For me, venture capital has always been a fuzzy term. They generally invest in start-ups and provide early stage capital for their growth. As a company progresses through later rounds of funding, that definition does not seem to work that well. For example, would you label the latest rounds of funding in Facebook as “venture capital”?
The other problem for a venture capital fund is that liquidity events for their portfolio companies may leave them holding valuable chunks of publicly traded stock or mature private company securities, leaving their capitalization.
Until recently, an exact definition was not needed. Venture capital fund managers could operate across a spectrum of business models, depending on what limitations they promised to their fund investors.
Now, the Securities and Exchange Commission has required a more precise definition. Venture Capital fund managers can take advantage of an exemption from registration under the Investment Advisers Act. This exemption is not available for the rest of the private equity world of investment managers.
The SEC published the final definition under a new Rule 203(l)-1
A venture capital fund is any private fund that:
(1) Represents to investors and potential investors that it pursues a venture capital strategy;
(2) Immediately after the acquisition of any asset, other than qualifying investments or short-term holdings, holds no more than 20 percent of the amount of the fund‘s aggregate capital contributions and uncalled committed capital in assets (other than short-term holdings) that are not qualifying investments, valued at cost or fair value, consistently applied by the fund;
(3) Does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15 percent of the private fund‘s aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days, except that any guarantee by the private fund of a qualifying portfolio company‘s obligations up to the amount of the value of the private fund‘s investment in the qualifying portfolio company is not subject to the 120 calendar day limit;
(4) Only issues securities the terms of which do not provide a holder with any right, except in extraordinary circumstances, to withdraw, redeem or require the repurchase of such securities but may entitle holders to receive distributions made to all holders pro rata; and
(5) Is not registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), and has not elected to be treated as a business development company pursuant to section 54 of that Act (15 U.S.C. 80a-53).
They piece of the definition is the term “qualifying investments.”
Qualifying investment means:
(i) An equity security issued by a qualifying portfolio company that has been acquired directly by the private fund from the qualifying portfolio company;
(ii) Any equity security issued by a qualifying portfolio company in exchange for an equity security issued by the qualifying portfolio company described in paragraph (c)(3)(i) of this section; or
(iii) Any equity security issued by a company of which a qualifying portfolio company is a majority-owned subsidiary, as defined in section 2(a)(24) of the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(24)), or a predecessor, and is acquired by the private fund in exchange for an equity security described in paragraph (c)(3)(i) or (c)(3)(ii) of this section.
Qualifying portfolio company means any company that:
(i) At the time of any investment by the private fund, is not reporting or foreign traded and does not control, is not controlled by or under common control with another company, directly or indirectly, that is reporting or foreign traded;
(ii) Does not borrow or issue debt obligations in connection with the private fund‘s investment in such company and distribute to the private fund the proceeds of such borrowing or issuance in exchange for the private fund‘s investment; and
(iii) Is not an investment company, a private fund, an issuer that would be an investment company but for the exemption provided by § 270.3a-7 of this chapter, or a commodity pool.
The big limitation throughout the definition is on the debt limitation.
Many funds use a subscription credit facility secured by the uncalled capital commitments. This gives them quicker access to cash for investments. Then the facility is paid down after capital is called. The use of a credit facility also allows the capital calls to be spread out and can be used to give fund investors more lead time to pull together their own cash. It seems this new rule will severly limit the ability of a venture capital fund to use a subscription credit facility.
- SEC Release No. IA-3222 – Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers (.pdf – 208 Pages)
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