If you’re starting out as a new firm and raising your first fund (or special purpose vehicle), there are a few securities laws principles that you’ll need to become familiar with. This post is intended to provide a quick introduction to the main securities laws that will apply to the fund, the management company and the fundraising process. Given the variables that can impact the actual requirements applicable to your firm, however, please reach out to your Cooley contact to discuss how these laws will apply to you. Below, we’ve included some questions you might consider asking at the outset of the establishment of your firm.

The three main statutory regimes to know are:

• Investment Company Act of 1940 (Company Act): This applies to the fund and governs whether the fund must register as an investment company.
• Investment Advisers Act of 1940 (Advisers Act): This applies to the management company and governs whether the management company must register as an investment adviser.
• Securities Act of 1933 (Securities Act): This applies to fundraising and governs whether the sale of fund interests must be registered as a securities offering.

As a general matter, you will want to be exempt from registration under all three statutory regimes. However, while exemptions from the Company Act and the Securities Act are existential to a VC firm, an exemption from the Advisers Act is something that’s nice to have, if not as critical.

Company Act

The Company Act is the body of law that mutual funds are subject to. Among other things, it requires registered investment companies to make public filings, appoint independent directors, and operate subject to various restrictions, such as minimum capital requirements and limitations on leverage. By their nature, VC funds are designed to operate as private funds, without being subject to the requirements of the Company Act. To be a private fund, a venture capital fund relies on Section 3(c)(1) and/or Section 3(c)(7) of the Company Act, both of which allow the fund to be excluded from being treated as an investment company for most purposes of the Company Act.

Both “3(c)(1) funds” and “3(c)(7) funds” are equally exempt from the Company Act requirements. A 3(c)(1) fund is limited to 100 beneficial owners who must be at least “accredited investors,” which in general includes individuals with investment capital of $1 million (or individuals who meet certain income requirements) and entities with investment capital of $5 million. A 3(c)(7) fund may accept up to 1,999 investors, but each must be a “qualified purchaser.” In general, to be a “qualified purchaser,” an individual must have $5 million in investment capital and an entity must have $25 million. In some cases, an entity may count as multiple investors based on the number of its underlying owners, or the qualified purchaser requirement may need to be satisfied with respect to each underlying owner of such entity (for example, if an entity is formed for the purpose of making the investment at hand or its underlying owners can make individual investment decisions). Thus, an analysis of each investor’s beneficial ownership status is crucially important from a regulatory perspective. Most first-time fund managers will likely default to a 3(c)(1) fund, as few of their investors are likely to meet the qualified purchaser standards.

It is important to note that the qualified purchaser and 100 beneficial owners limit requirements do not apply with respect to “knowledgeable employees” of a firm sponsoring a fund. This is a defined term in the Company Act, and it requires a facts and circumstances determination in some cases. The definition generally covers executive-level personnel, as well as investment personnel who have been performing investment advisory functions for at least 12 months.

Questions to ask your Cooley contact:

1. Can I have multiple 3(c)(1) funds that each have their own 100 beneficial owners limit?
2. Can I have a 3(c)(1) fund and a 3(c)(7) fund investing alongside each other?
3. Do friends and family who are not charged fees need to be qualified purchasers or count toward the 100 beneficial owners limit?

Advisers Act

The Advisers Act is the body of law that applies to anyone meeting the definition of “investment adviser” – i.e., anyone in the business of advising others with respect to securities and who receives compensation. One thing to note about the Advisers Act is that certain of the requirements apply whether or not a firm is registered as an investment adviser – something referred to as being a “registered investment adviser” or “RIA.” For instance, the general antifraud provisions of the Advisers Act apply to RIAs and unregistered investment advisers. And, all investment advisers – registered or not – owe a fiduciary duty to their funds.

Most VC fund managers rely on an exemption from registration as an RIA that’s available under Section 203(l) of the Advisers Act. This “VC exemption” allows investment advisers whose only clients are VC funds to be exempt from registration and be subject to a much lighter regulatory regime than RIAs. The key to relying on the VC exemption is the Advisers Act’s definition of “venture capital fund.” In general, most plain vanilla VC funds should meet this definition – a 3(c)(1) fund or a 3(c)(7) fund that holds itself out as pursuing a VC strategy, doesn’t incur leverage in excess of 15% of the fund’s capital commitments (with any leverage that is incurred not exceeding 120 days), doesn’t give ordinary redemption rights to investors, and mostly invests in primary issuance of equity securities (including securities convertible to equity) of private operating companies.

To drill in slightly deeper, the Advisers Act definition of VC fund has several components, the most important of which is the “20% nonqualifying basket.” A VC fund must invest at least 80% of the capital commitments in qualifying investments. Conversely, no more than 20% of the capital commitments can comprise nonqualifying investments, although the 20% nonqualifying basket can be filled with any type of nonqualifying investment (e.g., crypto, debt, public company shares, investments in other funds and securities acquired in secondary transactions). The 20% calculation is done immediately after the acquisition of each nonqualifying asset, and it can be based on either cost or fair value, as long as it’s consistently applied (i.e., a manager can’t switch between using cost and fair value).

