What Non-U.S. Venture Capital Fund Managers Need To Know Before Pursuing U.S. Investors
As the European venture capital fund industry continues to grow, many German and other European-based venture capital fund managers seeking to raise capital from U.S. investors are realizing that the United States regulatory landscape for private investment funds presents several challenges. While U.S. investors generally have an appetite for investing in early-stage or later-stage ventures around the globe, there are a number of business, legal, regulatory and tax hurdles to jump through for everybody who aims to tap into the U.S. market. This article summarizes key legal and U.S. regulatory considerations under the U.S. Securities Act of 1933, as amended (the “Securities Act”), as well as a particular exemption for venture capital fund managers from registration as an investment adviser under the U.S. Investment Advisers Act of 1940, as amended (the “Advisers Act”). We will address in separate articles considerations under other relevant U.S. laws governing the private investment funds industry, including important restrictions for U.S. capital raising pursuant to the U.S. Investment Company Act of 1940, as amended (the “Investment Company Act”). We will also separately address the adequate U.S. tax structure for a successful fund raising in the United States. Interested venture capital fund managers should also become familiar with effective marketing strategies, which include capital introduction meetings, road shows, the appropriate presentation of the manager’s track record and the engagement of the “right” service providers (placement agents, legal counsel, fund administrators and auditors) that can be determinative for the success of any U.S. fund raising.
Part 1 – The Rules and Regulations Governing Private Fund Offerings in the U.S.
In an effort to protect U.S. investors and the integrity of the securities industry, several rules and regulations have been developed over the years that impose certain restrictions on soliciting and accepting investments from U.S. Investors. Moreover, in the wake of several large scale frauds, like Ponzi schemes, the industry has evolved to become more conscious and vigilant about protecting Investors.
Any offering of “securities” in the U.S. must be conducted in compliance with applicable U.S. security laws, including the U.S. Securities Act of 1933, as amended (the “Securities Act”). The term “securities” generally covers the offering of “shares”, “units” or “interests” in private equity funds, venture capital funds, real estate funds or hedge funds, whether structured as limited partnerships or any other kind of company. Therefore, it is important for private fund managers, including venture capital funds, to be familiar with the various rules and regulations before beginning activities that target U.S. investors. Importantly, the sale of an interest in an investment fund that violates the Securities Act is arguably void, and investors may claim under U.S. federal or state laws to get all of their invested capital back which they may do if that fund is facing significant losses.
Why Care About Accredited Investors?
Under the Securities Act, an issuer that offers or sells its securities in the United States must register the offering of those securities under Section 5 of the Securities Act or must qualify for an exemption from such requirement. Such an exemption is available for any offering of securities which does not involve a “public offering”.
Because there could be different views on what exactly constitutes a “public offering”, Rule 506 of Regulation D promulgated by the U.S. Securities and Exchange Commission (“SEC”) provides for a “safe harbor” under Section 4(a)(2) of the Securities Act. If an issuer of securities (including a venture capital fund) satisfies the conditions of the Rule 506 safe harbor, its offering will be deemed non-public and exempt from the Securities Act’s registration requirements. The overwhelming majority of venture capital and other private investment fund managers choose to satisfy the conditions under subsection (b) of Rule 506 to utilize this safe harbor.
Generally, the Ruke 506(b) safe harbor permits an issuer to sell its securities only to persons who are “accredited investors”. “Accredited investors” are defined in Rule 501(a) of Regulation D, and include, among others:
- Natural persons who, either individually or jointly with their spouse, have a net worth, exclusive of their primary residence, in excess of U.S.$1 million, or who have had an annual income in excess of U.S.$200,000 (or U.S.$300,000 when combined with their spouse’s income) in each of the last two years and have a reasonable expectation of reaching the same income level in the current year; and
- Entities that have total assets in excess of $5 Million.
No General Solicitation
Rule 506(b) under Regulation D limits the manner in which an issuer can offer its securities to potential investors. Any form of “general solicitation or general advertising” will disqualify an offering from the Rule 506(b) safe harbor. In practical terms, fund managers who wish to rely on this safe harbor need to send materials to prospective investors in a targeted manner only (and not, for example, post such materials on a website that is accessible to the public in general).
Whether an act constitutes a “general solicitation or general advertising” can be a complex question, and U.S. legal counsel should be consulted prior to engaging in public discussions or presentations of the fund or the Manager.
Is General Solicitation Allowed Under Recent Rule 506(c)?
Pursuant to the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), the SEC also promulgated Rule 506(c) under Regulation D, which permits an offering to be deemed a “non-public offering” even if it involves general solicitation (i.e., advertising), given certain conditions. While this relatively recent rule created a lot of initial buzz, the private investment fund industry generally favors Rule 506(b), which does not permit general solicitations.
