must also be purchased from a third party and made directly by an investor. The venture capital fund cannot treat any interest it acquires in a company on the secondary market, or by buying out current owners or managers as a qualifying investment. This would prevent the venture capital fund from treating such interest as part of its 20% non-qualifying basket. A qualifying investment is still considered a qualifying one after a corporate restructuring or buyout in which the equity interests of the qualifying portfolio companies are exchanged for equity interests in another company.

Qualifying Portfolio Businesses

Next, let’s consider the question: What is a “qualifying Portfolio Company?” At the time of investment by the fund, a company must not be a reporting entity under the Securities Exchange Act of 1934 or listed on any foreign exchange. Directly or indirectly, the company must not be under common control with an Exchange Act reporting company or publicly traded foreign company. (iii) The company cannot borrow or issue debt obligations in relation to the private fund’s investments in the company. In exchange for such investment, the fund may distribute the proceeds of such borrowings or issuances to the fund (i.e. There are no leveraged buyouts; and (iii), it can’t be a mutual, hedge, private equity, private equity, other venture capital funds, commodity pool funds, or issuers of asset-backed securities.

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A “qualifying portfolio” company is the first requirement to ensure that any venture capital fund that invests in a company (other than its 20% nonqualifying basket) is not publicly traded. This requirement is not controversial as venture capital strategies often invest in young companies and may take them public. Venture capital funds can keep this investment, even if the company goes public. The test to determine whether an investment is a qualifying investment is performed at the initial investment. If the fund acquires more shares of a portfolio business after it goes public, this investment will not be considered a “qualifying” investment. Therefore, if a venture fund is asked to sign an agreement to participate in future rounds of financing for a portfolio firm, any such requirement would apply to shares that were sold during an IPO. This agreement could require them to buy non-qualifying investments. If this happens, the adviser to the venture capital fund could be required to register under the Advisers Act. The second requirement for a “qualifying portfolio fund” is that any leveraged buyout funds or other private funds that finance portfolio acquisitions and cause portfolio companies to incur debt will not be included in the definition of venture capital funds. This requirement, along with the requirement that “qualifying investments” must be equity securities acquired directly from the portfolio companies, effectively restricts the transactions venture capital funds are allowed to enter while still allowing for exemptions for their investment adviser.

The definition’s final requirement states that “venture capital fund” cannot include any type of fund of funds. This is true even if the underlying funds themselves are venture capital funds. A venture capital fund may invest in other funds as a part of its non-qualifying portfolio.

Holdings for the Short-Term

Remember that at least 80% must be invested in “qualifying investment” or “short term holdings”. This is a very restrictive definition. Although some funds might want to store their assets in low-risk liquid investments like commercial paper, municipal bonds, and foreign debt, not all assets would be eligible. These assets may be considered non-qualified investments for a venture capital fund, but they should not be used as a cash management tool.

The Non-Qualifying Basket

The “non-qualifying” basket is a portfolio of investments that are not “qualifying investment” or “short term holdings” and can only be used to invest in 20% of the total assets of a venture capital fund, which includes committed capital but not yet invested capital.

Each investment must be calculated by the fund to determine if it exceeds the 20% limit. The test does not apply continuously. This means that even if certain qualified investments lose value or non-qualifying investment increase in value, regulations will still be followed. The fund will not be allowed to acquire any non-qualifying investments until the proportion of non-qualifying investors falls back below 20%.

Another thing to remember is that capital commitments must all be bona fide. Funds cannot have “investors”, who commit capital, with the understanding that it would never be called. According to the SEC, such arrangements would decrease the ratio’s committed capital. The ratio is still calculated even if the investor does not provide the capital, even if the adviser to the fund calls it.

Venture capital funds can also choose from one of two methods to ensure compliance with non-qualifying investment limits. Funds can choose to value investments at their fair value. This is known as a “mark-to-market” approach. If a fund’s nonqualifying basket loses value due to market fluctuations, it may be allowed to buy additional non-qualifying investment if this does not exceed the 20% limit. All assets are assessed at fair market value. This could be costly as many fund investments are likely to not be liquid and therefore difficult to value. Therefore, frequent appraisals may be necessary. Another approach that a fund might consider is to value all investments at their historic cost, so that the investment’s value does not change regardless of market fluctuations. This avoids having to perform frequent appraisals if the fund chooses fair value for its calculations. The SEC believes that fund advisor should not be allowed to use different methods on different occasions. The fund must use the same method to value all investments throughout its life.

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Venture capital funds can use the non-qualifying basket to make non-qualifying transactions such as bridge loans to portfolio or potential portfolio companies, or purchase of publicly traded securities. They do not lose their status as venture capital funds.

Limits on leverage

The third condition for a “venture capital funds” is that the fund must:

“Doesn’t borrow, issue debt obligations or provide guarantees, or otherwise incur leverage, exceeding 15% of the aggregate capital contributions of the private funds. Any such borrowing, indebtedness or guarantee of leverage by the private fond of a qualifying portfolio firm’s obligations up the amount of private fund investment in the qualifying company is not subject the 120-day limit.

