Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers

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SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 275 [Release No. IA-3111; File No. S7-37-10] RIN 3235-AK81 Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (the “Commission”) is proposing rules that would implement new exemptions from the registration requirements of the Investment Advisers Act of 1940 for advisers to certain privately offered investment funds that were enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). As required by Title IV of the Dodd-Frank Act—the Private Fund Investment Advisers Registration Act of 2010, the new rules would define “venture capital fund” and provide for an exemption for advisers with less than $150 million in private fund assets under management in the United States. The new rules would also clarify the meaning of certain terms included in a new exemption for foreign private advisers.

DATES:

Comments should be received on or before January 24, 2011.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's Internet comment form ( http://www.sec.gov/rules/proposed.shtml ); or

• Send an e-mail to rule-comments@sec.gov. Please include File Number S7-37-10 on the subject line; or

• Use the Federal eRulemaking Portal ( http://www.regulations.gov ). Follow the instructions for submitting comments.

Paper Comments

• Send paper comments in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.

omments.

Paper Comments

• Send paper comments in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.

All submissions should refer to File Number S7-37-10. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site ( http://www.sec.gov/rules/proposed.shtml ). Comments are also available for Web site viewing and printing in the Commission's Public Reference Room, 100 F Street, NE., Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. FOR FURTHER INFORMATION CONTACT:

Tram N. Nguyen, Daniele Marchesani, or David A. Vaughan, at (202) 551-6787 or (IArules@sec.gov) , Division of Investment Management, U.S. Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION:

The Commission is requesting public comment on proposed rules 203(l)-1, 203(m)-1 and 202(a)(30)-1 (17 CFR 275.203(l)-1, 275.203(m)-1 and 275.202(a)(30)-1) under the Investment Advisers Act of 1940 (15 U.S.C. 80b) (“Advisers Act”). 1

1 Unless otherwise noted, all references to rules under the Advisers Act will be to title 17, part 275 of the Code of Federal Regulations (17 CFR 275).

Table of Contents

5 of the Code of Federal Regulations (17 CFR 275).

Table of Contents

I. Background II. Discussion A. Definition of Venture Capital Fund 1. Qualifying Portfolio Companies 2. Management Involvement 3. Limitation on Leverage 4. No Redemption Rights 5. Represents Itself as a Venture Capital Fund 6. Is a Private Fund 7. Other Factors 8. Application to Non-U.S. Advisers 9. Grandfathering Provision B. Exemption for Investment Advisers Solely to Private Funds With Less Than $150 million in Assets Under Management 1. Advises Solely Private Funds 2. Private Fund Assets 3. Assets Managed in the United States 4. United States Person 5. Transition Rule C. Foreign Private Advisers 1. Clients 2. Private Fund Investor 3. In the United States 4. Place of Business 5. Assets Under Management D. Subadvisory Relationships and Advisory Affiliates III. Request for Comment IV. Paperwork Reduction Act Analysis V. Cost-Benefit Analysis VI. Regulatory Flexibility Act Certification VII. Statutory Authority Text of Proposed Rules I. Background

On July 21, 2010, President Obama signed into law the Dodd-Frank Act, 2 which amends various provisions of the Advisers Act and requires or authorizes the Commission to adopt several new rules and revise existing rules. 3 Unless otherwise provided for in the Dodd-Frank Act, the amendments become effective on July 21, 2011. 4

2 Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010).

3 In this Release, when we refer to the “Advisers Act,” we refer to the Advisers Act as in effect on July 21, 2011.

4 Section 419 of the Dodd-Frank Act

ules and revise existing rules. 3 Unless otherwise provided for in the Dodd-Frank Act, the amendments become effective on July 21, 2011. 4

2 Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010).

3 In this Release, when we refer to the “Advisers Act,” we refer to the Advisers Act as in effect on July 21, 2011.

4 Section 419 of the Dodd-Frank Act.

The amendments include the repeal of section 203(b)(3) of the Advisers Act, which exempts any investment adviser from registration if the investment adviser (i) Has had fewer than 15 clients in the preceding 12 months, (ii) does not hold itself out to the public as an investment adviser and (iii) does not act as an investment adviser to a registered investment company or a company that has elected to be a business development company (the “private adviser exemption”). 5 Advisers specifically exempt under section 203(b) are not subject to reporting or recordkeeping provisions under the Advisers Act, and are not subject to examination by our staff. 6

5 15 U.S.C. 80b-3(b)(3) as in effect before July 21, 2011.

6 See section 204(a) of the Advisers Act. See also infra note 30.

The primary purpose of Congress in repealing section 203(b)(3) was to 7 Private funds include hedge funds, private equity funds and other types of pooled investment vehicles that are excluded from the definition of “investment company” under the Investment Company Act of 1940 8 (“Investment Company Act”) by reason of sections 3(c)(1) or 3(c)(7) of such Act. 9 Section 3(c)(1) is available to a fund that does not publicly offer the securities it issues 10 and has 100 or fewer beneficial owners of its outstanding securities. 11 A fund relying on section 3(c)(7) cannot publicly offer the securities it issues 12 and generally must limit the owners of its outstanding securities to “qualified purchasers.” 13

7 See S. Rep. No. 111-176, at 71-3 (2010) (“S. Rep. No. 111-176”); H. Rep. No. 111-517, at 866 (2010) (“H. Rep. No. 111-517”). H. Rep. No

sues 10 and has 100 or fewer beneficial owners of its outstanding securities. 11 A fund relying on section 3(c)(7) cannot publicly offer the securities it issues 12 and generally must limit the owners of its outstanding securities to “qualified purchasers.” 13

7 See S. Rep. No. 111-176, at 71-3 (2010) (“S. Rep. No. 111-176”); H. Rep. No. 111-517, at 866 (2010) (“H. Rep. No. 111-517”). H. Rep. No. 111-517 contains the conference report accompanying the version of H.R. 4173 that was debated in conference, infra note 39.

8 15 U.S.C. 80a.

9 Section 202(a)(29) of the Advisers Act defines the term “private fund” as “an issuer that would be an investment company, as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a-3), but for section 3(c)(1) or 3(c)(7) of that Act.”

10 Interests in a private fund may be offered pursuant to an exemption from registration under the Securities Act of 1933 (15 U.S.C. 77a) (“Securities Act”). Notwithstanding these exemptions, the persons who market interests in a private fund may be subject to the registration requirements of section 15(a) under the Securities Exchange Act of 1934 (“Exchange Act”) (15 U.S.C. 78o(a)). The Exchange Act generally defines a “broker” as any person engaged in the business of effecting transactions in securities for the account of others. Section 3(a)(4)(A) of the Exchange Act (15 U.S.C. 78c(a)(4)(A)). See also Definition of Terms in and Specific Exemptions for Banks, Savings Associations, and Savings Banks Under Sections 3(a)(4) and 3(a)(5) of the Securities Exchange Act of 1934, Exchange Act Release No. 44291 (May 11, 2001) [66 FR 27759 (May 18, 2001)], at n.124 (“Solicitation is one of the most relevant factors in determining whether a person is effecting transactions.”); Political Contributions by Certain Investment Advisers, Investment Advisers Act Release No. 3043 (July 1, 2010) [75 FR 41018 (July 14, 2010)], n.326 (“Pay to Play Release”)

urities Exchange Act of 1934, Exchange Act Release No. 44291 (May 11, 2001) [66 FR 27759 (May 18, 2001)], at n.124 (“Solicitation is one of the most relevant factors in determining whether a person is effecting transactions.”); Political Contributions by Certain Investment Advisers, Investment Advisers Act Release No. 3043 (July 1, 2010) [75 FR 41018 (July 14, 2010)], n.326 (“Pay to Play Release”).

11 See section 3(c)(1) of the Investment Company Act (providing an exclusion from the definition of “investment company” for any “issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities.”).

12 See supra note 10.

13 See section 3(c)(7) of the Investment Company Act (providing an exclusion from the definition of “investment company” for any “issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities.”). The term “qualified purchaser” is defined in section 2(a)(51) of the Investment Company Act.

Each of these types of private funds advised by an adviser typically qualifies as a single client for purposes of the private adviser exemption. 14 As a result, investment advisers could form up to 14 private funds, regardless of the total number of investors investing in the funds, without the need to register with us. 15 This has permitted the growth of unregistered investment advisers with large amounts of assets under management and significant numbers of investors but without the Commission oversight that registration under the Advisers Act provides. 16 Concern about this lack of Commission oversight led us to adopt a rule in 2004 extending registration to hedge fund advisers, 17 which was vacated by a federal court in 2006

itted the growth of unregistered investment advisers with large amounts of assets under management and significant numbers of investors but without the Commission oversight that registration under the Advisers Act provides. 16 Concern about this lack of Commission oversight led us to adopt a rule in 2004 extending registration to hedge fund advisers, 17 which was vacated by a federal court in 2006. 18 In Title IV of the Dodd-Frank Act (“Title IV”), Congress has now generally extended Advisers Act registration to advisers to hedge funds and many other private funds by eliminating the current private adviser exemption. 19

14 See rule 203(b)(3)-1(a)(2).

15 See Staff Report to the united states securities and exchange Commission, Implications of the Growth of Hedge Funds, at 21 (2003), http://www.sec.gov/news/studies/hedgefunds0903.pdf (discussing section 203(b)(3) of the Advisers Act as in effect before July 21, 2011).

16 See generally id. (noting that the private adviser exemption contributed to growth in the number and size of, and investor participation in, hedge funds).

17 See Registration Under the Advisers Act of Certain Hedge Fund Advisers, Investment Advisers Act Release No. 2333 (Dec. 2, 2004) [69 FR 72054 (Dec. 10, 2004)] (“Hedge Fund Adviser Registration Release”).

18 Goldstein v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir. 2006) (“ Goldstein” ).

19 Section 403 of the Dodd-Frank Act amends existing section 203(b)(3) of the Advisers Act by repealing the current private adviser exemption and inserting the foreign private adviser exemption. See infra Section II.C. Unlike our 2004 rule, which sought to apply only to advisers of “hedge funds,” the Dodd-Frank Act requires that, unless another exemption applies, all advisers previously eligible for the private adviser exemption register with us regardless of the type of private funds or other clients the adviser has

e adviser exemption and inserting the foreign private adviser exemption. See infra Section II.C. Unlike our 2004 rule, which sought to apply only to advisers of “hedge funds,” the Dodd-Frank Act requires that, unless another exemption applies, all advisers previously eligible for the private adviser exemption register with us regardless of the type of private funds or other clients the adviser has.

In addition to removing the broad exemption provided by section 203(b)(3), Congress created three exemptions from registration under the Advisers Act. 20 These new exemptions apply to: (i) Advisers solely to venture capital funds, without regard to the number of such funds advised by the adviser or the size of such funds; 21 (ii) advisers solely to private funds with less than $150 million in assets under management in the United States, without regard to the number or type of private funds advised; 22 and (iii) non-U.S. advisers with less than $25 million in aggregate assets under management from U.S. clients and private fund investors and fewer than 15 such clients and investors. 23

20 Title IV also created exemptions and exclusions in addition to the three discussed at length in this Release. See, e.g., sections 403 and 409 of the Dodd-Frank Act (exempting advisers to licensed small business investment companies from registration under the Advisers Act and excluding family offices from the definition of “investment adviser” under the Advisers Act). We proposed a rule defining “family office” in a prior release ( Family Offices, Investment Advisers Act Release No. 3098 (Oct. 12, 2010) [75 FR 63753 (Oct. 18, 2010)]).

21 See section 407 of the Dodd-Frank Act (exempting advisers solely to “venture capital funds,” as defined by the Commission).

22 See section 408 of the Dodd-Frank Act (directing the Commission to exempt private fund advisers with less than $150 million in aggregate assets under management in the United States)

tment Advisers Act Release No. 3098 (Oct. 12, 2010) [75 FR 63753 (Oct. 18, 2010)]).

21 See section 407 of the Dodd-Frank Act (exempting advisers solely to “venture capital funds,” as defined by the Commission).

22 See section 408 of the Dodd-Frank Act (directing the Commission to exempt private fund advisers with less than $150 million in aggregate assets under management in the United States).

23 See section 402 of the Dodd-Frank Act (defining “foreign private adviser” as “any investment adviser who—(A) Has no place of business in the United States; (B) has, in total, fewer than 15 clients and investors in the United States in private funds advised by the investment adviser; (C) has aggregate assets under management attributable to clients in the United States and investors in the United States in private funds advised by the investment adviser of less than $25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in accordance with the purposes of this title; and (D) neither—(i) Holds itself out generally to the public in the United States as an investment adviser; nor (ii) acts as—(I) an investment adviser to any investment company registered under the Investment Company Act of 1940 [15 U.S.C. 80a]; or a company that has elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940 (15 U.S.C. 80a-53), and has not withdrawn its election.”).

II. Discussion

Today we are proposing three rules that would implement these exemptions. 24 In a separate companion release (the “Implementing Release”), 25 we are proposing rules to implement other amendments made to the Advisers Act by the Dodd-Frank Act, some of which also concern certain advisers that qualify for the exemptions discussed in this Release. 26

24 The Commission provided the public with an opportunity to present its views on various rulemaking and other initiatives that the Dodd-Frank Act required the Commission to undertake

e”), 25 we are proposing rules to implement other amendments made to the Advisers Act by the Dodd-Frank Act, some of which also concern certain advisers that qualify for the exemptions discussed in this Release. 26

24 The Commission provided the public with an opportunity to present its views on various rulemaking and other initiatives that the Dodd-Frank Act required the Commission to undertake. Public views relating to our rulemaking in connection with the exemptions for certain advisers addressed in this Release are available at http://www.sec.gov/comments/df-title-iv/exemptions/exemptions.shtml.

25 Rules Implementing Amendments to the Investment Advisers Act of 1940, Investment Advisers Act Release No. 3110 (Nov. 19, 2010).

26 See infra note 30 and accompanying and following text.

New section 203(l) of the Advisers Act provides that an investment adviser that solely advises venture capital funds is exempt from registration under the Advisers Act and directs the Commission to define “venture capital fund” within one year of enactment. 27 We are proposing new rule 203(l)-1 to provide such a definition, which we discuss below in Section II.A of this Release.

27 See supra note 21.

New section 203(m) of the Advisers Act directs the Commission to provide 28 We are proposing such an exemption in a new rule 203(m)-1, which we discuss below in Section II.B of this Release. Proposed rule 203(m)-1 includes provisions for determining the amount of an adviser's private fund assets for purposes of the exemption and when those assets are deemed managed in the United States.

28 See supra note 22.

urposes of the exemption and when those assets are deemed managed in the United States.