Other Regulation D Requirements; States’ “Blue Sky” Filings
An issuer relying on Regulation D is also required to file with the SEC an online, publicly available, notice on “Form D” within 15 days following the date of the first sale of securities in the applicable offering.
The U.S. state in which a U.S. investor resides may have securities laws of its own (often referred to as “blue sky” laws) which are typically nearly identical in substance to the Securities Act. Most states will permit an offering that qualified for the Regulation D safe harbor to be exempt from state registration. However, states often require that a copy of the Form D filed with the SEC be filed with the state for a fee.
Any Bad Actors?
An offering is disqualified from relying on the Rule 506(b) safe harbor if the issuer or certain other persons (including, for example, an investor beneficially owning 20% or more of the issuer’s voting power) is a “bad actor”, which means having a relevant criminal conviction, regulatory or court order or other disqualifying event occurring on or after September 23, 2013. The issuer can continue relying on the Rule 506(b) safe harbor if, having used reasonable care, it did not identify any covered person as being a “bad actor”. Because of this, U.S. legal counsel typically works with fund managers to produce questionnaires that will permit the fund to claim it used reasonable care to identify bad actors.
Other Considerations Relating to Private Fund Offerings
European venture capital fund managers should also be familiar with the following regimes, which go beyond the scope of this article:
Under anti-fraud provisions of various U.S. laws governing transactions in securities, an offer of securities needs to be made on the basis of adequate disclosure. Investment fund managers need to provide U.S. investors with all the “material” information that a reasonable investor would want to have before making an investment decision. The question of what information is material should take into account industry practice, laws and regulations applicable to registered offerings that reasonable investors typically expect. As a practical matter, fund managers work closely with U.S. legal counsel to prepare offering memoranda that contain accurate and complete information about the fund and the material risks the investment presents.
Part 2 – Is the Investment Manager Exempt from SEC Registration?
In connection with any U.S. fund raising efforts, the investment manager of venture capital or other private investment funds must also analyze whether the management of assets attributable to U.S. investors, or the management of an investment fund organized under any U.S. law, may require the registration of the investment manager as an “investment adviser” with the SEC pursuant to the Advisers Act. The investment adviser registration, and potential exemption thereof, is an important U.S. regulatory threshold question that is completely separate from compliance with the requirements of a private placement of fund interests in the United States. Investment Adviser regulation under U.S. law is complex, and this article can only provide a brief overview.
As a general matter, a German or other European-based investment manager that has no place of business in the United States does not have to register as an investment adviser with the SEC if it can rely one of the following exemptions:
- It will either rely on Section 7(d) of the Advisers Act, provided that (i) the manager has no place of business in the United States, (ii) has no “U.S. clients”, and (iii) does not manage any non-U.S. fund that has any “U.S. investor”; or
- It will claim the so called “foreign private adviser” exemption under Section 203(b)(3) of the Advisers Act, provided that (i) the manager has no place of business in the United States, (ii) all of the manager’s clients are “private funds”, (iii) the manager has, in total, less than 15 U.S. clients and U.S. investors, and (iv) the manager manages less than $25 million in aggregate assets across all of its clients attributable to U.S. clients and U.S. investors.
Venture Capital Fund Manager Exemption?
The two exemptions from investment adviser regulations discussed above will very often not be available for a German or other European-based investment manager because U.S. investors will typically prefer to invest through an investment fund organized under U.S. law for tax reasons and other considerations. Such a U.S. fund is a “U.S. client” of the investment manager, and U.S. persons investing in the fund are “U.S. investors”, for purposes of the Advisers Act. Therefore, the two exemptions discussed above would not be available as soon as the investment manager manages an aggregate of $25 million or more in assets attributable to U.S. clients and U.S. investors across all of the investment manager’s clients.
However, there are other exemptions that are potentially available. In particular, Section 203(l) of the Advisers Act provides an exemption from registration as an investment adviser for any person whose only advisory clients are solely “venture capital funds”. Such venture capital advisers can claim the status of an “exempt-reporting adviser”, i.e., they are subject to a less stringent form of SEC registration that requires the investment manager to file a simplified Form ADV and comply with only a limited universe of Advisers Act rules.
Pursuant to the applicable Advisers Act rule, a venture capital fund is a private fund that:
- holds, immediately after the acquisition of an asset, at least 80 percent of its capital commitments in “qualifying investments” (determined excluding short-term holdings) which generally consist of equity securities of “qualifying portfolio companies” that are directly acquired by the fund (see further described below);
- does not borrow or otherwise incur leverage, other than limited short-term borrowing (excluding certain guarantees of qualifying portfolio company obligations by the fund);
- represents itself as pursuing a venture capital strategy to its investors and prospective investors; and
- is not registered under the Investment Company Act and has not elected to be treated as a business development Company.
