December 11, 2013

SEC Provides Guidance on Exemption for Advisers to Venture Capital Funds

Recent guidance from the SEC provides clarity for advisers to venture capital funds on the permissibility of a number of common practices in the venture capital industry under the VC Exemption. Specifically, the guidance indicates that the SEC Staff will not object to VC Advisers’ use of intermediate holding companies, alternative investment vehicles, warehoused investments, parallel funds and liquidating trusts while relying on the VC Exemption.

On December 5, 2013, the staff of the Securities and Exchange Commission’s (“SEC”) Division of Investment Management (the “Staff”) provided guidance (the “Guidance”) on the interpretation of Rule 203(1)-l (the “Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”), which defines the term “venture capital fund” (“VC Fund”) for purposes of the exemption from registration (the “VC Exemption”) for VC Fund managers or advisers that only advise VC Funds (“VC Advisers”).  The Guidance provided Staff answers to questions regarding certain common practices in the venture capital industry, the validity of which, for purposes of relying on the VC Exemption, was open to question.


Subject to grandfathering relief for pre-December 31, 2010 funds,[1] in order to be a VC Fund, a fund must: (1) represent to investors that the VC Fund pursues a venture capital strategy; (2) not hold non-qualifying investments that comprise more than 20% of the aggregate capital contributions and uncalled capital commitments of the VC Fund; (3) limit leverage and guarantees; (4) offer redemption rights only in extraordinary circumstances; (5) not have registered under the Investment Company Act of 1940 or elected to be a business development company; and (6) be a private fund.[2]  A “qualifying investment” generally means an “equity security issued by a qualifying portfolio company that has been acquired directly by the private fund from the qualifying portfolio company.”

The Guidance provides the Staff’s responses to questions it has received on compliance with the VC Exemption that focus on whether certain common practices in the venture capital industry are consistent with the Rule’s requirements relating to qualifying investments, particularly with respect to the requirement that an investment must be acquired directly from the qualifying portfolio company.

Scenario 1: Use of a Single Intermediate Holding Company Owned by Multiple VC Funds Advised by the Same VC Adviser 

The Guidance expands prior SEC guidance that permits an adviser to disregard an “intermediate holding company formed solely for tax, legal or regulatory reasons” to hold an investment in an otherwise qualifying portfolio company so long as such intermediate holding company is wholly owned by the fund.  Under the Guidance, the Staff will not object if a VC Adviser disregards an intermediate holding company used to make qualifying investments that is wholly-owned by more than one VC Fund that the VC Adviser manages. 

Scenario 2: Alternative Investment Vehicles 

To accommodate certain U.S. tax exempt and non-U.S. investors, a VC Adviser may create an alternative investment vehicle (“AIV”), treated as a corporation for U.S. tax purposes, whose sole purpose is to invest in the VC Fund.  The AIV, which is controlled and managed by the VC Adviser or a related person, is separate from the VC Fund and elects to be taxed as a corporation.  Under the Guidance, a VC Adviser may disregard such an AIV for purposes of determining its compliance with the conditions of the VC Exemption so long as the AIV is “formed solely to address investors’ tax, legal or regulatory concerns and such AIV is not intended to circumvent the VC Exemption’s general limitation on investing in other investment vehicles.” 

Scenario 3: Warehoused Investments

In anticipation of raising a VC Fund, a VC Adviser, or an affiliate of a VC Adviser, may invest in a qualifying investment, which it later transfers to the VC Fund once the VC Fund has closed (a “Warehoused Investment”). 

The Staff will not object if a VC Adviser treats a Warehoused Investment as if it were acquired directly from the qualifying portfolio company for purposes of satisfying the VC Exemption “provided that: (i) the Warehoused Investment is initially acquired” by the VC Adviser “(or a person wholly owned and controlled by)” the VC Adviser “directly from a qualifying portfolio company solely for the purpose of acquiring the investment for a prospective” VC Fund “that is actively fundraising; and (ii) the terms of the Warehoused Investment are fully disclosed to each investor” in the VC Fund before the investor commits to invest in the VC Fund.

Scenario 4: Parallel Funds 

A VC Adviser may transfer qualifying portfolio company securities held by a VC Fund (the “Main Fund”) it advises to one or more additional VC Funds (the “Parallel Funds”) it advises to invest in parallel alongside the Main Fund and still rely on the VC Exemption.  Such transfer may occur after the Main Fund has closed and the qualifying portfolio company securities may be transferred so that the Main Fund and the Parallel Funds each “hold their pro-rata share of portfolio company securities as if each fund had made the investment on the same day on the same terms.” 

The Staff will not object if a VC Adviser treats such transfer as if the Parallel Funds acquired the portfolio company securities directly from the qualifying portfolio company for purposes of satisfying the VC Exemption “so long as such transfer occurs within 12 months of the final closing of the Main Fund and the potential for this type of transfer is fully disclosed” in the constituent documents of the Main Fund and any Parallel Funds.

Scenario 5: Liquidating Trusts 

VC Advisers may establish a liquidating trust (of which the VC Adviser or an affiliate is the liquidating trustee) to wind-up the affairs of a VC Fund near the end of its term and liquidate the remaining assets of the VC Fund, so long as the possibility of creating a liquidating trust and its terms had been disclosed in the VC Fund constituent documents.  The Staff will not object if a VC Adviser uses a liquidating trust while relying on the VC Exemption in the scenario described in the previous sentence.   


The Guidance provided by the Staff provides clarity regarding the permissibility of a number of common practices in the venture capital industry under the VC Exemption and indicates that the Staff will not object to VC Advisers relying on the VC Exemption in connection with these common practices. If you have additional questions please contact your Goodwin Procter attorney.

[1]   See subsection (b) of the Rule with respect to certain VC Funds which sold securities prior to December 31, 2010.

[2]  For additional information on the VC Exemption, please consult Goodwin Procter’s Advisers Act Alert: Part 6 Registration Exemption for “Venture Capital Fund” Advisers, dated June 30, 2011.