28 See supra note 22.

The new exemptions under sections 203(l) and 203(m) provide that the Commission shall require advisers relying on them to provide the Commission with reports and keep records as the Commission determines necessary or appropriate in the public interest or for the protection of investors. 29 These new exemptions do not limit our statutory authority to examine the books and records of advisers relying upon these exemptions. 30 For purposes of this Release we will refer to these advisers as “exempt reporting advisers.” In the Implementing Release, we are proposing reporting requirements for exempt reporting advisers. 31

29 See supra notes 21 and 22.

30 Under section 204(a) of the Advisers Act, the Commission has the authority to require an investment adviser to maintain records and provide reports, as well as the authority to examine such adviser's records, unless the adviser is “specifically exempted” from the requirement to register pursuant to section 203(b) of the Advisers Act. Investment advisers that are exempt from registration in reliance on section 203(l) or 203(m) of the Advisers Act are not “specifically exempted” from the requirement to register pursuant to section 203(b), and thus the Commission has authority under section 204(a) of the Advisers Act to require those advisers to maintain records and provide reports and has authority to examine such advisers' records.

31 See Implementing Release, supra note 25, at section II.B.

The third exemption, set forth in amended section 203(b)(3) of the Advisers Act, provides an exemption from registration for certain foreign private advisers

ion has authority under section 204(a) of the Advisers Act to require those advisers to maintain records and provide reports and has authority to examine such advisers' records.

31 See Implementing Release, supra note 25, at section II.B.

The third exemption, set forth in amended section 203(b)(3) of the Advisers Act, provides an exemption from registration for certain foreign private advisers. New section 202(a)(30) of the Advisers Act defines “foreign private adviser” as an investment adviser that has no place of business in the United States, has fewer than 15 clients in the United States and investors in the United States in private funds advised by the adviser, 32 and less than $25 million in aggregate assets under management from such clients and investors. 33 As discussed in Section II.C of this Release, in order to clarify the application of this new exemption, we are proposing a new rule 202(a)(30)-1, which would define a number of terms included in the statutory definition of foreign private adviser. 34

32 Subparagraph (B) of section 202(a)(30) refers to number of “clients and investors in the United States in private funds,” while subparagraph (C) refers to the assets of “clients in the United States and investors in the United States in private funds” (emphasis added). We interpret these provisions consistently so that only clients in the United States and investors in the United States should be included for purposes of determining eligibility for the exemption under subparagraph (B).

33 The exemption is not available to an adviser that “acts as (I) an investment adviser to any investment company registered under the [Investment Company Act]; or (II) a company that has elected to be a business development company pursuant to section 54 of [that Act] and has not withdrawn its election.” Section 202(a)(30)(D)(ii). We interpret subparagraph (II) to prevent an adviser that advises a business development company from relying on the exemption

s (I) an investment adviser to any investment company registered under the [Investment Company Act]; or (II) a company that has elected to be a business development company pursuant to section 54 of [that Act] and has not withdrawn its election.” Section 202(a)(30)(D)(ii). We interpret subparagraph (II) to prevent an adviser that advises a business development company from relying on the exemption.

34 Proposed rule 202(a)(30)-1 would define the following terms: (i) “client;” (ii) “investor;” (iii) “in the United States;” (iv) “place of business;” and (v) “assets under management.” See discussion infra in section II.C of this Release. We are proposing rule 202(a)(30)-1 pursuant to section 211(a) of the Advisers Act, which Congress amended to explicitly provide us with the authority to define technical, trade, and other terms used in the Advisers Act. See section 406 of the Dodd-Frank Act.

These exemptions are not mandatory. Thus, an adviser that qualifies for any of the exemptions could choose to register (or remain registered) with the Commission, subject to section 203A of the Advisers Act, which generally prohibits from registering with the Commission most advisers that do not have at least $100 million in assets under management. 35 An adviser choosing to avail itself of the exemptions under sections 203(l), 203(m) or 203(b)(3), however, may be subject to registration by one or more state securities authorities. 36

35 Section 203A(a)(1) of the Advisers Act generally prohibits an investment adviser regulated by the state in which it maintains its principal office and place of business from registering with the Commission unless it has at least $25 million of assets under management, and preempts certain state laws regulating advisers that are registered with the Commission

e capital fund consistently with what we believe Congress understood venture capital funds to be, and in light of other provisions of the federal securities laws that seek to achieve similar objectives. 38

37 See proposed rule 203(l)-1.

38 See infra notes 94, 123, 125 (discussing the history of and regulatory framework applicable to business development companies under federal securities laws).

We understand that Congress sought to distinguish advisers to “venture capital funds” from the larger category of advisers to “private equity funds” for which Congress considered, but ultimately did not provide, an exemption. 39 As a general matter, venture capital funds are long-term investors in early-stage or small companies that are privately held, as distinguished from other types of private equity funds, which may invest in businesses at various stages of development including mature, publicly held companies. 40 Testimony received by Congress characterized venture capital funds as typically contributing substantial capital to early-stage companies 41 and generally not 42 and thus not contributing to systemic risk, a factor that appears significant to Congress' determination to exempt these advisers. 43 In drafting the proposed rule, we have sought to incorporate this Congressional understanding of the nature of investments of a venture capital fund, and these principles guided our consideration of the proposed venture capital fund definition.

39 While the Senate voted to exempt private equity fund advisers in addition to venture capital fund advisers, the final Dodd-Frank Act only exempts venture capital fund advisers. Compare Restoring American Financial Stability Act of 2010, S. 3217, 111th Cong. § 408 (2010) (as passed by the Senate) with Dodd-Frank Wall Street Reform and Consumer Protection Act of 2009, H.R. 4173, 111th Cong. (2009) (as passed by the House) (“H.R. 4173”) and Dodd-Frank Act

isers in addition to venture capital fund advisers, the final Dodd-Frank Act only exempts venture capital fund advisers. Compare Restoring American Financial Stability Act of 2010, S. 3217, 111th Cong. § 408 (2010) (as passed by the Senate) with Dodd-Frank Wall Street Reform and Consumer Protection Act of 2009, H.R. 4173, 111th Cong. (2009) (as passed by the House) (“H.R. 4173”) and Dodd-Frank Act.

40 See Testimony of Trevor Loy, Flywheel Ventures, before the Senate Banking Subcommittee on Securities, Insurance and Investment Hearing, July 15, 2009 (“Loy Testimony”), at 3; Testimony of James Chanos, Chairman, Coalition of Private Investment Companies, July 15, 2009, at 4 (“Chanos Testimony”) (“Private investment companies play significant, diverse roles in the financial markets and in the economy as a whole. For example, venture capital funds are an important source of funding for start-up companies or turnaround ventures. Other private equity funds provide growth capital to established small-sized companies, while still others pursue `buyout' strategies by investing in underperforming companies and providing them with capital and/or expertise to improve results.”); Testimony of Mark Tresnowksi, General Counsel, Madison Dearborn Partners, LLC, on behalf of the Private Equity Council, before the Senate Banking Subcommittee on Securities, Insurance and Investment, July 15, 2009, at 2 (“Tresnowski Testimony”) (stating that private equity firms invest in broad categories of companies, including “struggling and underperforming businesses” and ” promising or strong companies”). See also Preqin, Private Equity and Alternative Asset Glossary, http://www.preqin.com/itemGlossary.aspx?pnl=UtoZ (defining venture capital as “a type of private equity investment that provides capital to new or growing businesses. Venture funds invest in start-up firms and small businesses with perceived, long-term growth potential.”)

erperforming businesses” and ” promising or strong companies”). See also Preqin, Private Equity and Alternative Asset Glossary, http://www.preqin.com/itemGlossary.aspx?pnl=UtoZ (defining venture capital as “a type of private equity investment that provides capital to new or growing businesses. Venture funds invest in start-up firms and small businesses with perceived, long-term growth potential.”).

41 Loy Testimony, supra note 40, at 3; Testimony of Terry McGuire, General Partner, Polaris Venture Partners, and Chairman, National Venture Capital See also National Venture Capital Association Yearbook 2010, at 7-8 (noting that venture capital is a “long-term investment” and the “payoff [to the venture capital firm] comes after the company is acquired or goes public”) (“NVCA Yearbook 2010”); Private Equity Growth Capital Council, Private Equity: Frequently Asked Questions, http://www.privateequitycouncil.org/just-the-facts/private-equity-frequently-asked-questions/ (noting that venture capital funds focus on “start-up and young companies with little or no track record,” whereas buyout and growth funds focus on more mature businesses).

42 Loy Testimony, supra note 40, at 3. See also McGuire Testimony, supra note 41, at 3-4 (“most limited partnership agreements [of venture capital funds] * * * prohibit [the venture capital fund] from any type of long term borrowing. * * * Leverage is not part of the equation because start-ups do not typically have the ability to sustain debt interest payments and often do not have collateral that lenders desire. In fact most of our companies are not profitable and require our equity to fund their losses through their initial growth period.”).

ten do not have collateral that lenders desire. In fact most of our companies are not profitable and require our equity to fund their losses through their initial growth period.”).

43 See S. Rep. No. 111-176, supra note 7, at 74-5 (noting that venture capital funds “do not present the same risks as the large private funds whose advisers are required to register with the SEC under this title [IV]. Their activities are not interconnected with the global financial system, and they generally rely on equity funding, so that losses that may occur do not ripple throughout world markets but are borne by fund investors alone. Terry McGuire, Chairman of the National Venture Capital Association, wrote in congressional testimony that `venture capital did not contribute to the implosion that occurred in the financial system in the last year, nor does it pose a future systemic risk to our world financial markets or retail investors.'”). See also Loy Testimony, supra note 40, at 7 (noting the factors by which the venture capital industry is exposed to “entrepreneurial and technological risk not systemic financial risk”).

This is not the first time that Congress has included special provisions to the federal securities laws for these types of private funds and the advisers that advise them. In 1980, in an effort to promote capital raising by small businesses, 44 Congress provided exemptions from various requirements in the Investment Company Act and Advisers Act for “business development companies” (or “BDCs”). 45 Congress adopted the term BDC to avoid “semantical disagreements” over what constituted a venture capital or small business company, 46 but acknowledged that the purpose of the BDC provisions was to support “venture capital” activity in capital formation for small businesses

rom various requirements in the Investment Company Act and Advisers Act for “business development companies” (or “BDCs”). 45 Congress adopted the term BDC to avoid “semantical disagreements” over what constituted a venture capital or small business company, 46 but acknowledged that the purpose of the BDC provisions was to support “venture capital” activity in capital formation for small businesses. 47 The BDC provisions and venture capital exemption reflect many similar policy considerations, and thus in drafting the definition of “venture capital fund,” we have looked, in part, to language Congress previously used to describe these types of funds.

44 See H. Rep. No. 96-1341, at 21-22 (1980) (“1980 House Report”).

45 See infra note 123 for a discussion of these definitions.

46 See 1980 House Report, supra note 44, at 22.

47 See id., at 21.

As described in more detail below, we propose to define a venture capital fund as a private fund that: (i) Invests in equity securities of private companies in order to provide operating and business expansion capital ( i.e., “qualifying portfolio companies,” which are discussed below) and at least 80 percent of each company's securities owned by the fund were acquired directly from the qualifying portfolio company; (ii) directly, or through its investment advisers, offers or provides significant managerial assistance to, or controls, the qualifying portfolio company; (iii) does not borrow or otherwise incur leverage (other than limited short-term borrowing); (iv) does not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances; (v) represents itself as a venture capital fund to investors; and (vi) is not registered under the Investment Company Act and has not elected to be treated as a BDC. 48 We also propose to grandfather an existing fund as a venture capital fund if it satisfies certain criteria under the grandfathering provision

stors redemption or other similar liquidity rights except in extraordinary circumstances; (v) represents itself as a venture capital fund to investors; and (vi) is not registered under the Investment Company Act and has not elected to be treated as a BDC. 48 We also propose to grandfather an existing fund as a venture capital fund if it satisfies certain criteria under the grandfathering provision. 49 An adviser would be eligible to rely on the exemption under section 203(l) of the Advisers Act (the “venture capital exemption”) only if it solely advised venture capital funds that met all of the elements of the proposed definition or if it were grandfathered.

48 Proposed rule 203(l)-1(a).

49 Proposed rule 203(l)-1(b).

1. Qualifying Portfolio Companies

We propose to define a venture capital fund for the purposes of the exemption as a fund that invests in equity securities issued by “qualifying portfolio companies,” which we define generally as any company that: (i) Is not publicly traded; (ii) does not incur leverage in connection with the investment by the private fund; (iii) uses the capital provided by the fund for operating or business expansion purposes rather than to buy out other investors; and (iv) is not itself a fund ( i.e., is an operating company). 50 In addition to equity securities, the venture capital fund may also hold cash (and cash equivalents) and U.S. Treasuries with a remaining maturity of 60 days or less. 51 We understand each of the criteria to be characteristic of issuers of portfolio securities held by venture capital funds. 52 Moreover, collectively, these criteria would operate to exclude most other private equity funds and hedge funds from the definition. We describe each element of a qualifying portfolio company below.

50 Proposed rule 203(l)-1(c)(4).

51 Proposed rule 203(l)-1(a)(2).

52 See infra sections II.A.1.a-II.A.1.e of this Release.

of issuers of portfolio securities held by venture capital funds. 52 Moreover, collectively, these criteria would operate to exclude most other private equity funds and hedge funds from the definition. We describe each element of a qualifying portfolio company below.

50 Proposed rule 203(l)-1(c)(4).

51 Proposed rule 203(l)-1(a)(2).

52 See infra sections II.A.1.a-II.A.1.e of this Release.

a. Private Companies

We propose to define a venture capital fund as a fund that invests in equity securities of qualifying portfolio companies and cash and cash equivalents and U.S. Treasuries with a remaining maturity of 60 days or less. 53 At the time of each investment by the venture capital fund, the portfolio company could not be publicly traded nor could it control, be controlled by, or be under common control with, a publicly traded company. 54 Under the proposed definition, a venture capital fund could continue to hold securities of a portfolio company that subsequently becomes public.

53 Proposed rule 203(l)-1(a)(2).

54 Proposed rule 203(l)-1(c)(4)(i); proposed rule 203(l)-1(c)(3) (defining a “publicly traded” company as one that is subject to the reporting requirements under section 13 or 15(d) of the Exchange Act, or has a security listed or traded on any exchange or organized market operating in a foreign jurisdiction). This definition is similar to rule 2a51-1 under the Investment Company Act (defining “public company,” for purposes of the qualified purchaser standard, as “a company that files reports pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934”) and rule 12g3-2 under the Exchange Act (conditioning a foreign private issuer's exemption from registering securities under section 12(g) of the Exchange Act if, among other conditions, the “issuer is not required to file or furnish reports” pursuant to section 13(a) or section 15(d) of the Exchange Act). Under the proposed rule, securities of a publicly traded company, as defined, would include securities of non-U.S

r the Exchange Act (conditioning a foreign private issuer's exemption from registering securities under section 12(g) of the Exchange Act if, among other conditions, the “issuer is not required to file or furnish reports” pursuant to section 13(a) or section 15(d) of the Exchange Act). Under the proposed rule, securities of a publicly traded company, as defined, would include securities of non-U.S. companies that are listed on a non-U.S. market or non-U.S. exchange. Some securities that are “pink sheets” ( i.e., generally over-the-counter securities that are quoted on an electronic quotation system operated by Pink OTC Markets) are not subject to the reporting requirements under sections 13 and 15(d) of the Exchange Act and would not be publicly traded for purposes of the proposed rule.

