A serious theme of this Weblog has at all times been ongoing legislative, regulatory and market initiatives to reform capital markets by concentrating on unreasonable or outdated impediments to capital formation to make it simpler for early-stage corporations to lift capital. These impediments usually are not at all times apparent or direct. One such oblique obstacle has been the enterprise capital adviser exemption below the Funding Advisors Act of 1940, the eligibility necessities of which disincentivize VC funding in secondary transactions and in different VC funds, thereby unnecessarily hampering liquidity within the innovation ecosystem. If a brand new piece of proposed laws handed by the Home Monetary Providers Committee turns into regulation, nevertheless, this obstacle will likely be eradicated.
Earlier than Dodd Frank, enterprise capital fund advisers didn’t have to fret critically about Funding Advisors Act regulation. That’s as a result of the Advisers Act exempted any funding advisor that had fewer than 15 purchasers and didn’t maintain itself out to the general public as an funding adviser. For the aim of the 15-client cap, the SEC handled every fund as one shopper. Because of this, funding advisers might advise as much as 14 personal funds, whatever the complete variety of LPs investing in a fund or the quantity of property within the funds, with out the necessity to register with the SEC.
However as a part of Dodd Frank, Congress repealed the exemption for advisers with fewer than 15 purchasers and changed it with three extra restricted exemptions below the Advisers Act, considered one of which is an exemption for funding advisers that solely advise “enterprise capital funds”. The SEC definition of “enterprise capital fund” incorporates 5 parts, considered one of which is that the fund might not make investments greater than 20% of its combination capital contributions and uncalled dedicated capital in property that aren’t “qualifying investments”. Qualifying investments are usually direct investments in qualifying portfolio corporations, which exclude personal funds or different pooled funding automobiles. Secondaries and fund-of-fund investments are thought of non-qualifying investments as a result of the property obtained by means of such transactions usually are not acquired straight from a qualifying personal firm.
The “straight acquired” requirement implies that secondary investments, i.e., purchases from non-issuers akin to founders, staff and different buyers, don’t represent qualifying investments. Additionally, investments in different VC funds are excluded from the definition of qualifying investments. Meaning VCs should rigorously monitor their secondary and funding car investments to verify they don’t exceed 20% of dedicated capital, and I believe some VCs as a matter of coverage keep away from these transactions completely to keep away from the compliance headache.
The SEC’s said rationale for the direct funding rule is its want to differentiate between VC funds, that are the topic of the funding advisor exemption, and different funding funds which aren’t. The SEC observes that one of many options of VC funds that distinguishes them from hedge funds and personal fairness funds is that they make investments capital straight in portfolio corporations for the aim of funding enlargement and growth of an organization’s enterprise quite than shopping for out current safety holders.
The inclusion inside non-qualifying investments of secondary and fund-of-funds investments, nevertheless, has been perceived by many within the VC house as contributing to an pointless obstacle to liquidity within the innovation ecosystem.
Secondary transactions have develop into more and more widespread within the enterprise capital business. As corporations stay personal longer and defer exits, the need for liquidity grows amongst founders and different shareholders. Founders and staff usually have most of their web value tied up of their firm’s shares and have an comprehensible want to diversify and generate some liquidity at present. Angel buyers search liquidity to have the ability to fund new funding alternatives. Syndicate members usually simply get drained and need out.
VCs usually make secondary purchases of shares from founders and different holders to extend their possession. The extra shares bought by VC funds in secondary transactions usually function a crucial bridge between the wants of a fund to acquire ample possession in a portfolio firm to generate enhanced returns for LPs and the issues of entrepreneurs and angel buyers over the dilution they might expertise if such extra shares have been bought straight from the corporate. With out secondary transactions, many enterprise funds and potential portfolio corporations could also be unable to bridge that hole, leading to a decline in VC investing in early-stage corporations. Secondary transactions additionally serve to align the objectives of VC funds and founders to proceed to develop the corporate quite than promoting it early to realize founder liquidity.
VC Funding in VC and Different Autos
It’s develop into widespread for VC funds to allocate a few of their funding to different VC funds in addition to different funding automobiles akin to “feeder”, “incubator”, “accelerator” or “micro-VC” funds. These seed or seed-type funds in flip make investments on the very earliest phases of a portfolio firm’s life after which depend on bigger VC funds to take part in follow-on Collection A or different future rounds. Seed funds are an incredible asset to each startups and bigger VCs, as they permit for a considerably bigger pool of corporations to obtain seed funding and kind a bigger universe of investable corporations for bigger VCs.
One other group of VC funds that receives funding from bigger VC funds is rising funds. Rising fund supervisor sponsored funds are inclined to put money into startups creating new disruptive applied sciences, and thus play an vital position within the enterprise economic system. Investing in these rising VC funds is perceived by many asset managers as posing greater threat however providing larger upside potential than extra established funds with monitor data.
Institutional LPs are sometimes occupied with greater threat, greater reward rising funds however could also be constrained by their very own minimal funding necessities which generally exceed the spherical measurement of a typical rising fund. Different institutional LPs might wish to mitigate in opposition to the danger of investing in a smaller rising fund by taking a diversified method to their funding within the house. For such institutional LPs, it will make sense to allocate some funding to a fund-of-VC funds that invests partly in rising VC funds and partly in conventional VC funds.
VCs make investments in nonetheless different kinds of funding automobiles. One instance is expertise incubators that create and spin out start-ups. One other is corporations which can be within the “invention enterprise” whose property consist nearly completely of patent portfolios. VCs additionally generally put money into funding automobiles whose different members are well-connected expertise entrepreneurs who assist VCs determine potential portfolio corporations after which put money into them facet by facet with the VCs by means of the car.
All these oblique investments at present fall inside the 20% limitation, leading to impediments to each capital formation and liquidity within the innovation ecosystem.
The DEAL Act
Final month, the Home Monetary Providers Committee handed and launched to the total Home of Representatives a centered piece of laws to revise the definition of “qualifying funding” for functions of the exemption from registration for enterprise capital fund advisers below the Funding Advisers Act. Referred to as the Creating and Empowering our Aspiring Leaders Act of 2023 or the “DEAL Act of 2023” (Congress loves catchy acronyms), it particularly orders the SEC to revise the enterprise capital fund adviser exemption’s definition of a “qualifying funding” to incorporate secondary acquisitions and investments in different enterprise capital funds. Underneath the brand new rule, shares bought by VC funds in secondary transactions or in different enterprise capital funds will now not be deemed non-qualifying investments and thus not included within the portion of a VC fund’s funding portfolio that will not exceed 20% of dedicated capital.
If handed by Congress and signed into regulation, this reform of the enterprise capital fund exemption might result in larger funding in early-stage corporations and considerably extra liquidity for founders and different early buyers. The invoice is an element of a bigger piece of laws known as the Increasing Entry to Capital Act of 2023 and now strikes by means of the legislative course of.