Venture Capital Fund Regulation

Venture capital fund regulation is based on a comprehensive set of federal securities laws and regulations and is primarily overseen in the US by the Securities and Exchange Commission (SEC). These laws and regulations inform the ways in which venture capital funds raise capital, establish fund structures, and market to potential investors, among various other facets of venture capital fund operation. Venture capital fund regulation varies in scope based on the fund’s organization, management, size, and investor profile, among other factors. While it is highly encouraged for fund managers to engage competent legal counsel to assist with venture capital fund regulation, it is nevertheless also crucial for managers to have a basic understanding of the regulatory landscape in which their funds operate, and that is the purpose of this Insight.

When examining venture capital fund regulation, there are three levels of regulation to consider: the fund itself, the fund manager, and the process by which the fund conducts its fundraising. It is also vital to note that there is much more to venture capital fund regulation than can be easily and simply distilled for the purposes of this Insight, and that this Insight serves as a summary only.

The Fund

The first and most important thing to understand about venture capital fund regulation is that venture capital funds are most typically “private funds,” which means they do not need to register with the SEC as an “investment company” pursuant to the Investment Company Act of 1940 (the “Company Act”). In order to qualify as a private fund, a fund must qualify under one of three exclusions from the registration requirement.

• The first exclusion, under §3(c)(1) of the Company Act, is for funds with less than 100 beneficial owners.
• The second, from the same section, allows for up to 250 beneficial owners but requires that the fund qualify as a “qualified venture capital fund” under the definitions contained in §3(c)(1)(C)(i) of the Company Act and §203(l)-1 of the Investment Advisers Act of 1940 (the “Advisers Act,” covered in more detail further below).
• The third, from §3(c)(7) of the Company Act, limits the fund to “qualified purchasers” only, as such term is defined under the Advisers Act and subsequent rulemaking. The qualified purchasers bar is higher than that for “accredited investor,” as used, for example, in Rule 506 under Regulation D. It is also vital to note that while the Company Act does not provide a limit to the number of beneficial owners under this exclusion, other registration requirements (for example, under the Securities Exchange Act of 1934 (the “Exchange Act”)) may apply at certain thresholds.

Drilling down further into the second exclusion, §3(c)(1)(C)(i) of the Company Act caps the size (i.e., aggregate capital contributions and uncalled capital commitments) of a “qualified” venture capital fund at $10 million, and the term “venture capital fund” is furthermore defined in rulemaking pursuant to the Advisers Act (specifically §203(l)-1) as a fund which represents itself as pursuing a venture capital strategy, has limited redemption rights, holds no more than 20% of assets in “non-qualifying investments,” and adheres to certain limits on the fund’s use of leverage. For these funds, a “qualifying investment” is typically a direct equity investment into a private company, though this term and related terms are further defined in §203(l)-1(c).

The Fund Manager

Prior to the passage of the Dodd-Frank Act (“Dodd-Frank” or the “DFA”) in 2010, many private fund managers (or “advisers”) were exempt from registration with the SEC. Post-DFA, private fund advisers are subject to the same registration requirements as Registered Investment Advisers (“RIAs”) unless such private fund advisers qualify as an Exempt Reporting Adviser (“ERA”).

Under §3(l) of the Advisers Act, an adviser may qualify as an ERA if it acts as an adviser solely to venture capital funds (as defined in §203(l)-1). This is a common route taken by venture capital fund advisers, though there are others, particularly in instances where an adviser advises both venture and non-venture funds. Qualifying as an ERA relieves the adviser of some fairly significant regulatory requirements associated with being an RIA, though ERAs may still subject to basic registration requirements and are still subject to regulation around anti-fraud, anti-money laundering (AML), and other areas.

The extent to which basic registration filings are required depends on factors such as the size of the fund and the location of its principal place of business, among others. Unlike RIAs, ERAs are not required to file a full Form ADV, but instead may be required to file a truncated version either with the SEC or the relevant state securities regulator or regulators.

The Fundraising Process

When it comes to fundraising, venture capital fund regulation is not dissimilar from the ways in which many startups’ capital raises are regulated, e.g., by the SEC’s Regulation D (“Reg D”), promulgated under the Securities Act of 1933 (the ’33 Act). Like many startups, venture capital funds often undertake Reg D private placements under Rule 506(b) or Rule 506(c). These placements are subject to several requirements, which we have discussed in further detail in a separate Insight. For example, these offerings are not open to the general public, have compliance requirements with respect to vetting the accredited status of investors, and require other forms of regulatory compliance on the part of issuers. Venture capital funds looking to raise capital are encouraged to consult with competent legal counsel to advise on these and other matters pertaining to private fund capital raises.