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So you think you're a venture capitalist?

by contributors Gordon R. Caplan, Barry P. Barbash and Stephen O'Connor | Published August 23, 2011 at 1:40 PM

You run a private fund that invests in young companies exploiting potentially disruptive technologies and ideas. Your fund locks its investors into long-term commitments because the bulk of the investments it makes are in illiquid equity securities. Your fund rarely holds securities of publicly traded companies except on those infrequent occasions when one of your portfolio companies consummates the increasingly arduous task of going public or when you feel it is appropriate to help a small cash-starved public company through a private investment in the unregistered equity of the nominally public company, or a PIPE. You utilize debt in your investments as infrequently as you put on a tie to go to meetings with prospects. So you think you are a venture capitalist? Well, the Securities and Exchange Commission may beg to differ.

Does your fund buy shares from founders or other existing shareholders of private companies? Does your fund invest in PIPEs so as to support small-cap public companies in need of cash, like many young biotechnology and medical-device companies? Does your fund make growth equity investments in companies that have shown traction in the marketplace and can no longer really be considered a startup? In your latest round of fundraising, have you indicated to potential investors that you will likely do some or all of these things? If so, the SEC does not think you are a venture capitalist.

The SEC recently adopted a definition of "venture capital fund" for purposes of implementing the "venture capital exemption" created by the Dodd-Frank Act. Under the venture capital exemption, managers that advise solely one or more venture capital funds are exempt from registration with the SEC as an investment adviser. The adoption of the venture capital fund definition was eagerly anticipated by the venture capital community because the ability to rely on the venture capital exemption means the difference between having to register as an investment adviser with the SEC (and being subject to the SEC's extensive regulations and policies related to registered investment advisers) and being able to continue operating largely outside the scope of SEC regulation.

Shortly after the SEC adopted the venture capital fund definition, the National Venture Capital Association published a blog post highlighting its role in broadening the scope of the definition and its optimism that the majority of its members would not have to register as investment advisers with the SEC. On the day of the SEC's announcement, peHUB published an article with the picture of an uncorked bottle of champagne titled "Venture Capital Firms Win Favorable SEC Decision on Fund Registration." The NVCA and peHUB were celebrating because the definition of venture capital fund as adopted by the SEC was not as narrow as the definition it had first proposed in November. Both the NVCA and peHUB were pleased that the SEC broadened its proposed definition of venture capital fund by including a 20% carveout for "non-qualifying investments" such that a private fund that mainly invests in traditional venture capital early-stage equity investments could hold a limited amount of its assets in investments that do not meet the SEC's otherwise narrow characterization of a venture capital investment, which the SEC embodied in the definition as a "qualifying investment."

Unfortunately for active venture capitalists, it may be premature to uncork the champagne. Although the definition of a venture capital fund ultimately adopted by the SEC is broader than the original proposal, it remains a narrow definition. Many funds that currently consider themselves to be in the venture capital business will have a hard time qualifying as a venture capital fund under the SEC's definitional criteria (although the definition does grandfather existing funds meeting certain conditions as venture capital funds). As if the stakes of having to register with the SEC aren't already high enough, the SEC has said a manager could face charges of fraud if it claims to operate a fund that pursues a venture capital strategy but then makes significant nonqualifying investments, even in circumstances where these investments do not exceed the 20% limit for nonqualifying investments.

The SEC defines a venture capital fund as a private fund with five components: (1) no more than 20% of the amount of the fund's capital commitments are invested in nonqualifying investments; (2) the fund does not incur material leverage; (3) the fund has been represented to investors as a fund that pursues a venture capital strategy; (4) the fund does not provide its investors with redemption rights except in extraordinary circumstances; and (5) the fund is not otherwise registered under the Investment Company Act of 1940. The SEC goes on to define a "qualifying investment" as, generally, an investment in the equity securities of a private operating company, where the equity securities are issued directly to the investing fund by the private company, and the private company does not borrow in connection with the investment and distribute the proceeds of the borrowing to the investing fund in exchange for its investment. By this definition, therefore, purchases of shares from existing shareholders are nonqualifying investments, as are investments in PIPEs and certain investments involving portfolio company leverage.

In the age of larger, capital-hungry social media and gaming companies such as Facebook Inc., Groupon Inc. and Twitter Inc., and the advent of private markets such as Second Market, the opportunity for venture capitalists to purchase stock from existing shareholders has increased dramatically. The increasing ability to provide founders and other early investors with some level of liquidity is a positive development for venture-backed companies but, alas, the SEC does not deem that type of activity venture capital investing. Venture funds that focus on biotechnology and medical-device companies, many of which do not generate meaningful revenue for many years while they develop and test their products, often provide much-needed capital to development-stage companies through PIPEs. Yet that critical capital formation activity is also nonqualifying, according to the SEC.

In her comments at the meeting at which the SEC's definition of a venture capital fund was adopted, SEC Chairwoman Mary Schapiro emphasized the purposefully narrow nature of the definition and highlighted that the definition focuses on the provision of capital for the operation and expansion of startup businesses. Perhaps that is a proper view of what venture capital should be, but it is certainly not the investing activity to which all, or even most, funds that may consider themselves venture capital funds restrict themselves.

What this means for many managers that currently consider themselves advisers to venture capital-focused funds is that they will have to register as investment advisers with the SEC and join the ever-expanding community of highly regulated financial institutions. Regardless of whether you wear ties to the office or operate from Wall Street or Menlo Park, Calif., you and your colleagues may not be spared from joining the ranks of the highly regulated.

It is at least ironic that an industry that did not contribute to the systemic risk identified as a cause of the financial crises over the last several years, and that has been pointed to by politicians on both sides of the aisle as a beacon for America's economic future, is and will be caught up in the net of Wall Street reform. Unfortunately, the irony may be lost on many fund managers who never considered themselves as anything other than venture capitalists. Perhaps the cork should be put back into the champagne bottle.

Gordon R. Caplan is a partner in Willkie Farr & Gallagher LLP's corporate and financial services department and co-chairman of the private equity practice. Barry P. Barbash is partner and chairman of the firm's asset management group, while Stephen O'Connor is associate in the asset management group.

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Tags: asset manager | investments | SEC | Securities and Exchange Commission | venture capital firm

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