Venture capital funds provide operating capital to companies in the early stages of their development with the goal of eventually either selling the company or taking it public. 55 Unlike 56 As of year-end 2009, U.S. venture capital funds managed approximately $179.4 billion in assets. 57 In comparison, as of year-end 2009, the U.S. publicly traded equity market had a market value of approximately $13.7 trillion, 58 whereas global hedge funds had approximately $1.4 trillion in assets under management. 59 As a consequence, the aggregate amount invested in venture capital funds is considerably smaller, and Congressional testimony asserted that these funds may be less connected with the public markets and may involve less potential for systemic risk. 60 This appears to be a key consideration by Congress that led to the enactment of the venture capital exemption. 61

ess that led to the enactment of the venture capital exemption. 61

55 See Chanos Testimony, supra note 40, at 4 (“[V]enture capital funds are an important source of funding for start-up companies or turnaround supra note 41, at 7-8 (noting that venture capital is a “long-term investment” and the “payoff [to the venture capital firm] comes after the company is acquired or goes public.”); George W. Fenn, Nellie Liang and Stephen Prowse, The Economics of the Private Equity Market, December 1995, 22, n.61 and accompanying text (“Fenn et al. ”) (“Private sales” are not normally the most important type of exit strategy as compared to IPOs, yet of the 635 successful portfolio company exits by venture capitalists between 1991-1993 “merger and acquisition transactions accounted for 191 deals and IPOs for 444 deals.” Furthermore, between 1983 and 1994, of the 2,200 venture capital fund exits, 1,104 (approximately 50%) were attributed to mergers and acquisitions of venture-backed firms.). See also Jack S. Levin, Structuring Venture Capital, Private Equity and Entrepreneurial Transactions, 2000 (“Levin”) at 1-2 to 1-7 (describing the various types of venture capital and private equity investment business but stating that “the phrase `venture capital' is sometimes used narrowly to refer only to financing the start-up of a new business”); Anna T. Pinedo & James R. Tanenbaum, Exempt and Hybrid Securities Offerings (2009), Vol. 1 at 12-2 (“Pinedo”) (discussing the role initial public offerings play in providing venture capital investors with liquidity).

56 See Loy Testimony, supra note 40, at 5 (“We do not trade in the public markets.”)

capital' is sometimes used narrowly to refer only to financing the start-up of a new business”); Anna T. Pinedo & James R. Tanenbaum, Exempt and Hybrid Securities Offerings (2009), Vol. 1 at 12-2 (“Pinedo”) (discussing the role initial public offerings play in providing venture capital investors with liquidity).

56 See Loy Testimony, supra note 40, at 5 (“We do not trade in the public markets.”). See also McGuire Testimony, supra note 41, at 11 (“[V]enture capital funds do not typically trade in the public markets and generally limit advisory activities to the purchase and sale of securities of private operating companies in private transactions”); Levin, supra note 55, at 1-4 (“A third distinguishing feature of venture capital/private equity investing is that the securities purchased are generally privately held as opposed to publicly traded * * * a venture capital/private equity investment is normally made in a privately-held company, and in the relatively infrequent cases where the investment is into a publicly-held company, the [venture capital fund] generally holds non-public securities.”) (emphasis in original).

57 NVCA Yearbook 2010, supra note 41, at 9.

58 Bloomberg Terminal Database, WCAUUS (Bloomberg United States Exchange Market Capitalization).

59 See Saijel Kishan, Hedge Funds Hold Investors “Hostage” After Decade's Best Year, Bloomberg Businessweek, Jan. 20, 2010, available at http://www.businessweek.com/news/2010-01-20/hedge-funds-hold-investors-hostage-after-decade-s-best-year.html.

60 See supra note 43; McGuire Testimony, supra note 41, at 6 (noting that the “venture capital industry's activities are not interwoven with U.S. financial markets.”). See also Group of Thirty, Financial Reform: A Framework for Financial Stability, January 15, 2009, at 9 (discussing the need for registration of managers of “private pools of capital that employ substantial borrowed funds” yet recognizing the need to exempt venture capital from registration).

61 See supra note 43

re capital industry's activities are not interwoven with U.S. financial markets.”). See also Group of Thirty, Financial Reform: A Framework for Financial Stability, January 15, 2009, at 9 (discussing the need for registration of managers of “private pools of capital that employ substantial borrowed funds” yet recognizing the need to exempt venture capital from registration).

61 See supra note 43.

We request comment on our proposed approach. We considered more narrow definitions, such as defining a qualifying portfolio company as a “start-up company” or “small company.” 62 There appears to be little consensus, however, as to what a start-up company is. A company may be considered a “start-up” business depending on when it was formed as a legal entity, 63 whether it employs workers or paid employment taxes, 64 or whether it has generated revenues. 65 Defining a portfolio company based on any one of these factors may inadvertently exclude too many start-up portfolio companies. For example, solely relying on the age of the company ( e.g., first year since incorporation) fails to recognize that many companies may be incorporated for some period of time prior to initiating business operations or remain unincorporated for significant periods of time. 66 Likewise, payment of employment taxes assumes the hiring of employees, despite the fact that many new business ventures are sole proprietorships without employees. 67 Such a test could also have the unintended effect of discouraging hiring. Similarly, a bright-line revenue test set too low could exclude young or new businesses that generate significant revenues more quickly than other companies. 68 This could have the unintended consequence of venture capital funds that seek to fall within the definition investing in less promising, non-revenue generating, young companies.

62 See S. Rep. No

unintended effect of discouraging hiring. Similarly, a bright-line revenue test set too low could exclude young or new businesses that generate significant revenues more quickly than other companies. 68 This could have the unintended consequence of venture capital funds that seek to fall within the definition investing in less promising, non-revenue generating, young companies.

62 See S. Rep. No. 111-176, supra note 7, at 74 (describing venture capital funds as a subset of private investment companies, specializing in long-term equity investments in “small or start-up businesses”).

63 There is no generally accepted definition of a “start-up” entity although it is generally used to refer to new business ventures. See, e.g., U.S. Census Bureau, Business Dynamics Statistics, available at http://www.ces.census.gov/index.php/bds/bds_overview (which tracks information on businesses, based on the size and age of the business, and assigns a “birth” year to a business beginning in the year in which it reports positive employment of workers on the payroll); The Kauffman Foundation, Where Will the Jobs Come From?, November 2009, at 5 (identifying “start-ups” as those firms younger than one year); Anastasia Di Carlo & Roger Kelly, Private Equity Market Outlook 27 (European Investment Fund, Working Paper 2010/005) (defining start-ups as companies that are “in the process of being set up or may have been in business for a short time, but have not sold their product commercially”)

here Will the Jobs Come From?, November 2009, at 5 (identifying “start-ups” as those firms younger than one year); Anastasia Di Carlo & Roger Kelly, Private Equity Market Outlook 27 (European Investment Fund, Working Paper 2010/005) (defining start-ups as companies that are “in the process of being set up or may have been in business for a short time, but have not sold their product commercially”).

64 See, e.g., The Kauffman Foundation, An Overview of the Kauffman Firm Survey, Results from the 2004-2008 Data, May 2010, at 26 (“ Overview of the Kauffman Firm Survey” ) (discussing the difficulties of compiling data on new businesses; start-up businesses were generally identified based on several factors: the payment of state unemployment taxes, the payment of Federal Insurance Contributions Act taxes, the existence of a legal entity, use of an employer identification number, and use of a schedule C to report business income on a personal tax return).

65 See, e.g., NVCA Yearbook 2010, supra note 41, at 61, 69, 111 (not defining “start-up” but classifying investments in “start-up/seed” companies and defining the “seed stage” of a company as “the state of a company when it has just been incorporated and its founders are developing their product or service,” whereas an “early stage” company is one that is beyond the “seed stage” but has not yet generated revenues). Cf. PricewaterhouseCoopers MoneyTree Report Definitions, https://www.pwcmoneytree.com/MTPublic/ns/nav.jsp?page=definitions (last visited Sept. 23, 2010) (defining a “seed/start-up” company as one that has a concept or product in development but not yet operational and usually has been in existence for less than 18 months).

66 According to the Kauffman Survey, in 2004, 36.0% of all start-up companies were sole proprietorships; by 2008, 34.4% of all surviving companies were sole proprietorships. Overview of the Kauffman Firm Survey, supra note 64, at 8

ning a “seed/start-up” company as one that has a concept or product in development but not yet operational and usually has been in existence for less than 18 months).

67 See, e.g., Ying Lowrey, Startup Business Characteristics and Dynamics: A Data Analysis of the Kauffman Firm Survey, Aug. 2009, at 6 (Working Paper) (based on a survey sample of businesses started in 2004, reporting that 59% of all start-up companies in 2004 had zero employees; a “start-up” business was any business that met any one of the five following criteria for being a start-up: the payment of state unemployment taxes, the payment of Federal Insurance Contributions Act taxes, the existence of a legal entity, use of an employer identification number, and use of a schedule C to report business income on a personal tax return).

68 According to the Kauffman Survey, which conducted a longitudinal study of “start-up” businesses that began in 2004, 46.5% of all such “start-up” companies in 2004 had zero revenues; by 2008, 30.2% of the surviving companies in the sample reported zero revenues. In comparison, in 2004, 15.3% of start-up companies reported revenues of more than $100,000 and in 2008, 36.1% of the surviving companies in the survey reported revenues of more than $100,000. Overview of the Kauffman Firm Survey, supra note 64, at 9.

We also considered defining a qualifying portfolio company as a small company. As in the case of defining “start-up,” there is no single definition for what constitutes a “small company.” 69 We are concerned that

As in the case of defining “start-up,” there is no single definition for what constitutes a “small company.” 69 We are concerned that

69 Among countries that are members of the Organisation for Economic Co-operation and Development, “small and medium-sized enterprises” (“SMEs”) are defined as non-subsidiary, independent firms employing fewer than the number of employees as is set by each country. The definition of SME may be used to determine funding or other programs sponsored by member countries. Although the European Union generally defines SMEs as businesses with fewer than 250 employees, the United States sets the threshold at fewer than 500 employees. Moreover, “small” firms are generally defined as those with fewer than 50 employees, while micro-enterprises have at most 10, or in some cases five, workers. In 2005, the i.e., 10-49 employees) as those with no more than €10 million in annual revenue and no more than €10 million in assets as evidenced on their annual balance sheet. See, e.g., Organisation for Economic Co-operation and Development, Glossary of Statistical Terms, http://stats.oecd.org/glossary/detail.asp?ID=3123.

Under one regulatory framework in the United States, a business may be considered “small” depending on the specified number of employees or the net worth or net income of such business. Separate tests are specified for a business based on various factors, such as the size of the industry, its geographical concentration, and the number of market participants. See, e.g., Small Business Administration, SBA Size Standards Methodology (Apr. 2009) at 8, http://www.sba.gov/idc/groups/public/documents/sba_homepage/size_standards_methodology.pdf (noting that the Small Business Administration (“SBA”) decided to apply the net worth and net income measures to its Small Business Investment Company (“SBIC”) financing program because investment companies typically evaluate businesses using these measures when determining whether or not to invest)

9) at 8, http://www.sba.gov/idc/groups/public/documents/sba_homepage/size_standards_methodology.pdf (noting that the Small Business Administration (“SBA”) decided to apply the net worth and net income measures to its Small Business Investment Company (“SBIC”) financing program because investment companies typically evaluate businesses using these measures when determining whether or not to invest). For example, under the SBIC program administered by the SBA, SBA loans may be made to SBICs that invest in companies that are “small” (usually defined as having a net worth of $18 million or less and an average after-tax net income for the prior two years of no more than $6 million, although there are specific tests depending on the industry of the company that may be based on net income, net worth or number of employees). The size requirement is codified at 13 CFR 121.301(c)(2). See SBA, Investment Program Summary, http://www.sba.gov/financialassistance/borrowers/vc/sbainvp/index.html.

Other tests also present concerns. A test adopted by the California Corporations Commission and the U.S. Department of Labor requires that a venture capital company hold at least 50 percent of its assets in “operating companies,” which are defined as companies primarily engaged in the production or sale of a product or services other than the investment of capital. 70 Under the California exemption, a venture capital fund could invest in older and more mature companies that qualify as “operating companies” as well as in securities issued by publicly traded companies provided that the venture capital fund obtained management rights in such publicly traded companies. 71 Hence, although the California venture capital exemption is for advisers to so-called “venture capital companies,” the rule provides a much broader exemption that would include many types of private equity and other types of private funds and thus does not appear consistent with our understanding of the intended scope of section 203(l)

tained management rights in such publicly traded companies. 71 Hence, although the California venture capital exemption is for advisers to so-called “venture capital companies,” the rule provides a much broader exemption that would include many types of private equity and other types of private funds and thus does not appear consistent with our understanding of the intended scope of section 203(l). 72 We request comment on any of these approaches or alternative ones that we have not discussed. 73

70 Under section 260.204.9 of the California Code of Regulations (the “California VC exemption”), an adviser is exempt from the requirement to register if it provides investment advice only to “venture capital companies,” which are generally defined as entities that, on at least one annual occasion (commencing with the first annual period following the initial capitalization), have at least 50% of their assets (other than short-term investments pending long-term commitment or distribution to investors), valued at cost, in “venture capital investments.” A venture capital investment is defined as an acquisition of securities in an operating company as to which the adviser has or obtains management rights. See Cal. Code Regs. tit. 10, § 260.204.9(a), (b)(3), (b)(4) (2010). An “operating company” is defined to mean any entity “primarily engaged, directly or through a majority owned subsidiary or subsidiaries, in the production or sale (including any research or development) of a product or service other than the management or investment of capital but shall not include an individual or sole proprietorship.” Id. tit. 10, § 260.204.9(b)(7). “Management rights” is defined as the “right, obtained contractually or through ownership of securities . .

y or through a majority owned subsidiary or subsidiaries, in the production or sale (including any research or development) of a product or service other than the management or investment of capital but shall not include an individual or sole proprietorship.” Id. tit. 10, § 260.204.9(b)(7). “Management rights” is defined as the “right, obtained contractually or through ownership of securities . . . to substantially participate in, to substantially influence the conduct of, or to provide (or offer to provide) significant guidance and counsel concerning, the management, operations or business objectives of the operating company in which the venture capital investment is made.” Id. tit. 10, § 260.204.9(b)(6). Management rights may be held by the adviser, the fund or an affiliated person of the adviser, and may be obtained either through one person or through two or more persons acting together. Id.

