This is the third post in a series exploring recent SEC regulations which define the term “venture capital fund” for the purposes of determining whether a fund’s manager is exempt from SEC registration requirements under the Dodd-Frank Act.
Previously, I provided a general overview of how the SEC has defined the term “venture capital fund.” A private fund manager that solely advises venture capital funds (as defined in SEC regulations) qualifies for an exemption from investment adviser registration under the Investment Advisers Act of 1940. There are five elements to the definition. In a previous installment, I described the first element of the definition; in this installment I will begin to describe the second element, which is that no more than 20% of the fund’s total assets (including committed but not yet invested capital) can be invested in assets that are not “qualifying investments” or “short term holdings.” This post discusses what constitutes a “qualifying investment.”
A “qualifying investment” is one of three things: (i) an equity security issued by a “qualifying portfolio company” that is acquired directly by a private fund from such qualifying portfolio company; (ii) any equity security that is issued by a qualifying portfolio company in exchange for another equity security of such qualifying portfolio company; and (iii) any equity security issued by a parent of a qualifying portfolio company in exchange for an equity security in that qualifying portfolio company. There are two main consequences to this definition: (i) qualifying investments must be equity and not debt and (ii) they must be acquired by making an investment directly into a company and not acquired by purchasing them from a third party.
The term equity security is, thankfully, defined rather broadly and includes preferred stock, warrants, securities convertible into common stock, such as convertible debt, and limited partnership interests. However, bridge loans that are not convertible would not be considered a qualifying investment.
Another consequence of this rule is that a VC fund would not be able to treat as a qualifying investment any interest in a company that it acquires on the secondary market or through buying out existing owners or management. However, a qualifying investment retains its status as such after a corporate reorganization or buyout where the qualifying portfolio company’s equity interests are exchanged for new equity interests in such company or in another company which acquires the qualifying portfolio company.
The next important question is: what exactly is a “qualifying portfolio company?” The answer to this question will be the next installment in this series of posts.
As always, you should consult an attorney who is familiar with securities regulatory issues in assessing whether your particular fund management business is required to register with the SEC.
 Item (ii) was included in the regulation so that a VC fund can retain its interest in a qualifying portfolio company after a corporate reorganization where there is some kind of exchange of equity interests.
 Item (iii) was included in the regulation so that a VC fund can retain its interest in a qualifying portfolio company after such qualifying portfolio company has been acquired by another company, including a publicly traded company. In such instance, the qualifying portfolio company would become a majority-owned subsidiary of the new parent company.
 However, a VC fund is permitted to have up to 20% of its committed capital in a “non-qualifying basket,” which can include any investment that does not constitute a qualifying investment or a short term holding.
© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.