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On Friday, Nov. 19, most venture capital funds let out a huge sigh of relief. Why? Because after several months of soliciting input from the investment fund industry regarding the proper scope and nature of the “venture capital fund” definition, the Securities and Exchange Commission (SEC) proposed its much anticipated set of proposed rules.

If you are questioning why the SEC is defining venture capital funds, it is because the Dodd-Frank Wall Street Reform and Consumer Protection Act that President Obama signed into law on July 21, 2010, assigned the SEC with the task of defining “venture capital fund.”

As for a little background, the Dodd-Frank Act eliminated the cost-prohibitive requirement that VC fund managers register with the SEC under the Investment Advisors Act of 1940.

Prior to the Dodd-Frank Act, many venture capital and private equity fund managers did not registration under the Advisers Act because of the “private investment adviser” exemption. According to this exemption, firms that had fewer than 15 clients over the course of the preceding 12 months and neither had held themselves out generally to the public as an investment adviser nor acted as an investment adviser to any investment company registered under the Investment Company Act of 1940 were exempt.

However, Title IV of the Dodd-Frank Act replaced the private investment adviser exemption with new, more narrow exemptions, including an exemption for private fund managers that provide advice solely to one or more “venture capital funds.”

So, what did the SEC suggest? According to the proposal, the definition of a “venture capital fund” would be any private fund that meets all of the following criteria:

  • The fund represents itself as a venture capital fund to investors
  • The fund owns solely equity securities of private companies and cash, cash equivalents and certain U.S. treasuries
  • None of the portfolio companies of the fund: issue debt obligations (directly or indirectly) in connection with the fund’s investment in such company; redeem, exchange or repurchase any securities of the company or distribute to existing security holders cash or other company assets in connection with the fund’s investment in such company; or are themselves a private fund or other pooled investment vehicle
  • At least 80% of the equity securities of each portfolio company of the fund were acquired by the fund directly from the portfolio company
  • The fund and/or its managers: offer to provide significant guidance regarding the management, operations or business objectives and policies of each portfolio company (and, if accepted actually provides such guidance) or control each portfolio company
  • The fund does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15% of the fund’s committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days
  • The fund does not offer its investors redemption, withdrawal or other similar liquidity rights except in extraordinary circumstances
  • The fund is neither registered under the Investment Company Act nor has elected to be treated as a “business development company”

In addition, new reporting rules are applicable even to exempt VC funds. Even if an adviser is able to avoid registration under the Advisers Act by qualifying under the VC Exemption, the Proposed Rules requires them to comply with new reporting, recordkeeping and other compliance requirements proposed under the Private Fund Act.

Keep in mind, however, this is just a proposal. The SEC is asking for public comment over the next month or so. Given the importance of the Proposed Rules to the venture capital community, and the immediate reaction of many firms to certain aspects of the VC Exemption, I expect the comment process to be very active and am hopeful that the SEC will see fit to make at least some corresponding revisions.

For more information on the Proposed Rules, please click here.

It is important that fund managers review the Proposed Rules and Exemption Release as soon as possible to assess the likelihood of whether they will need to register under the Advisers Act, and, at a minimum, familiarize themselves with the obligations and contours of the new recordkeeping, reporting, and other compliance requirements applicable to exempt fund managers as a matter of initial compliance readiness. To review the proposal and submit comments to the SEC, click here.