The U.S. Department of Labor regulations (“VCOC exemption”) are similar to the California VC exemption. The regulations define “operating company” to mean an entity that is “primarily engaged, directly or through a majority owned subsidiary or subsidiaries, in the production or sale of a product or service other than the investment of capital. The term `operating company' includes an entity that is not described in the preceding sentence, but that is a `venture capital operating company' described in paragraph (d) or a `real estate operating company' described in paragraph (e).” 29 CFR 2510.3-101(c)(1). The regulations define a venture capital operating company (“VCOC”) as any entity that, as of the date of the first investment (or other relevant time), has at least 50% of its assets (other than short-term investments pending long-term commitment or distribution to investors), valued at cost, invested in venture capital investments. 29 CFR 2510.3-101(d)

in paragraph (e).” 29 CFR 2510.3-101(c)(1). The regulations define a venture capital operating company (“VCOC”) as any entity that, as of the date of the first investment (or other relevant time), has at least 50% of its assets (other than short-term investments pending long-term commitment or distribution to investors), valued at cost, invested in venture capital investments. 29 CFR 2510.3-101(d). A venture capital investment is defined as “an investment in an operating company (other than a venture capital operating company) as to which the investor has or obtains management rights” that are “contractual rights * * * to substantially participate in, or substantially influence the conduct of, the management of the operating company.” 29 CFR 2510.3-101(d)(3).

71 See Cal. Code Reg. tit. 10, § 260.204.9 .

72 The California VC exemption does not limit permitted investments to companies that are start-up or privately held companies, which were cited as characteristic of venture capital investing in testimony to Congress. See McGuire Testimony, supra note 41; Loy Testimony, supra note 40.

73 See Letter of Keith P. Bishop (July 28, 2009) (recommending elements of the California VC exemption). Cf. Letter of P. James (August 21, 2010) (expressing the view that the provision of management services does not distinguish venture capital from private equity). We received these letters in response to our request for public views on rulemaking and other initiatives under the Dodd-Frank Act . See generally supra note 24.

We also request comment on our approach to “follow-on” investments. 74 Under our proposed rule, a qualifying portfolio company is defined to include a company that is not publicly traded (or controlled by a publicly traded company) at the time of each fund investment, 75 but would not exclude a portfolio company that ultimately becomes a successful venture capital investment (typically when the company is taken “public”)

on our approach to “follow-on” investments. 74 Under our proposed rule, a qualifying portfolio company is defined to include a company that is not publicly traded (or controlled by a publicly traded company) at the time of each fund investment, 75 but would not exclude a portfolio company that ultimately becomes a successful venture capital investment (typically when the company is taken “public”). Under this approach, an adviser could continue to rely on the exemption even if the venture capital fund's portfolio ultimately consisted entirely of publicly traded securities, a result that could be viewed as inconsistent with section 203(l) of the Advisers Act. We believe that our proposed approach would give advisers to venture capital funds sufficient flexibility to exercise their business judgment on the appropriate time to dispose of portfolio company investments—which may occur at a time when the company is privately held or publicly held. 76 Moreover, under the federal securities laws, a person that is deemed to be an affiliate of a publicly traded company may be limited in its ability to dispose of publicly traded securities. 77 Would our proposed approach to follow-on investments accommodate the way venture capital funds typically invest? Are there circumstances in which a venture capital fund would provide follow-on investments in a company that has become public? Should the rule specifically provide that a venture capital fund includes a fund that invests a limited percentage of its capital in publicly traded securities under certain circumstances ( e.g., a follow-on investment in a company in which the fund's previous investments were made when the company was private)? If so, what is the appropriate percentage threshold ( e.g., 5, 10 or 20 percent)?

74 See, e.g., Loy Testimony, supra note 40, at 3 (discussing the role of follow-on investments); NVCA Yearbook 2010, supra note 41, at 34 (statistics comparing initial investments versus follow-on investments made by venture capital funds at Figure 3.15)

previous investments were made when the company was private)? If so, what is the appropriate percentage threshold ( e.g., 5, 10 or 20 percent)?

75 See proposed rule 203(l)-1(c)(4)(i).

76 See supra note 55.

77 See, e.g., rule 144 under the Securities Act (17 CFR 230.144) (prohibiting the resale of certain restricted and control securities by “affiliates” unless certain conditions are met).

We request comment on whether our definition should exclude any venture capital fund that holds any publicly traded securities or a specified percentage of publicly traded portfolio 78 Should the rule specify that publicly traded securities may only be held for a limited period of time, such as one-year, or that a venture capital fund's entire portfolio may not consist only of publicly traded securities except for a limited period of time, such as one-year or other period?

78 Cf. note 94 (discussing limits applicable to BDCs).

b. Equity Securities, Cash and Cash Equivalents and Short-Term U.S. Treasuries.

We propose to define venture capital fund for purposes of the exemption as a fund that invests in equity securities of qualifying portfolio companies, cash and cash equivalents and U.S. Treasuries with a remaining maturity of 60 days or less. 79 Under our proposed definition, a fund would not qualify as a venture capital fund for purposes of the exemption if it invested in debt instruments (unless they met the definition of “equity security”) of a portfolio company or otherwise lent money to a portfolio company, strategies that are not the typical form of venture capital investing

reasuries with a remaining maturity of 60 days or less. 79 Under our proposed definition, a fund would not qualify as a venture capital fund for purposes of the exemption if it invested in debt instruments (unless they met the definition of “equity security”) of a portfolio company or otherwise lent money to a portfolio company, strategies that are not the typical form of venture capital investing. 80 Congress received testimony that, unlike other types of private funds, venture capital funds “invest cash in return for an equity share of the company's stock.” 81 As a consequence, venture capital funds avoid using financial leverage, and leverage appears to have raised systemic risk concerns for Congress. 82 Should our definition of venture capital fund include funds that invest in debt, or certain types of debt, issued by qualifying portfolio companies, or make certain types of loans to qualifying portfolio companies? We understand that some venture capital funds may extend “bridge” financing to portfolio companies in anticipation of a future round of venture capital investment. 83 Such financings may take the form of investment in instruments that are ultimately convertible into a portfolio company's common or preferred stock at a subsequent investment stage and thus would meet the definition of “equity security.” 84 Should our definition include any fund that extends bridge financing that does not meet the definition of “equity security” on a short-term limited basis to a qualifying portfolio company? Should our definition be limited to those funds that make bridge loans to a portfolio company that are convertible into equity funding only in the next round of venture capital investing? Under our proposed definition, debt investments or loans with respect to qualifying portfolio companies that did not meet the definition of “equity security” could not be made by a fund seeking to qualify as a venture capital fund

ion be limited to those funds that make bridge loans to a portfolio company that are convertible into equity funding only in the next round of venture capital investing? Under our proposed definition, debt investments or loans with respect to qualifying portfolio companies that did not meet the definition of “equity security” could not be made by a fund seeking to qualify as a venture capital fund. Should we modify the proposed rule so that such investments and loans could be made subject to a limit? If so, what would be an appropriate limit ( e.g., 5 or 10 percent) and how should the limit be determined ( e.g., as a percentage of the fund's capital commitments)?

79 Proposed rule 203(l)-1(a)(2).

80 See Loy Testimony, supra note 40, at 2, 4; Pinedo, supra note 55, Vol. 1 at 12-2; Levin, supra note 55, at 1-5 (noting that venture capital funds focus on “common stock or common equivalent securities, with any purchase of subordinated debentures and/or preferred stock generally designed merely to fill a hole in the financing or to provide [the venture capitalist] with some priority over management in liquidation or return of capital”). See also Jesse M. Fried and Mira Ganor, Agency Costs of Venture Capitalist Control in Startups, 81 N.Y.U. Law Journal 967, 970 (2006) (venture capital funds investing in U.S. start-ups “almost always receive convertible preferred stock”); Fenn et al. , supra note 55, at 32.

81 McGuire Testimony, supra note 41, at 4; Loy Testimony, supra note 40, at 2.

82 See infra section II.A.3 of this Release.

83 See, e.g., Darian M. Ibrahim, Debt as Venture Capital, 4 U. Ill. L. Rev

rol in Startups, 81 N.Y.U. Law Journal 967, 970 (2006) (venture capital funds investing in U.S. start-ups “almost always receive convertible preferred stock”); Fenn et al. , supra note 55, at 32.

81 McGuire Testimony, supra note 41, at 4; Loy Testimony, supra note 40, at 2.

82 See infra section II.A.3 of this Release.

83 See, e.g., Darian M. Ibrahim, Debt as Venture Capital, 4 U. Ill. L. Rev. 1169, 1173, 1206 (2010) (“VCs sometimes [provide] bridge loans to their portfolio companies * * * [A] bridge loan * * * is [essentially] about `funding to subsequent rounds of equity' rather than relying on the underlying start-up's ability to repay the loan through cash flows.”); Alan Olsen, Venture Capital Financing: Structure and Pricing, VirtualStreet (July 25, 2010), available at http://www20.csueastbay.edu/news/2010/07/alan-olsen-venture-capital.html (“Bridge financing is designed as temporary financing in cases where the company has obtained a commitment for financing at a future date, which funds will be used to retire the debt.”); Thomas Flynn, Venture Capital: Current Trends and Lessons Learned, Ventures and Intellectual Property Letter (2003), available at http://www.shipmangoodwin.com/publications/Detail.aspx?pub=194 (“The bridge financing, intended to take the cash strapped company either to the next full round of venture investment or alternatively to a liquidity event or wind-up, has become a familiar fixture in the life cycle of a venture-backed company.”).

84 Provided such financings were structured to satisfy the definition of equity security, we would view such transactions to satisfy the definition of qualifying portfolio company under proposed rule 203(l)-1(c)(4)(ii).

We propose to use the definition of equity security in section 3(a)(11) of the Securities Exchange Act of 1934 (“Exchange Act”) and rule 3a11-1 thereunder

re-backed company.”).

We propose to use the definition of equity security in section 3(a)(11) of the Securities Exchange Act of 1934 (“Exchange Act”) and rule 3a11-1 thereunder. 85 This definition is broad, and includes common stock as well as preferred stock, warrants and other securities convertible into common stock in addition to limited partnership interests. 86 This definition would include various securities in which venture capital funds typically invest and would provide venture capital funds with flexibility to determine which equity securities in the portfolio company capital structure are appropriate for the fund. 87 We request comment on the use of this definition. Should we consider a more limited definition of equity security? Do venture capital funds typically invest in other types of equity securities that are not covered by the proposed definition?

85 See 15 U.S.C. 78c(a)(11) (defining “equity security” as “any stock or similar security; or any security future on any such security; or any security convertible, with or without consideration, into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any other security which the Commission shall deem to be of similar nature and consider necessary or appropriate, by such rules and regulations as it may prescribe in the public interest or for the protection of investors, to treat as an equity security.”); rule 3a11-1 under the Exchange Act (17 CFR 240.3a11-1) (defining “equity security” to include “any stock or similar security, certificate of interest or participation in any profit sharing agreement, preorganization certificate or subscription, transferable share, voting trust certificate or certificate of deposit for an equity security, limited partners

vestors, to treat as an equity security.”); rule 3a11-1 under the Exchange Act (17 CFR 240.3a11-1) (defining “equity security” to include “any stock or similar security, certificate of interest or participation in any profit sharing agreement, preorganization certificate or subscription, transferable share, voting trust certificate or certificate of deposit for an equity security, limited partnership interest, interest in a joint venture, or certificate of interest in a business trust; any security future on any such security; or any security convertible, with or without consideration into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any put, call, straddle, or other option or privilege of buying such a security from or selling such a security to another without being bound to do so.”).

86 See rule 3a11-1 under the Exchange Act (17 CFR 240.3a11-1) (defining “equity security” to include any “limited partnership interest”).

87 Our proposed use of the definition of equity security under the Exchange Act acknowledges that venture capital funds typically invest in common stock and other equity instruments that may be convertible into equity common stock. See supra note 80. Our proposed definition does not otherwise specify the types of equity instruments that a venture capital fund could hold in deference to the business judgment of venture capital investors.

Under the proposed rule, we define a venture capital fund for purposes of the exemption as a fund that holds cash and cash equivalents or short-term U.S. Treasuries, in recognition of the manner in which venture capital funds operate. 88 A venture capital fund may hold cash funded by its investors until the cash is allocated to an investment opportunity; subsequently, upon liquidation of the investment, the venture capital fund will receive cash as a return on its investment, which is then distributed to the fund's investors

ents or short-term U.S. Treasuries, in recognition of the manner in which venture capital funds operate. 88 A venture capital fund may hold cash funded by its investors until the cash is allocated to an investment opportunity; subsequently, upon liquidation of the investment, the venture capital fund will receive cash as a return on its investment, which is then distributed to the fund's investors. 89 90 We define “cash and cash equivalents” by reference to rule 2a51-1(b)(7)(i) under the Investment Company Act. 91 Rule 2a51-1, however, is used to determine whether an owner of an investment company excluded by reason of section 3(c)(7) of the Investment Company Act meets the definition of a qualified purchaser by examining whether such owner holds sufficient “investments” (generally securities and other assets held for investment purposes). 92 We do not propose to define a venture capital fund's cash holdings by reference to whether the cash is held “for investment purposes” or to the net cash surrender value of an insurance policy. Furthermore, since rule 2a51-1 does not explicitly include short-term U.S. Treasuries, which we believe would be an appropriate form of cash equivalent for a venture capital fund to hold pending investment in a portfolio company or distribution to investors, our rule would include short-term U.S. Treasuries with a remaining maturity of 60 days or less among the investments a venture capital fund could hold. 93 Should we specify a shorter or longer period of remaining maturity for U.S. Treasuries?

88 Proposed rule 203(l)-1(a)(2)(ii).

89 “[T]he capital supplied to a venture capital fund consists entirely of equity commitments provided as cash from investors in installments on an as-needed basis

ies with a remaining maturity of 60 days or less among the investments a venture capital fund could hold. 93 Should we specify a shorter or longer period of remaining maturity for U.S. Treasuries?

88 Proposed rule 203(l)-1(a)(2)(ii).

89 “[T]he capital supplied to a venture capital fund consists entirely of equity commitments provided as cash from investors in installments on an as-needed basis. * * * The `capital calls' for investments generally happen in cycles over the full life of the fund on an `as needed' basis as investments are identified by the general partners and then as further rounds of investment are made into the portfolio companies.” Loy Testimony, supra note 40, at 2; Paul A. Gompers & Josh Lerner,

90 Proposed rule 203(l)-1(a)(2)(ii).

91 Rule 2a51-1(b)(7) under the Investment Company Act provides that cash and cash equivalents include foreign currencies “held for investment purposes” and “(i) [b]ank deposits, certificates of deposit, bankers acceptances and similar bank instruments held for investment purposes; and (ii) [t]he net cash surrender value of an insurance policy.” 17 CFR 270.2a51-1(b)(7).

92 See generally sections 2(a)(51) and 3(c)(7) of the Investment Company Act; 17 CFR 270.2a51(b) and (c).

93 We have treated debt securities with maturities of 60 days or less differently than debt securities with longer maturities under our rules. In particular, we have recognized that the potential for fluctuation in those shorter-term securities' market value has decreased sufficiently that, under certain conditions, we allow certain open-end investment companies to value them using amortized cost value rather than market value. See Valuation of Debt Instruments by Money Market Funds and Certain Other Open-End Investment Companies, Investment Company Act Release No. 9786 (May 31, 1977) [42 FR 28999 (June 7, 1977)]. We believe that the same consideration warrants treating U.S

tly that, under certain conditions, we allow certain open-end investment companies to value them using amortized cost value rather than market value. See Valuation of Debt Instruments by Money Market Funds and Certain Other Open-End Investment Companies, Investment Company Act Release No. 9786 (May 31, 1977) [42 FR 28999 (June 7, 1977)]. We believe that the same consideration warrants treating U.S. Treasury securities with a remaining maturity of 60 days or less as more akin to cash equivalents than Treasuries with longer maturities for purposes of the definition of venture capital fund.