There are two main requirements for the leverage restriction. The first is that a venture capital fund cannot borrow, indebtedness, or guarantee the debts of portfolio businesses in excess of 15% its aggregate capital contributions and uncalled committed capital. It can also incur significant leverage during the fund’s early years of existence, even before it has called all its capital. If a fund has $10 million in capital commitments but has not called $2 million yet, it could theoretically be subject to leverage of up $1.5 million. This is because the 15% calculation uses the total aggregate number.

A second requirement is that all borrowing, including those incurred to comply with the 15% limit, must not exceed 120 calendar days. Portfolio company debt guarantees are exempted from this limitation. The guarantee of portfolio company debt cannot exceed the fund’s investment in the portfolio company. Except for that exception, any borrowing by a fund must not be longer than one year.

These two requirements result in very restrictive leverage restrictions within the SEC’s definitions of portfolio companies. They effectively prevent funds that use substantial leverage from using the venture capital exception to registration as investment advisers.

Investors do not have any redemption rights

The fourth condition demands that the fund:

“Only issues securities whose terms do not give holders any rights, except in exceptional circumstances, to withdraw, redeem, or require the purchase of such securities. However, holders may be entitled to receive distributions made pro-rata to all holders.”

In its comments to the rule, the SEC provided guidance on what “extraordinary circumstances” mean. It stated that it would be restricted to events outside the control of either the fund adviser or investor. SEC only gives one example: a material modification in law or regulation. Evidently, the SEC meant that this exception would be very limited in scope.

One question that might arise is whether an adviser to a fund would be allowed to receive distributions from its carry interest without making a pro-rata distribution to investors. It can, according to the commentary. This is because the regulations state that venture capital funds can only issue securities without redemption rights. The carried interest of the fund adviser is typically a general partnership interest in a limited partnership, or a managing member of a limited liability business. This would not be considered security in the context of fund formation. There are potential problems. A few fund advisers structure their carried interests as a limited partnership interest that is held by a special limited partner, which is an entity independent from the fund adviser. This limited partnership interest could be considered a security and a fund that is structured in this way may not be allowed to distribute the carried interest of the fund adviser without pro rata distribution to investors.

This requirement also raises the question of whether it prohibits investors from transferring their interest in venture capital funds. Private funds’ offering documents must limit the transferability of fund interests as a condition of making use of Regulation D. However, certain exemptions, such as Rule 144 and Section 4(a),(7) of the Securities Act of 1934, or the “Section 4 (1 1/2 ) exemption”, allow for resale. Fund offering documents often state that the owner of an interest is allowed to transfer it if counsel gives an opinion stating that there is a resale exemption. Is this a violation of the redemption restriction? Commentary to the rule suggests that the SEC believes that such a provision does not violate the redemption restriction, provided that the adviser is not giving de facto redemption rights by helping investors find potential transferees. Venture capital funds should not offer to help investors locate potential transferees.

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These restrictions are in line with the practices of the venture capital fund industry. This requirement will mean that some funds will not be able to qualify for the SEC’s definition. The definition may not apply to funds that are “evergreen”, that accept new investors, allow redemptions like hedge funds do, or that use a special limited partner and intend to distribute to that partner at a pro rata rate to investors.

Registering the Prohibition Against Investment Company Act

The fifth and final condition is that the fund (i) must not be registered under Investment Company Act of 1940, and (ii) must not elect to be treated in accordance with the Investment Company Act as a business development firm. Venture capital funds should not be affected by this requirement.

Funds that are registered as investment corporations are usually publicly traded mutual funds. Contrary to this, venture capital funds are generally private funds. These funds are exempted from the Investment Company Act’s registration requirements. A venture capital fund typically uses one of two exemptions: the “3(c)(1)” exemption or the “3(c)(7)” exemption. Funds with 100 or less investors are exempted from registration under the Investment Company Act by the 3(c(1) exemption. The Investment Company Act exemption 3(c)(7) exempts any fund sold only to qualified purchasers. This is, roughly speaking, a person or entity that has $5 million or more in investment assets. Practically speaking, this means that private funds, such as venture capital funds, are either (i) limited to 100 or less accredited investors or (ii) limited to qualified purchasers.

Advisors to funds that have elected to be classified as business development companies under the Investment Company Act are exempt from the venture capital exemption. A business development company can be described as a publicly traded private equity fund that provides capital to financially distressed companies. If an exemption applies, advisers to such funds must register with the SEC as investment advisors.


It may seem easy to be exempted from the requirements for venture capital advisor exemption by restricting the adviser’s business only to advising venture capital funds. However, it can be difficult to determine if a fund meets the complex conditions to be a “venture fund”. Also note that a private fund adviser exempt under the venture capital exemption is still an exempt reporting adviser, which means it will still be required to provide an abbreviated Form ADV to the SEC. In addition, fund advisers exempt from the SEC may also still nonetheless be subject to state investment adviser registration requirements. An attorney with experience in securities regulatory issues should be consulted to determine if your fund management company is required to register with either the SEC or state authorities, and what filings are necessary.