While the VC exemption is what most VC firms rely on, some smaller managers might rely on the private fund adviser exemption – the “PF exemption” – in lieu of, or in addition to, the VC exemption. The PF exemption, which is provided under Section 203(m) of the Advisers Act, is available to investment advisers whose only clients are “private funds” and whose gross assets under management total less than $150 million. A private fund is any 3(c)(1) fund or 3(c)(7) fund, even if it is not a VC fund. The trade-off between the VC exemption and the PF exemption is that the VC exemption does not have a cap on assets under management, but it does have a cap on nonqualifying investments (among other conditions), while the PF exemption has a cap on assets under management but no operational restrictions beyond that cap.

To rely on the VC exemption or the PF exemption and avoid registration as an RIA, a fund manager needs to file a Form ADV as an exempt reporting adviser (ERA). This is a public filing with the Securities and Exchange Commission (SEC), and it includes information about the management company, its affiliates, funds, executive officers, and direct and indirect owners. While filing a Form ADV is not difficult, it is important to make the filing in a timely manner – and submit annual and interim amendments as required.

As indicated above, ERAs have a fiduciary duty to their funds and are subject to certain Advisers Act requirements. In addition to general antifraud provisions, ERAs are subject to the limitations around political contributions, must adopt an insider trading policy, and must obtain investor consent to principal transactions and other similar situations involving conflicts of interest. In addition, the SEC adopted rules in 2023 around preferential treatment (colloquially known as the “side letter rule”) and certain restricted activities by private fund advisers. (For more information, see our September 2023 post about the SEC’s rules.) However, ERAs are not subject to various other requirements under the Advisers Act, including those around custody, audit, marketing, personal trading, record-keeping and quarterly statements. (For an overview of transitioning from relying on the VC exemption to becoming an RIA, refer to our August 2023 post.)

Questions to ask your Cooley contact:

1. Can I create two entities and rely on the VC exemption for one and the PF exemption for the other?
2. Can I switch between the VC exemption and the PF exemption?
3. What do I do if I don’t qualify for the VC exemption or PF exemption?
4. When do I need to file the Form ADV?

Securities Act

The Securities Act is the body of law that applies to the sale of securities, like in an initial public offering. VC and other private funds rely on an exemption that applies to private offerings. While there is a statutory exemption for transactions not involving any public offering generally, most funds rely on the safe harbor provided by Regulation D under the Securities Act. At a high level, there are two key requirements for relying on Regulation D. First, the fund cannot engage in general solicitation or general advertising. Second, the fund must only admit accredited investors. Called a “506(b) offering,” it’s what the vast majority of VC funds rely on. Technically, a fund is allowed to admit up to 35 non-accredited investors. However, doing so would require preparation and disclosure of financial and nonfinancial information that goes far beyond what private funds typically share. Therefore, private funds typically do not admit non-accredited investors.

The restriction on general solicitation or general advertising means that a firm is prohibited from publicly speaking about the fund, posting the fund’s marketing materials on its website, or reaching out to investors it doesn’t have a relationship with. As a general rule, the SEC requires the existence of a “substantive preexisting relationship” with potential investors in order to establish that there has not been general solicitation or general advertising. This is the type of relationship that allows a firm to evaluate a potential investor’s sophistication and accredited investor status. To a limited extent, a firm may rely on their existing network to be introduced to new prospective investors. But the manner, nature, and number of such introductions must be carefully tracked to avoid what can amount to general solicitation or general advertising.

Instead of choosing a 506(b) offering, a few funds choose to do a “506(c) offering,” which also is an exempt offering under Regulation D. The benefit of a 506(c) offering is that a firm may freely engage in general solicitation or general advertising – blog posts, cold emails and speaking at conferences all would be permitted. However, a crucial condition to a 506(c) offering is the requirement to take “reasonable steps to verify” that each investor in the fund is an accredited investor. While this may sound simple enough, the types of documentation that firms are expected to obtain from investors in order to satisfy the verification requirement are often considered intrusive and invasive, and the cost of the process itself can be expensive. While there are service providers that can assist with the verification requirement, and letters from a prospective investor’s accountant or lawyer verifying the investor’s accredited status would suffice, 506(c) offerings still tend to be much less common than 506(b) offerings.

Questions to ask your Cooley contact:

1. What are some ways I can fundraise in a 506(b) offering beyond my immediate network?
2. What are the do’s and don’ts to avoid general solicitation or general advertising?
3. What happens if I’ve inadvertently engaged in general solicitation or general advertising?
4. What type of documentation is requested from investors to satisfy the verification requirement for a 506(c) offering?

Other considerations

The securities laws principles we discussed above relate to US federal requirements. State requirements also will apply, although most firms will only need to make notice filings at the state level. Firms looking to fundraise outside the United States, and firms that are based outside the United States, will have different considerations – and other bodies of law may apply to them and their fundraising efforts.

[View source.]