We request comment on whether the proposed rule's provision for cash holdings is too broad or too narrow. Should the rule only specify that cash be held in anticipation of investments, or in connection with the payment of expenses or liquidations from underlying portfolio companies? Are there other types of cash instruments in which venture capital funds typically invest and/or that should be reflected in the proposed rule?

We do not propose to define venture capital fund for purposes of the exemption as one that invests solely in U.S. companies. In contrast, the BDC provisions in the Investment Company Act generally limit the exemption to U.S. companies and require that permitted investments generally be made in U.S. companies. 94 However, as we discuss below, there is no indication in the legislative record that Congress intended the venture capital exemption would be available only to U.S. advisers or to advisers that invest fund assets solely in U.S. companies. 95 Should our proposed definition similarly define a venture capital fund as a fund formed under the laws of the United States and/or that invests exclusively or primarily in U.S. portfolio companies or a sub-set of such companies ( e.g., U.S. companies operating in non-financial sectors)? Are venture capital funds that invest in non-U.S

o advisers that invest fund assets solely in U.S. companies. 95 Should our proposed definition similarly define a venture capital fund as a fund formed under the laws of the United States and/or that invests exclusively or primarily in U.S. portfolio companies or a sub-set of such companies ( e.g., U.S. companies operating in non-financial sectors)? Are venture capital funds that invest in non-U.S. portfolio companies more or less likely to have financial relationships that may pose systemic risk issues, a rationale that was presented and appeared significant to Congress in exempting advisers to venture capital funds?

94 See sections 2(a)(46) and 2(a)(48) of the Investment Company Act. Under section 55 of the Investment Company Act, a BDC is prohibited from acquiring any assets, except for permitted assets, unless, at the time the acquisition is made, permitted assets “represent at least 70 per centum of the value of [the BDC's] total assets.” Permitted assets for this purpose generally mean securities of an “eligible portfolio company,” which is defined in section 2(a)(46) of the Investment Company Act.

95 See infra section II.A.8 of this Release .

c. Portfolio Company Leverage

Proposed rule 203(l)-1 would define a qualifying portfolio company for purposes of the exemption as one that does not borrow, issue debt obligations or otherwise incur leverage in connection with the venture capital fund's investments. 96 As a consequence, certain types of funds that use leverage or finance their investments in portfolio companies or the buyout of existing investors with borrowed money ( e.g., leveraged buyout funds, which are a different subset of private equity funds) would not meet the proposed rule's definition of a venture capital fund. 97 As discussed in greater detail below, we believe that Congress did not intend the venture capital fund definition to apply to these other types of private equity funds

olio companies or the buyout of existing investors with borrowed money ( e.g., leveraged buyout funds, which are a different subset of private equity funds) would not meet the proposed rule's definition of a venture capital fund. 97 As discussed in greater detail below, we believe that Congress did not intend the venture capital fund definition to apply to these other types of private equity funds. 98 This definition of qualifying portfolio company would only exclude companies that borrow in connection with a venture capital fund's investment, but would not exclude companies that borrow in the ordinary course of their business ( e.g., to finance inventory or capital equipment, manage cash flows, and meet payroll). We would generally view any financing or loan (unless it met the definition of equity security) to a portfolio company that was provided by, or was a condition of a contractual obligation with, a fund or its adviser as part of the fund's investments as being a type of financing that is “in connection with” the fund's investment, although we recognize that other types of financings may also be “in connection with” a fund's investment. Should we provide guidance on other types of financing transactions as being “in connection with” a fund's investment in a qualifying portfolio company? If so, what types of financing transactions should such guidance address? We propose this element of the qualifying portfolio company definition because of the focus on leverage in the Dodd-Frank Act as a potential contributor to systemic risk as discussed by the Senate Committee report, 99 and the testimony 100 Should we use a test other than whether the loan is “in connection with” the fund's investments? For example, should the test be whether the portfolio company currently intends to borrow at the time of the fund's investment? Should the test depend only on how the portfolio company uses the proceeds of borrowing, such as by excluding companies that use proceeds to buyout investors or return capital to a fund?

96 Pr

t other than whether the loan is “in connection with” the fund's investments? For example, should the test be whether the portfolio company currently intends to borrow at the time of the fund's investment? Should the test depend only on how the portfolio company uses the proceeds of borrowing, such as by excluding companies that use proceeds to buyout investors or return capital to a fund?

96 Proposed rule 203(l)-1(c)(4)(ii) (setting forth this requirement as a condition for the portfolio company to qualify as a “qualifying portfolio company”).

97 A leveraged buyout fund is a private equity fund that will “borrow significant amounts from banks to finance their deals—increasing the debt-to-equity ratio of the acquired companies.” U.S. Govt. Accountability Office, Private Equity: Recent Growth in Leveraged Buyouts Exposed Risks that Warrant Continued Attention (2008) (“GAO Private Equity Report”), at 1. A leverage buyout fund in 2005 typically financed a deal with 34% equity and 66% debt. Id. at 13. See also Fenn et al., supra note 55, at 23 (companies that have been taken private in an LBO transaction generally “spend less on research and development, relative to assets, and have a greater proportion of fixed assets; their debt-to-assets ratios are high, above 60%, and are two to four times those of venture-backed firms.” Moreover, compared to venture capital backed companies, LBO-private equity backed companies that are taken public typically use proceeds from an IPO to reduce debt whereas new venture capital backed firms tend to use proceeds to fund growth.); Tresnowski Testimony, supra note 40, at 2 (indicating that portfolio companies in which private equity funds invest typically have 60% debt and 40% equity).

98 See infra discussion in section II.A.1.d of this Release.

99 See S. Rep. No

ompanies that are taken public typically use proceeds from an IPO to reduce debt whereas new venture capital backed firms tend to use proceeds to fund growth.); Tresnowski Testimony, supra note 40, at 2 (indicating that portfolio companies in which private equity funds invest typically have 60% debt and 40% equity).

98 See infra discussion in section II.A.1.d of this Release.

99 See S. Rep. No. 111-176, supra note 7, at 74 (“The Committee believes that venture capital funds, a subset of private investment funds specializing in long-term equity investment in small or start-up businesses, do not present the same risks as the large private funds whose advisers are required to register with the SEC under this title.”); id. at 75 (concluding that private funds that use limited or no leverage at the fund level engage in activities that do not pose risks to the wider markets through credit or counterparty relationships).

100 See Loy Testimony, supra note 40, at 6 (noting that “many venture capital funds significantly limit borrowing”). See also McGuire Testimony, supra note 41, at 7 (“Not only are our partnerships run without debt but our portfolio companies are usually run without debt as well.”).

Venture capital has been described as investing in companies that cannot borrow from the usual lending sources. 101 Should we define a qualifying portfolio company as a company that does not incur certain specified types of borrowing or other forms of leverage? Would such a definition narrow the current range of portfolio companies in which venture capital funds typically invest?

101 See Loy Testimony, supra note 40, at 3. See also James Schell, Private Equity Funds: Business Structure and Operations (2010), at § 1.03[1] (“Schell”) (“Venture Capital Funds provide investment capital to business enterprises early in their development cycle at a time when access to conventional financing sources is non-existent or extremely limited.”).

re capital funds typically invest?

d. Capital Used for Operating and Business Purposes

Under proposed rule 203(l)-1, a venture capital fund is defined as a fund that holds equity securities of qualifying portfolio companies, and at least 80 percent of each company's equity securities owned by the venture capital fund were acquired directly from each such qualifying portfolio company. 102 This element reflects the distinction between venture capital funds that provide capital to portfolio companies for operating and business purposes (in exchange for an equity investment) and leveraged buyout funds, which acquire controlling equity interests in operating companies through the “buy out” of existing security holders. Hence, in addition to the definitional element that a venture capital fund is one that does not redeem or repurchase securities from other shareholders ( i.e. , a “buyout”), a related criterion in the rule specifies that a qualifying portfolio company is one that does not distribute company assets to other security holders in connection with the venture capital fund's investment in the company (which could be an indirect buyout). 103

102 Proposed rule 203(l)-1(a)(2)(i).

103 Proposed rule 203(l)-1(c)(4)(iii).

One of the distinguishing features of venture capital funds is that, unlike many hedge funds and private equity funds, they invest capital directly in portfolio companies for the purpose of funding the expansion and development of the company's business rather than buying out existing security holders, otherwise purchasing securities from other shareholders, or leveraging the capital investment with debt financing

guishing features of venture capital funds is that, unlike many hedge funds and private equity funds, they invest capital directly in portfolio companies for the purpose of funding the expansion and development of the company's business rather than buying out existing security holders, otherwise purchasing securities from other shareholders, or leveraging the capital investment with debt financing. 104 Testimony received by Congress and our research suggest that venture capital funds provide capital to many types of businesses at different stages of development, 105 generally with the goal of financing the expansion of the company 106 and helping it progress to the next stage of its development through successive tranches of investment ( i.e. , “follow-on” investments) if the company reaches agreed-upon milestones. 107

104 See Loy Testimony, supra note 40, at 2 (“Although venture capital funds may occasionally borrow on a short-term basis immediately preceding the time when the cash installments are due, they do not use debt to make investments in excess of the partner's capital commitments or `lever up' the fund in a manner that would expose the fund to losses in excess of the committed capital or that would result in losses to counter parties requiring a rescue infusion from the government.”). See also infra notes 109-111; Mark Heesen & Jennifer C. Dowling, National Venture Capital Association, Venture Capital & Adviser Registration, materials submitted in connection with the Commission's Government-Business Forum on Small Business Capital Formation (“Heesen”) (summarizing the differences between venture capital funds and buyout and hedge funds), available at http://www.sec.gov/info/smallbus/2010gbforumstatements.htm

ark Heesen & Jennifer C. Dowling, National Venture Capital Association, Venture Capital & Adviser Registration, materials submitted in connection with the Commission's Government-Business Forum on Small Business Capital Formation (“Heesen”) (summarizing the differences between venture capital funds and buyout and hedge funds), available at http://www.sec.gov/info/smallbus/2010gbforumstatements.htm.

105 See, e.g., McGuire Testimony, supra note 41, at 1; NVCA Yearbook 2010, supra note 41; PricewaterhouseCoopers/National Venture Capital Association MoneyTree Report, Q4 2009/Full-year 2009 Report (providing data on venture capital investments in portfolio companies); Schell, supra note 101, at § 1.03[1]; Gompers & Lerner, supra note 89, at 178, 180 table 8.2 (displaying percentage of annual venture capital investments by stage of development and classifying “early stage” as seed, start-up, or early stage and “late stage” as expansion, second, third, or bridge financing).

106 See McGuire Testimony, supra note 41, at 1; Loy Testimony, supra note 40, at 3 (“Once the venture fund is formed, our job is to find the most promising, innovative ideas, entrepreneurs, and companies that have the potential to grow exponentially with the application of our expertise and venture capital investment.”). See also William A. Sahlman, The Structure and Governance of Venture-Capital Organizations, Journal of Financial Economics 27 (1990), at 473, 503 (“Sahlman”) (noting venture capitalists typically invest more than once during the life of a company, with the expectation that each capital investment will be sufficient to take the company to the next stage of development, at which point the company will require additional capital to make further progress).

107 See Sahlman, at 503; Loy Testimony, supra note 40, at 3 (“[W]e continue to invest additional capital into those companies that are performing well; we cease follow-on investments into companies that do not reach their agreed upon milestones.”)

sufficient to take the company to the next stage of development, at which point the company will require additional capital to make further progress).

In contrast, private equity funds that are identified as buyout funds typically provide capital to an operating company in exchange for majority or complete ownership of the company, 108 generally achieved through the buyout of existing shareholders or other security holders and financed with debt incurred by the portfolio company, 109 and compared to venture capital funds, hold the investment for shorter periods of time. 110 As a result of the use of the capital provided and the incurrence of this debt, following the buyout fund investment, the operating company may carry debt several times its equity and may devote significant levels of its cash flow and corporate earnings to repaying the debt financing, rather than investing in capital improvement or business operations. 111

108 GAO Private Equity Report, supra note 97, at 8 (“A private equity-sponsored LBO generally is defined as an investment by a private equity fund in a public or private company (or division of a company) for majority or complete ownership.”).

109 See Annalisa Barrett et al. , Prepared by the Corporate Library Inc., under contract for the IRRC Institute, What is the Impact of Private Equity Buyout Fund Ownership on IPO Companies' Corporate Governance?, at 7 (June 2009) (“Barrett et al. ”) (“In general, VC firms provide funding to companies in early stages of their development, and the money they provide is used as working capital for the firm

e Annalisa Barrett et al. , Prepared by the Corporate Library Inc., under contract for the IRRC Institute, What is the Impact of Private Equity Buyout Fund Ownership on IPO Companies' Corporate Governance?, at 7 (June 2009) (“Barrett et al. ”) (“In general, VC firms provide funding to companies in early stages of their development, and the money they provide is used as working capital for the firm. Buyout firms, in contrast, work with mature companies, and the funds they provide are used to compensate the firm's existing owners.”); Ieke van den Burg and Poul Nyrup Rasmussen, Hedge Funds and Private Equity: A Critical Analysis (2007), at 16-17 (“van den Burg”); Sahlman, supra note 106, at 517. See also Tax Legislation: CRS Report, Taxation of Hedge Fund and Private Equity Managers, Tax Law and Estate Planning Course Handbook Series, Practicing Law Institute (Nov. 2, 2007) at 2 (noting that in a leveraged buyout “private equity investors use the proceeds of debt issued by the target company to acquire all the outstanding shares of a public company, which then becomes private”).

110 Unlike venture capital funds, which generally invest in portfolio companies for 10 years or more, private equity funds that use leveraged buyouts invest in their portfolio companies for shorter periods of time. See Loy Testimony, supra note 40, at 3 (citing venture capital fund investments periods in portfolio companies of five to 10 years or longer); van den Burg, at 19 (noting that LBO investors generally retain their investment in a listed company for 2 to 4 years or even less after the company goes public). See also Paul A. Gompers, The Rise and Fall of Venture Capital, Business And Economic History, vol. 23, no. 2, Winter 1994, at 17 (“Gompers”) (stating that “an LBO investment is significantly shorter than that of a comparable venture capital investment. Assets are sold off almost immediately to meet debt burden, and many companies go public again (in a reverse LBO) in a very short period of time”).

111 See Barrett et al

The Rise and Fall of Venture Capital, Business And Economic History, vol. 23, no. 2, Winter 1994, at 17 (“Gompers”) (stating that “an LBO investment is significantly shorter than that of a comparable venture capital investment. Assets are sold off almost immediately to meet debt burden, and many companies go public again (in a reverse LBO) in a very short period of time”).

111 See Barrett et al. , supra note 109. See also Fenn et al. , supra note 55, at 23 (when comparing venture capital backed companies that are taken public to LBO-private equity backed companies that are taken public, the common use of proceeds from an IPO are used by LBO-private equity backed

We believe that these differences ( i.e. , the use of buyouts and associated leverage) distinguish venture capital funds from buyout private equity funds for which Congress did not provide an exemption. 112 Under our proposed rule, an exempt adviser relying on section 203(1) of the Advisers Act would not be eligible for the exemption if it advised these types of private equity funds that in effect acquire a majority of the equity securities of portfolio companies directly from other security holders. 113 Correspondingly, we also propose to define a qualifying portfolio company for purposes of the exemption as one that does not redeem or repurchase outstanding securities in connection with a venture capital fund's investment. 114 Because at least 80 percent of each portfolio company's equity securities in which the fund invests must be acquired directly from the portfolio company, a venture capital fund relying on the exemption could purchase the remainder of the securities directly from existing shareholders ( i.e. , a “buyout”). Under our proposed definition, however, a company that achieves an indirect buyout of its security holders, such as through the complete recapitalization or restructuring of the portfolio company capital structure would not be a qualifying portfolio company

capital fund relying on the exemption could purchase the remainder of the securities directly from existing shareholders ( i.e. , a “buyout”). Under our proposed definition, however, a company that achieves an indirect buyout of its security holders, such as through the complete recapitalization or restructuring of the portfolio company capital structure would not be a qualifying portfolio company. 115 The 80 percent test is not intended to preclude conversions of directly acquired securities into other equity securities. Similarly, we would not view a capital reorganization intended merely to simplify a qualifying portfolio company's capital structure and outstanding securities without any change in the existing beneficial owners' rights, priority, or economic terms as breaching the 80 percent condition.

112 See supra notes 39, 42, 43, 99 and accompanying text.

113 Proposed rule 203(l)-1(a)(2)(i).

114 Proposed rule 203(l)-1(c)(4)(iii).

115 For example, concurrently with the issuance of new securities to the venture capital fund, a portfolio company could redeem existing shareholders and use proceeds from the venture capital fund investment to pay such shareholders redemption proceeds. Similarly, existing shareholders may receive new securities that are subordinated to the securities issued to the venture capital fund in exchange for tendering their outstanding securities, partially funded with investments received from the venture capital fund. In each of these examples, the fund becomes a majority owner of the company by “buying out” the existing owners with investment capital initially provided by the fund

s may receive new securities that are subordinated to the securities issued to the venture capital fund in exchange for tendering their outstanding securities, partially funded with investments received from the venture capital fund. In each of these examples, the fund becomes a majority owner of the company by “buying out” the existing owners with investment capital initially provided by the fund.

We propose to define a venture capital fund by reference to ownership of equity securities of a qualifying portfolio company, wherein at least 80 percent of the securities owned were acquired directly from the company, in order to give venture capital funds relying on the exemption some flexibility to acquire securities from a portfolio company founder or “angel” investor who may seek liquidity from his or her initial investment. 116 We adopted this 80 percent threshold because we understand that many venture capital funds currently are managed in a manner that seeks to rely on provisions of the tax code providing favorable tax treatment for directly acquired equity securities of issuers that satisfy certain conditions. 117 Thus, using this threshold in our definition may not result in substantial changes to either investment strategies employed, or the compliance programs currently used, by venture capital advisers. Is our assumption that venture capital funds do not generally acquire portfolio company securities directly from existing shareholders correct? Is 80 percent the appropriate threshold? Should the threshold be set lower? Should direct acquisitions of equity securities be increased to 90 percent or 100 percent in order to more effectively prevent advisers to funds engaged in activities that are not characteristic of venture capital funds from relying on the exemption?

116 See NVCA Yearbook 2010, supra note 41, at 57 (defining “angel” as “a wealthy individual that invests in companies in relatively early stages of development”). See also Fenn et al

y securities be increased to 90 percent or 100 percent in order to more effectively prevent advisers to funds engaged in activities that are not characteristic of venture capital funds from relying on the exemption?

116 See NVCA Yearbook 2010, supra note 41, at 57 (defining “angel” as “a wealthy individual that invests in companies in relatively early stages of development”). See also Fenn et al. , supra note 55, at 2 (defining angel capital as “investments in small, closely held companies by wealthy individuals, many of whom have experience operating similar companies [and] * * * may have substantial ownership stakes and may be active in advising the company, but they generally are not as active as professional managers in monitoring the company and rarely exercise control.”).

117 See Int. Rev. Code § 1202(e)(1)(A) (26 U.S.C. 1202) (“IRC 1202”) (which permits partial exclusion from income tax gain on directly acquired equity securities of certain issuers that, among other things, devote at least 80% of their assets to the conduct of their business as specified in IRC 1202). Under our proposed rule, at least 80% of the portfolio company securities owned by a venture capital fund must be acquired directly from the portfolio company, which in turn cannot redeem or repurchase existing security holders in connection with such venture capital fund investment. Thus we presume that venture capital funding proceeds (or at least 80% of such proceeds) will be used for operating and business expansion purposes, which is similar to the requirements under IRC 1202.

business expansion purposes, which is similar to the requirements under IRC 1202.

In contrast to leveraged buyout fund financing, venture capital received by a portfolio company is devoted to developing the company's business rather than repurchasing the securities of other shareholders or making payments to fund debt financing through the portfolio company. We request comment on this criterion. Does the definition's focus on a portfolio company's use of capital received from a venture capital fund impose any unnecessary burdens on the company's operation or business? Rather than define a venture capital fund by reference to the manner in which it acquires equity securities (or the manner in which qualifying portfolio companies may indirectly facilitate a buyout), should the proposed rule instead define the manner in which proceeds from a venture capital investment may be used? For example, should the rule specify that proceeds of borrowings or other financings not be used to finance the acquisition of equity securities by a venture capital fund or otherwise distribute company assets to equity owners? Would defining qualifying portfolio company in this manner facilitate compliance or would this approach make it easier for a company to achieve a “buyout” and thereby circumvent the intended scope of the exemption, given the fungibility of cash and the privately negotiated nature of typical venture capital transactions? We do not intend that a venture capital fund would not meet the proposed definition if it acquired equity securities from a portfolio company in connection with a capital reorganization intended to simplify the company's capital structure without changing the existing beneficial owners' rights, priority, or economic terms. Are there other capital reorganizations that would be consistent with the intent of our proposed rule but that would prevent a venture capital fund from satisfying the proposed definition?

from a portfolio company in connection with a capital reorganization intended to simplify the company's capital structure without changing the existing beneficial owners' rights, priority, or economic terms. Are there other capital reorganizations that would be consistent with the intent of our proposed rule but that would prevent a venture capital fund from satisfying the proposed definition?

e. Operating Companies

Proposed rule 203(l)-1 would define the term qualifying portfolio company for the purposes of the exemption to exclude any private fund or other pooled investment vehicle. 118 There is no indication that Congress intended the venture capital exemption to apply to funds of funds. Without this definition, a venture capital fund could circumvent the intended scope of the exemption by investing in other pooled investment vehicles that are not themselves subject to the definitional criteria under our proposed rule. For example, a venture capital fund could circumvent the intent of the proposed rule by incurring off-balance sheet leverage or indirectly investing in companies that may be publicly traded. Our proposed exclusion would be similar to the approach of other 119 We request comment on this definitional element. Under the proposed definition, a venture capital fund would not invest in another private fund, a commodity pool or other “investment companies.” Should the proposed definition specifically identify other types of pooled investment vehicles ( e.g. , real estate funds or structured investment vehicles) in which a fund seeking to satisfy the proposed definition could not invest?

118 Proposed rule 203(l)-1(c)(4)(iv). For this purpose, pooled investment vehicles include investment companies, investment companies relying on rule 3a-7 under the Investment Company Act and commodity pools.

119 See California VC exemption, supra notes 70-72; see also VCOC exemption under 29 CFR 2510.3-101(d), supra note 70.

und seeking to satisfy the proposed definition could not invest?

119 See California VC exemption, supra notes 70-72; see also VCOC exemption under 29 CFR 2510.3-101(d), supra note 70.

1. Management Involvement

To qualify as a venture capital fund under our proposed definition, the fund or its investment adviser would: (i) Have an arrangement under which it offers to provide significant guidance and counsel concerning the management, operations or business objectives and policies of the portfolio company (and, if accepted, actually provides the guidance and counsel) or (ii) control the portfolio company. 120 Because a key distinguishing characteristic of venture capital investing is the assistance beyond the mere provision of capital, we propose that advisers seeking to rely on the rule have a significant level of involvement in developing a fund's portfolio companies. 121 Managerial assistance generally takes the form of active involvement in the business, operations or management of the portfolio company, or less active forms of control of the portfolio company, such as through board representation or similar voting rights. 122 We also acknowledge that the nature of managerial assistance may evolve over time as the needs of qualifying portfolio companies change, and hence the proposed rule does not specify that managerial assistance has a fixed character.

120 Proposed rule 203(l)-1(a)(3)

company, or less active forms of control of the portfolio company, such as through board representation or similar voting rights. 122 We also acknowledge that the nature of managerial assistance may evolve over time as the needs of qualifying portfolio companies change, and hence the proposed rule does not specify that managerial assistance has a fixed character.

120 Proposed rule 203(l)-1(a)(3). Under section 202(a)(12) of the Advisers Act, “control” is defined to mean “the power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company.”

121 See McGuire Testimony, supra note 41, at 1 (“[W]e build companies by actively partnering with each entrepreneur and management team to help propel their ideas into market leading businesses. We do this by providing a small amount of capital and a large amount of operating expertise and strategic counsel over a long period of time. While providing capital is the first order of business, it is the least time consuming of all our activities. We also recruit and attract employees at all levels [for the portfolio company]. We identify and structure strategic partnerships. We raise additional equity to help the [portfolio] company make it to the next milestone. And, we're available 24/7 to support great teams, solve problems, identify opportunities and detect `land mines.' * * * We provide access to [our] expertise and network at all stages of a [portfolio] company's development and across all strategic areas of the business.”). See also Levin, supra note 55, at 1-3 (noting that the “ first feature distinguishing venture capital/private equity investing is the VC professional's active involvement in identifying the investment, negotiating and structuring the transaction, and monitoring the portfolio company after the investment has been made. Often, the VC professional will serve as a board member and/or financial advisor to the portfolio company

e 55, at 1-3 (noting that the “ first feature distinguishing venture capital/private equity investing is the VC professional's active involvement in identifying the investment, negotiating and structuring the transaction, and monitoring the portfolio company after the investment has been made. Often, the VC professional will serve as a board member and/or financial advisor to the portfolio company. Hence, venture capital/private equity investing is significantly different from passive selection and retention of stock and debt investments by a money manager.”) (emphasis in original); Sahlman, supra note 106, at 508 (noting that venture capitalists typically play a role in the operation of the company, help to establish tactics and strategy, work with suppliers and customers, and often assume more direct control by changing management and sometimes taking over day-to-day operations themselves). See also Fenn et al. , supra note 55, at 32-33 for a discussion of various control mechanisms available to venture capital and private equity funds, including preferred stock ownership, representation on the board and various contractual covenants.

122 See generally supra note 121 . See also Alan T. Frankel, et al., Venture Capital: Financial and Tax Considerations, The CPA Journal (Aug. 2003) at 1 (noting that the “VC will also monitor the portfolio company after the investment has been made. Oftentimes, the VC will serve as a board member or financial and strategic advisor to the portfolio company.”).

Oftentimes, the VC will serve as a board member or financial and strategic advisor to the portfolio company.”).

We have modeled the proposed approach to managerial assistance in part on existing provisions under the Advisers Act and the Investment Company Act dealing with BDCs, which were added over the years to ease the regulatory burdens on venture capital and other private equity investments. 123 In 1980, when Congress first introduced BDCs into the Advisers Act and Investment Company Act, it acknowledged that the purpose of the BDC provisions was to support “venture capital” activity in capital formation for small business, and described BDCs as principally investing in and providing managerial assistance to small, growing and financially troubled businesses. 124 Because Congress modeled the definition of BDC under the Advisers and Investment Company Acts on the capital formation activities of venture capital funds, both definitions under such Acts incorporate the requirement to make available significant managerial assistance to portfolio companies. 125

123 The term “business development company” was first introduced into the Investment Company Act and the Advisers Act in 1980 as part of the Small Business Investment Incentive Act of 1980 (“Small Business Act”), and was amended as part of the National Securities Markets Improvement Act of 1996, Public Law 104-290, 110 Stat. 3416 (1996) (“NSMIA”). Congress introduced an alternative regulatory framework applicable to BDCs, which was designed to remove “unnecessary disincentives” for BDCs to provide capital to small businesses, while also preserving protection for investors and preventing fraud and abuse. See 1980 House Report, supra note 44, at 21-22.

In the Small Business Act, Congress modeled the definition of a BDC under section 202(a)(22) of the Advisers Act on the capital formation activities of venture capital funds

s designed to remove “unnecessary disincentives” for BDCs to provide capital to small businesses, while also preserving protection for investors and preventing fraud and abuse. See 1980 House Report, supra note 44, at 21-22.

In the Small Business Act, Congress modeled the definition of a BDC under section 202(a)(22) of the Advisers Act on the capital formation activities of venture capital funds. Congress recognized that the principal activity of a BDC is to invest in and provide managerial assistance to small, growing and financially troubled companies. See 1980 House Report, supra note 44, at 21. See also infra note 129 (definition of “making available significant managerial assistance” by a BDC under section 2(a)(47) of the Investment Company Act).

124 See 1980 House Report, supra note 44, at 21.

125 See section 202(a)(22) of the Advisers Act; section 2(a)(48)(B) of the Investment Company Act. Generally, a BDC under the Advisers Act is any company that meets the definition of BDC under the Investment Company Act, except that certain requirements were modified for “private” BDCs under the Advisers Act. See also Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles; Accredited Investors in Certain Private Investment Vehicles, Investment Advisers Act Release No. 2576 (Dec. 27, 2006) [72 FR 400 (Jan. 4, 2007)] (“Accredited Natural Person Release”), at n.69 (discussing the difference between the term BDC under the Investment Company Act and the Advisers Act). In 1996, as part of NSMIA, Congress sought to encourage greater investment in small businesses by giving BDCs more flexibility, and therefore expanded the class of eligible portfolio companies in which BDCs could invest without being required to provide “managerial assistance.” See S. Rep. No. 104-293, at 13 (1996)

erence between the term BDC under the Investment Company Act and the Advisers Act). In 1996, as part of NSMIA, Congress sought to encourage greater investment in small businesses by giving BDCs more flexibility, and therefore expanded the class of eligible portfolio companies in which BDCs could invest without being required to provide “managerial assistance.” See S. Rep. No. 104-293, at 13 (1996).

Congress did not use the existing BDC definitions when determining the scope of the venture capital exemption, 126 and the primary policy considerations that led to the adoption of the BDC exemptions differed from those under the Dodd-Frank Act. However, we believe these provisions are instructive because they reflect many of the same characteristics of venture capital and private equity fund activity presented in testimony before Congress in connection with the Dodd-Frank Act. 127 Although Congress viewed BDC activities as typical of “venture capital” investing, 128 the BDC provisions are complex. Hence, we are proposing a modified version of the definition of “making available significant managerial assistance” in order to simplify the language and to reduce the potential for confusion that

126 We have looked to the BDC definition to define a venture capital fund before. In 2006, we proposed to impose a qualification standard for all investors of private investment funds, excluding venture capital funds, which we proposed to define by reference to section 202(a)(22) of the Advisers Act. See Accredited Natural Person Release, supra note 125 (proposing to define the term “accredited natural person” as any natural person who satisfies the requirements in Regulation D as an accredited investor and who also owns investments of at least $2.5 million). We sought additional comment on this proposal in a subsequent release but a rule has not been adopted. See Revisions of Limited Offering Exemptions in Regulation D, Securities Act Release No. 8828 (Aug. 3, 2007) [72 FR 45116 (Aug. 10, 2007)]

erson” as any natural person who satisfies the requirements in Regulation D as an accredited investor and who also owns investments of at least $2.5 million). We sought additional comment on this proposal in a subsequent release but a rule has not been adopted. See Revisions of Limited Offering Exemptions in Regulation D, Securities Act Release No. 8828 (Aug. 3, 2007) [72 FR 45116 (Aug. 10, 2007)].

127 See generally Loy Testimony, supra note 40; McGuire Testimony, supra note 41.

128 See 1980 House Report, supra note 44, at 21-2.

We request comment on the approach to managerial assistance in the definition of venture capital fund. As we have noted above, Congressional testimony asserted that a key characteristic of venture capital funds is the provision of managerial assistance. Is this true in the industry generally? We request comment on the description of managerial assistance in proposed rule 203(l)-1. Is this description easier to understand and apply than the definition in section 2(a)(47) of the Investment Company Act? 129 As under the definition of BDC in the Advisers and Investment Company Acts, the proposed definition specifies the fund or its adviser need only offer assistance. Should the rule specify that the fund or its adviser actually provide assistance? If so, what if a portfolio company that initially accepts the offer of assistance later refuses any actual or further assistance? We understand that when venture capital funds invest as a group, there may be an understanding among the funds and the portfolio company that while all fund advisers may be available to provide managerial assistance if necessary, one adviser is generally expected to provide most, if not all, of the assistance to the portfolio company. Is that understanding correct? Under proposed rule 203(l)-1, venture capital funds that invest as a group would only satisfy the definition if each venture capital fund (or its adviser) offered (and, if accepted, provided) managerial assistance or exercised control

al assistance if necessary, one adviser is generally expected to provide most, if not all, of the assistance to the portfolio company. Is that understanding correct? Under proposed rule 203(l)-1, venture capital funds that invest as a group would only satisfy the definition if each venture capital fund (or its adviser) offered (and, if accepted, provided) managerial assistance or exercised control. 130 Should the rule specify how managerial assistance or control is to be determined in the case of venture capital funds that invest as a group if only one fund (or its adviser) provides the assistance? Should the rule specify the extent to which each fund (or its adviser) must offer or provide managerial assistance or adopt the approach of other regulatory definitions of “venture capital” funds, which impose strict numerical investment or ownership tests for determining whether a venture capital fund exercises supervision or influence over the operation or business of the operating company? 131 Does the fact that the assistance need only be offered render the condition so readily met that the criterion should be removed from the rule? Should our rule provide guidance on what constitutes “control” under our proposed definition? For example, instructions to Form ADV provide a presumption of control if a person has the power to vote 25 percent or more of a corporation's voting securities, or a person acts as manager of a limited liability company

nder the condition so readily met that the criterion should be removed from the rule? Should our rule provide guidance on what constitutes “control” under our proposed definition? For example, instructions to Form ADV provide a presumption of control if a person has the power to vote 25 percent or more of a corporation's voting securities, or a person acts as manager of a limited liability company. 132 Should the proposed rule rely on similar or different presumptions?

129 Section 2(a)(47) of the Investment Company Act states:

“`Making available significant managerial assistance' by a business development company means—

(A) Any arrangement whereby a business development company, through its directors, officers, employees, or general partners, offers to provide, and, if accepted, does so provide, significant guidance and counsel concerning the management, operations, or business objectives and policies of a portfolio company;

(B) the exercise by a business development company of a controlling influence over the management or policies of a portfolio company by the business development company acting individually or as part of a group acting together which controls such portfolio company; or

(C) with respect to a small business investment company licensed by the Small Business Administration to operate under the Small Business Investment Act of 1958, the making of loans to a portfolio company.

For purposes of subparagraph (A), the requirement that a business development company make available significant managerial assistance shall be deemed to be satisfied with respect to any particular portfolio company where the business development company purchases securities of such portfolio company in conjunction with one or more other persons acting together, and at least one of the persons in the group makes available significant managerial assistance to such portfolio company, except that such requirement will not be deemed to be satisfied if the business development company, in all cases, makes available sign

the business development company purchases securities of such portfolio company in conjunction with one or more other persons acting together, and at least one of the persons in the group makes available significant managerial assistance to such portfolio company, except that such requirement will not be deemed to be satisfied if the business development company, in all cases, makes available significant managerial assistance solely in the manner described in this sentence.”

In contrast to section 2(a)(47) of the Investment Company Act, our proposed definitional approach to managerial assistance does not specifically define managerial assistance by referring to a fund's directors, officers, employees, or general partners or address how managerial assistance is determined for funds that invest as a group.

130 According to one study, funds focusing on later-stage companies and middle-market buyout investing tend to invest alongside other funds, whereas venture capital funds focusing on early stage companies tend to invest individually in portfolio companies. See Fenn et al., supra note 55, at 31.

131 See supra note 70 and accompanying text (discussing the California VC exemption and the VCOC exemption).

132 See Amendments to Form ADV, Investment Advisers Act Release No. 3060 (July 28, 2010) [75 FR 49234 (Aug. 12, 2010)] (“Form ADV Release”).

Our proposed rule provides that when a fund controls the qualifying portfolio company, an offer to provide managerial assistance is not required. As in the case of “managerial assistance” as defined in the BDC provisions, the proposed rule presumes that when a fund acquires control, it is likely to be exercised. Should the rule specify that in all cases managerial assistance includes both the offer of assistance as well as the exercise of control? We request comment on whether venture capital funds (or their advisers) typically have the personnel to provide significant managerial assistance to all of their portfolio companies or only a subset

hat when a fund acquires control, it is likely to be exercised. Should the rule specify that in all cases managerial assistance includes both the offer of assistance as well as the exercise of control? We request comment on whether venture capital funds (or their advisers) typically have the personnel to provide significant managerial assistance to all of their portfolio companies or only a subset. Would the requirement to offer and potentially provide managerial assistance to all of a fund's portfolio companies result in potential demands on a fund or its adviser that could not be satisfied if all or a significant subset of a fund's portfolio companies accepted the offer? Alternatively, does the proposed definition provide a venture capital fund (including those that invest as a group) with sufficient flexibility to determine the scope of any managerial assistance or control it may seek to offer (or provide) to a portfolio company?

2. Limitation on Leverage

Under proposed rule 203(l)-1, the definition of a venture capital fund for purposes of the exemption would be limited to a private fund that does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15 percent of the fund's 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. 133 Under the proposed definition, a fund could borrow and still be a venture capital fund provided it did not borrow or otherwise use leverage in excess of the specified threshold.

133 Proposed rule 203(l)-1(a)(4). Similarly, our proposed rule would exclude from the definition of “qualifying portfolio company” a company that borrowed in connection with the venture capital fund's investments in the company. Proposed rule 203(l)-1(c)(4)(ii). See supra section II.A.1 of this Release

und provided it did not borrow or otherwise use leverage in excess of the specified threshold.

By specifying that loans be non-renewable, we would avoid the transformation of short-term debt into long-term debt without full repayment to the lender. Should the rule specify other borrowing or financing terms or conditions that would nevertheless avoid this type of transformation? Do venture capital funds use lines of credit repeatedly but pay the outstanding amounts in full before drawing down additional credit? Should loans of this nature be included in the definition? Under our proposed definition, it would be possible for a venture capital fund to issue commercial paper on a short-term basis to potential investors because the proposed definition does not specify which types of instruments a venture capital fund issues. Should the proposed rule specifically exclude commercial paper from debt issuances to avoid the potential that a venture capital fund could convert short-term debt into long-term debt by continuing to roll over its commercial paper 134 This criterion regarding leverage at the venture capital fund level is in addition to the conditions relating to a qualifying portfolio company's debt issuances in connection with the venture capital fund's investment. 135 Under this condition, a venture capital fund seeking to satisfy the definitional criteria could not avoid the borrowing element at the portfolio company level by incurring such leverage at the venture capital fund level

enture capital fund level is in addition to the conditions relating to a qualifying portfolio company's debt issuances in connection with the venture capital fund's investment. 135 Under this condition, a venture capital fund seeking to satisfy the definitional criteria could not avoid the borrowing element at the portfolio company level by incurring such leverage at the venture capital fund level.

134 We note that because commercial paper issuers often refinance the repayment of maturing commercial paper with newly issued commercial paper, they may face roll-over risk, i.e., the risk that investors may not be willing to refinance maturing commercial paper. These risks became particularly apparent for issuers of asset-backed commercial paper beginning in August 2007. At that time, structured investment vehicles (“SIVs”), which are off-balance sheet funding vehicles sponsored by financial institutions, issued commercial paper to finance the acquisition of long-term assets, including residential mortgages. As a result of problems in the residential home mortgage market, short-term investors began to avoid asset-backed commercial paper tied to residential mortgages, regardless of whether the securities had substantial exposure to sub-prime mortgages. Unable to roll over their commercial paper, SIVs suffered severe liquidity problems and significant losses. See Money Market Fund Reform, Investment Company Act Release No. 28807 (June 30, 2009) [74 FR 32688 (July 8, 2009)] (“Money Market Fund Reform Release”) at nn.37-39 and preceding and accompanying text; Marcin Dacperczyk and Philipp Schnabl, When Safe Proved Risky: Commercial Paper During the Financial Crisis of 2007-2009 (Nov. 2009).

135 See proposed rule 203(l)-1(c)(4)(ii); supra section II.A.1.c of this Release. Because private equity funds often engage in leveraged buy-out transactions in which the portfolio company, rather than the fund, incurs debt, our proposed definition would exclude leveraged buy-out funds

Philipp Schnabl, When Safe Proved Risky: Commercial Paper During the Financial Crisis of 2007-2009 (Nov. 2009).

Congress cited the implementation of trading strategies that use financial leverage by certain private funds as creating a potential for systemic risk. 136 In testimony before Congress, the venture capital industry identified the lack of financial leverage in venture capital funds as a basis for exempting advisers to venture capital funds 137 in contrast to other types of private funds such as hedge funds, which may engage in trading strategies that may contribute to systemic risk and affect the public securities markets. 138 For this reason, our proposed rule is designed to address concerns that financial leverage may contribute to systemic risk by excluding funds that incur more than a limited amount of leverage from the definition of venture capital fund. 139

136 See, e.g., section 115 of the Dodd-Frank Act (enumerating prudential standards for addressing systemic risks, including risk-based capital requirements, leverage limits, liquidity requirements, resolution plan and credit exposure report requirements, concentration limits, a contingent capital requirement, enhanced public disclosures, short-term debt limits, and overall risk management requirements)

ee, e.g., section 115 of the Dodd-Frank Act (enumerating prudential standards for addressing systemic risks, including risk-based capital requirements, leverage limits, liquidity requirements, resolution plan and credit exposure report requirements, concentration limits, a contingent capital requirement, enhanced public disclosures, short-term debt limits, and overall risk management requirements). See also G20 Working Group 1, Enhancing Sound Regulation and Strengthening Transparency, at iii-iv (March 25, 2009) (“G20 Working Group Report”), at iii (noting contribution to “market turmoil” when “the financial system developed new structures and created new instruments, some with embedded leverage.” Further, “[w]hile the build-up of leverage and the underpricing of credit risk were recognized in advance of the turmoil, their extent was under-appreciated and there was no coordinated approach to assess the implications of these systemic risks * * *”); International Monetary Fund, Lessons of the Global Crisis for Macroeconomic Policy, February 19, 2009, at 6 (noting how “[l]everage * * * increases lender exposure by magnifying the impact of a price adjustment on borrowers' balance sheets and, thus on banks' losses and capital.”). See generally Department of Treasury, Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and Regulation, June 2009, available at http://www.financialstability.gov/docs/regs/FinalReport_web.pdf.

137 See McGuire Testimony, supra note 41, at 7 (“Venture capital firms do not use long term leverage, rely on short term funding, or create third party or counterparty risk * * * [F]rom previous testimony submitted by the buy-out industry, the typical capital structure of the companies acquired by a buyout fund is approximately 60% debt and 40% equity. In contrast, borrowing at the venture capital fund level, if done at all, typically is only used for short-term capital needs (pending drawdown of capital from its partners) and does not exceed 90 days

ounterparty risk * * * [F]rom previous testimony submitted by the buy-out industry, the typical capital structure of the companies acquired by a buyout fund is approximately 60% debt and 40% equity. In contrast, borrowing at the venture capital fund level, if done at all, typically is only used for short-term capital needs (pending drawdown of capital from its partners) and does not exceed 90 days. Not only are our partnerships run without debt but our portfolio companies are usually run without debt as well.”); Loy Testimony, supra note 40, at 2 (“Although venture capital funds may occasionally borrow on a short-term basis immediately preceding the time when the cash installments are due, they do not use debt to make investments in excess of the partner's capital commitments or `lever up' the fund in a manner that would expose the fund to losses in excess of the committed capital or that would result in losses to counter parties requiring a rescue infusion from the government.”).

138 See S. Rep. No. 111-176, supra note 7, at 74-75.

139 In proposing an exemption for advisers to private equity funds, which would have required the Commission to define the term private equity fund, the Senate Banking Committee noted the difficulties in distinguishing some private equity funds from hedge funds and expected the Commission to exclude from the exemption private equity funds that raise significant potential systemic risk concerns. S. Rep. No. 111-176, supra note 7, at 75. See also G20 Working Group Report, supra note 136, at 7 (noting that unregulated entities such as hedge funds may contribute to systemic risks through their trading activities).

We also understand that venture capital funds generally do not rely on short-term financing, 140 which has been identified as another potential systemic risk factor

isk concerns. S. Rep. No. 111-176, supra note 7, at 75. See also G20 Working Group Report, supra note 136, at 7 (noting that unregulated entities such as hedge funds may contribute to systemic risks through their trading activities).

We also understand that venture capital funds generally do not rely on short-term financing, 140 which has been identified as another potential systemic risk factor. 141 Should we increase or reduce the 15 percent threshold for short-term borrowing? If so, what is the appropriate threshold ( e.g., 20, 10, or 5 percent)? Or should we define a venture capital fund as a private fund that does not borrow at all or otherwise incur any financial leverage? Would even the limited ability to engage in short-term borrowing or other forms of leverage encourage venture capital funds to incur other investment risks different from those typically associated with venture capital investing today? To the extent that venture capital funds use short-term leverage or borrowing, 90 days has been cited as typical. 142 Would a 120-day period, as specified in our proposed rule, create other investment risks for venture capital funds? Our proposed rule refers specifically to borrowing but also is designed to give venture capital funds the flexibility to issue debt (which is also a form of borrowing) for short-term purposes. Should the rule refer specifically to additional forms of borrowing not already identified? Do any or many venture capital funds borrow in excess of 120 days? Should the 15 percent limit not apply when a fund borrows in order to invest in a qualifying portfolio company and is repaid with capital called from the fund's investors? Would the 120-day limit alone achieve a similar result?

140 See Loy Testimony, supra note 40, at 7 (“[V]enture capital firms do not generally rely on short-term funding

many venture capital funds borrow in excess of 120 days? Should the 15 percent limit not apply when a fund borrows in order to invest in a qualifying portfolio company and is repaid with capital called from the fund's investors? Would the 120-day limit alone achieve a similar result?

140 See Loy Testimony, supra note 40, at 7 (“[V]enture capital firms do not generally rely on short-term funding. In fact, quite the opposite is true.”); Schell, supra note 101, at § 1.03[6] (“Venture Capital Funds rarely have the ability to borrow money, other than short-term loans to cover Partnership Expenses or to `bridge' Capital Contributions.”); Heesen, supra note 104, at 17.

141 See, e.g., Financial Crisis Inquiry Commission, Preliminary Staff Report, Shadow Banking and the Financial Crisis (May 4, 2010).

142 See McGuire Testimony, supra note 41, at 7.

Our proposed rule specifies that the 15 percent calculation must be determined based on the fund's aggregate capital contributions and uncalled capital commitments. Unlike most registered investment companies or hedge funds, venture capital funds rely on investors funding their capital commitments from time to time in order to acquire portfolio companies. 143 A capital commitment is a contractual obligation to acquire an interest in, or provide the total commitment amount over time to, a fund, when called by the fund. Accordingly, advisers to venture capital funds manage the fund in anticipation of all investors fully funding their commitments when due and typically have the right to penalize investors for failure to do so. 144 Venture 145 Venture capital fund advisers typically report and market themselves to investors on the basis of aggregate capital commitment amounts raised for prior or existing funds

und. Accordingly, advisers to venture capital funds manage the fund in anticipation of all investors fully funding their commitments when due and typically have the right to penalize investors for failure to do so. 144 Venture 145 Venture capital fund advisers typically report and market themselves to investors on the basis of aggregate capital commitment amounts raised for prior or existing funds. 146 These factors would lead to the conclusion that, in contrast to other types of private funds, such as hedge funds, which trade on a more frequent basis, a venture capital fund would view the fund's total capital commitments as the primary metric for managing the fund's assets and for determining compliance with investment guidelines. Hence, we believe that calculating the leverage threshold to include uncalled capital commitments is appropriate, given that capital commitments are already used by venture capital funds themselves to measure investment guideline compliance.

143 Schell, supra note 101, at § 1.03[8] (“The typical Venture Capital Fund calls for Capital Contributions from time to time as needed for investments.”); id. at § 2.05[2] (stating that “[venture capital funds] begin operation with Capital Commitments but no meaningful assets. Over a specific period of time, the Capital Commitments are called by the General Partner and used to acquire Portfolio Investments.”).

e Capital Commitments are called by the General Partner and used to acquire Portfolio Investments.”).

144 See Loy Testimony, supra note 40, at 5 (“[Limited partners] make their investment in a venture fund with the full knowledge that they generally cannot withdraw their money or change their commitment to provide funds. Essentially they agree to “lock-up” their money for the life of the fund.”). See also Stephanie Breslow & Phyllis Schwartz, Private Equity Funds, Formation and Operation 2010 (“Breslow & Schwartz”), at § 2:5.6 (discussing the various remedies that may be imposed in the event an investor fails to fund its contractual capital commitment, including, but not

145 See, e.g., Breslow & Schwartz, supra note 144, at § 2:5.7 (noting that a cap of 10% to 25% of remaining capital commitments is a common limitation on follow-on investments). See also Schell, supra note 101, at § 1.01 (noting that capital contributions made by the investors are used to “make investments * * * in a manner consistent with the investment strategy or guidelines established for the Fund.”); id. at § 1.03 (“Management fees in a Venture Capital Fund are usually an annual amount equal to a fixed percentage of total Capital Commitments.”); see also Dow Jones, Private Equity Partnership Terms and Conditions, 2007 edition (“Dow Jones Report”) at 15.

146 See, e.g., NVCA Yearbook 2010, supra note 41, at 16; John Jannarone, Private Equity's Cash Problem, Wall St. J., June 23, 2010, http://online.wsj.com/article/SB10001424052748704853404575323073059041024.html#printMode.

The proposed 15 percent threshold would be determined based on the venture capital fund's aggregate capital commitments

d Conditions, 2007 edition (“Dow Jones Report”) at 15.

The proposed 15 percent threshold would be determined based on the venture capital fund's aggregate capital commitments. In practice, this means that a venture capital fund relying on the exemption could leverage an investment transaction up to 100 percent when acquiring equity securities of a particular portfolio company as long as the investment amount does not exceed 15 percent of the fund's total capital commitments, albeit on a short-term basis that did not exceed 120 days. Should the 15 percent calculation be determined with respect to the total investment amount for each portfolio company? Would this standard be easier to apply?

Our proposed rule defines a venture capital fund by reference to a maximum of 15 percent of borrowings based on our understanding that venture capital funds typically would not incur borrowings in excess of 10 to 15 percent of the fund's total capital contributions and uncalled capital commitments. 147 We believe that imposing a maximum at the upper range of borrowings typically used by venture capitals may accommodate existing practices of the vast majority of industry participants.

147 See Loy Testimony, supra note 40, at 6 (“[M]any venture capital funds significantly limit borrowing such that all outstanding capital borrowed by the fund, together with guarantees of portfolio company indebtedness, does not exceed the lesser of (i) 10-15% of total limited partner commitments to the fund and (ii) undrawn limited partner commitments.”).

majority of industry participants.

3. No Redemption Rights

Proposed rule 203(l)-1 would define a venture capital fund as a fund that issues securities that do not provide investors redemption rights except in “extraordinary circumstances” but that do entitle investors generally to receive pro rata distributions. 148 Unlike hedge funds, venture capital funds do not typically permit investors to redeem their interests during the life of the fund, 149 but rather distribute assets generally as investments mature. 150 Although venture capital funds typically return capital and profits to investors only through pro rata distributions, such funds may also provide extraordinary rights for an investor to withdraw from the fund under foreseeable but unexpected circumstances or rights to be excluded from particular investments due to regulatory or other legal requirements. 151 These events may be “foreseeable” because they are circumstances that are known to occur ( e.g., changes in law, corporate events such as mergers) but are unexpected in their timing or scope. Thus, withdrawal or exclusion rights might be triggered by a change in the tax law after an investor invests in the fund, or the enactment of laws that may prohibit an investor's participation in the fund's investment in particular countries or industries. 152 The trigger events for these rights are typically beyond the control of the adviser and fund investor ( e.g., tax and regulatory changes)

. Thus, withdrawal or exclusion rights might be triggered by a change in the tax law after an investor invests in the fund, or the enactment of laws that may prohibit an investor's participation in the fund's investment in particular countries or industries. 152 The trigger events for these rights are typically beyond the control of the adviser and fund investor ( e.g., tax and regulatory changes).

148 Proposed rule 203(l)-1(a)(5) (limiting venture capital funds to funds that “[o]nly issue[] 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”).

149 See Schell, supra note 101, at § 1.03[7] (venture capital fund “redemptions and withdrawals are rarely allowed, except in the case of legal compulsion”); Breslow & Schwartz, supra note 144, at § 2:14.2 (“the right to withdraw from the fund is typically provided only as a last resort”).

150 Loy Testimony, supra note 40, at 2-3 (“As portfolio company investments are sold in the later years of the [venture capital] fund—when the company has grown so that it can access the public markets through an initial public offering (an IPO) or when it is an attractive target to be bought—the liquidity from these `exits' is distributed back to the limited partners. The timing of these distributions is subject to the discretion of the general partner, and limited partners may not otherwise withdraw capital during the life of the venture [capital] fund.”). Id. at 5 (Investors “make their investment in a venture [capital] fund with the full knowledge that they generally cannot withdraw their money or change their commitment to provide funds. Essentially they agree to `lock-up' their money for the life of the fund, generally 10 or more years as I stated earlier.”)

ers may not otherwise withdraw capital during the life of the venture [capital] fund.”). Id. at 5 (Investors “make their investment in a venture [capital] fund with the full knowledge that they generally cannot withdraw their money or change their commitment to provide funds. Essentially they agree to `lock-up' their money for the life of the fund, generally 10 or more years as I stated earlier.”). See also Dow Jones Report, supra note 145, at 60 (noting that an investor in a private equity or venture capital fund typically does not have the right to transfer its interest).

151 See Hedge Fund Adviser Registration Release, supra note 17, at n.240 and accompanying text (“Many partnership agreements provide the investor the opportunity to redeem part or all of its investment, for example, in the event continuing to hold the investment became impractical or illegal, in the event of an owner's death or total disability, in the event key personnel at the fund adviser die, become incapacitated, or cease to be involved in the management of the fund for an extended period of time, in the event of a merger or reorganization of the fund, or in order to avoid a materially adverse tax or regulatory outcome. Similarly, some investment pools may offer redemption rights that can be exercised only in order to keep the pool's assets from being considered `plan assets' under ERISA [Employee Retirement Income Security Act of 1974].”). See, e.g., Breslow & Schwartz, supra note 144, at § 2:14.1 (“Private equity funds generally provide for mandatory withdrawal of a limited partner [ i.e., investor] only in the case where the continued participation by a limited partner in a fund would give rise to a regulatory or legal violation by the investor or the fund (or the general partner [ i.e., adviser] and its affiliates). Even then, it is often possible to address the regulatory issue by excusing the investor from particular investments while leaving them otherwise in the fund.”)

i.e., investor] only in the case where the continued participation by a limited partner in a fund would give rise to a regulatory or legal violation by the investor or the fund (or the general partner [ i.e., adviser] and its affiliates). Even then, it is often possible to address the regulatory issue by excusing the investor from particular investments while leaving them otherwise in the fund.”).

152 See, e.g., Breslow & Schwartz, supra note 144, at § 2:14.2 (“The most common reason for allowing withdrawals from private equity funds arises in the case of an ERISA violation where there is a substantial likelihood that the assets of the fund would be treated as `plan assets' of any ERISA partner for purposes of Title I of ERISA or section 4975 of the Code.”). See also Schell, supra note 101, at § 9.04[3] (“Exclusion provisions allow the General Partner to exclude a Limited Partner from participation in any or all investments if a violation of law or another material adverse effect would otherwise occur.”); id. at Appendix D-31 (attaching model limited partnership agreement providing “The General Partner at any time may cancel the obligations of all Partners to make Capital Contributions for Portfolio Instruments if * * * changes in applicable law * * * make such cancellation necessary or advisable. * * * ”).

For these purposes, for example, a fund that permits quarterly or other periodic withdrawals would be considered to have granted investors redemption rights in the ordinary course even if those rights may be subject to an initial lock-up or suspension or restrictions on redemption. Is the phrase “extraordinary circumstances” sufficiently clear to distinguish the investor liquidity terms of venture capital funds, as they operate today, 153 Although a fund prohibiting redemptions would be a venture capital fund for purposes of the exemption, the rule does not specify a minimum period of time for an investor to remain in the fund

-up or suspension or restrictions on redemption. Is the phrase “extraordinary circumstances” sufficiently clear to distinguish the investor liquidity terms of venture capital funds, as they operate today, 153 Although a fund prohibiting redemptions would be a venture capital fund for purposes of the exemption, the rule does not specify a minimum period of time for an investor to remain in the fund. Should the rule define when withdrawals by investors would be “extraordinary?” Should the rule specify minimum investment periods for investors? Could venture capital funds provide investors with “extraordinary” rights to redeem that could effectively result in redemption rights in the ordinary course? 154 Should we address this potential for circumvention of the definition by establishing a maximum amount that may be redeemed during any period of time ( e.g., 10 percent of an investor's total capital commitments)? Would such a limit constrain investors in a way so as to prevent them from complying with other legal or regulatory requirements?

153 See supra notes 149-150 and accompanying text.

154 For example, a private fund's governing documents may provide that investors do not have any right to redeem without the consent of the general partner. In practice, if the general partner typically permits investors to redeem or transfer their otherwise non-redeemable, non-transferable interests on a periodic basis, then the fund would not be considered to have issued securities that “do not provide a holder with any right, except in extraordinary circumstances, to withdraw.”

4. Represents Itself as a Venture Capital Fund

ed to have issued securities that “do not provide a holder with any right, except in extraordinary circumstances, to withdraw.”

4. Represents Itself as a Venture Capital Fund

Proposed rule 203(l)-1 would limit the definition of venture capital fund for the purposes of the exemption to a private fund that represents itself as being a venture capital fund to its investors and potential investors. 155 A private fund could satisfy this definitional element by, for example, describing its investment strategy as venture capital investing or as a fund that is managed in compliance with the elements of our proposed rule. Without this element, a fund that did not engage in typical venture capital activities could be treated as a venture capital fund simply because it met the other elements specified in our proposed rule (because for example it only invests in short term Treasuries, controls portfolio companies, does not borrow, does not offer investors redemption rights, and is not a registered investment company). 156 We believe that only funds that do not significantly differ from the common understanding of what a venture capital fund is, 157 and that are actually offered to investors as venture capital funds, should qualify for the exemption. Thus, an adviser to a venture capital fund that is otherwise relying on the exemption could not identify the fund as a hedge fund or multi-strategy fund ( i.e., venture capital is one of several strategies used to manage the fund) or include the fund in a hedge fund database or hedge fund index.

155 Proposed rule 203(l)-1(a)(1).

156 We also note that a fund that represents to investors that it is one type of fund while pursuing a different type of fund strategy may raise concerns under rule 206(4)-8 of the Advisers Act.

157 See Gompers, supra note 110, at 6-7.

We request comment on a venture capital fund's representations regarding itself as a criterion under the proposed definition

155 Proposed rule 203(l)-1(a)(1).

156 We also note that a fund that represents to investors that it is one type of fund while pursuing a different type of fund strategy may raise concerns under rule 206(4)-8 of the Advisers Act.

157 See Gompers, supra note 110, at 6-7.

We request comment on a venture capital fund's representations regarding itself as a criterion under the proposed definition. Is our criterion inconsistent with current practice? Does the proposed criterion regarding venture capital fund representations adequately address our concern that advisers should not be eligible for the exemption if they advise fund

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