“Qualifying investments” are generally “equity securities” that were acquired by the fund in one of three ways that each suggest that the fund’s capital is being used to finance the operations of businesses, rather than for trading in secondary markets:
- any equity security issued by a qualifying portfolio company that is directly acquired by the private fund from the company (“directly acquired equity”);
- any equity security issued by a qualifying portfolio company in exchange for directly acquired equity issued by the same qualifying portfolio company (this exception permits the fund to participate in the reorganization of the capital structure of a portfolio company); and
- any equity security issued by a company of which a qualifying portfolio company is a majority-owned subsidiary, or a predecessor, and that is acquired by the fund in exchange for directly acquired equity (this exception enables the fund to acquire securities in connection with the acquisition (or merger) of a qualifying portfolio Company.
A “qualifying portfolio company” is defined as any company that:
- at the time of investment, is not a publicly traded company in the U.S.;
- does not incur leverage in connection with the investment by the private fund and distribute the proceeds of any such borrowing to the private fund in exchange for the private fund investment; and
- is not itself a fund (i.e., the company must be an operating company).
Thus, to meet the definition, at least 80 percent of a fund’s investment in each portfolio company must be acquired directly from the company, in effect limiting a venture capital fund’s ability to acquire secondary market shares to 20 percent of the fund’s investment in each company.
The SEC argued as follows:
“We believe that the limit on secondary purchases remains an important element for distinguishing advisers to venture capital funds from advisers to the types of private equity funds for which Congress did not provide an exemption. However, as discussed above, a venture capital fund may purchase shares in secondary markets to the extent it has room for such securities in its non-qualifying basket.”
The SEC Staff issued in December 2013 additional guidance regarding the venture capital exemption. To summarize, it permits:
- investments through wholly-owned holding companies (without violating the requirement to make “direct” investments);
- acceptance of non-U.S. or U.S. tax-exempt investors through a feeder fund;
- investments in “warehoused” investments (i.e., investments that were initially acquired, on a temporary basis, by the manager and then transferred to the fund); and
- transfer of investments to “side funds” so that each funds holds its pro rata share of each Investment.
Should we do it?
Navigating the regulatory landscape in the United States can seem perplexing and overwhelming. However, the U.S. regulatory regime applicable to soliciting and accepting investments in venture capital funds is fairly comprehensive and has proven manageable for quite some time. With the appropriate legal and compliance advice and processes, accessing the U.S. market is often a very viable option.
Dr. Christian Gloger
(Attorney At Law (New York), LL.M. (NYU), M.A.)
Kleinberg, Kaplan, Wolff & Cohen, P.C.
551 Fifth Avenue, New York, NY 10176
 The offer may in theory also include up to 35 non-accredited investors. However, if a fund does accept non-accredited investors, it is obligated to satisfy several other conditions which render accepting the non-accredited investors impractical in many cases. In addition, given the relatively low threshold that an investor needs to meet to qualify as an “accredited investor”, it is industry practice to accept only accredited Investors.
 In order to qualify for Rule 506(c): (i) there cannot be any unaccredited investors (while under Rule 506(b), however, an offering can remain within the safe harbor if it ends up having up to 35 unaccredited, but sophisticated investors); (ii) the fund must take “reasonable steps” to verify the accredited investor status of each investor and it is possible that these steps will include a review of the investors’ tax returns or other similar documents that few investors are willing to provide (while under Rule 506(b), however, the fund can have investors self-verify their accredited investor status without providing any back-up documentation); and (iii) the fund must have elected the Rule 506(c) safe harbor for the offering and can no longer rely on Rule 506(b) (for instance, if the fund discovers that one of the persons who purchased securities in the Rule 506(c) offering is not accredited, the fund cannot amend its election to Rule 506(b)).
 Note that other rules and regulations restrict the kind of information that can be provided. For instance, there is guidance as to the provision of investment track records, selective disclosure of past investments, etc.
 See the following general overview on investment adviser regulation with the SEC: https://www.sec.gov/divisions/investment/iaregulation/memoia.htm. See also “Regulation of Investment Advisers by the U.S. Securities and Exchange Commission”, March 2013, at: https://www.sec.gov/about/offices/oia/oia_investman/rplaze-042012.pdf
 Rule 203(m)-1 under the Advisers Act defines a “place of business” by reference to Rule 222-1(a) under the Advisers Act as any office where the adviser “regularly provides advisory services, solicits, meets with, or otherwise communicates with clients,” and “any other location that is held out to the general public as a location at which the investment adviser provides investment advisory services, solicits, meets with, or otherwise communicates with clients.”
 As an important distinction under the U.S. investment adviser regulation, the “client” of an investment manager is the investment fund or (in case of a separately managed account) the individual or other legal entity whose assets are being managed on a discretionary or non-discretionary basis. Importantly, the “investors” in an investment fund managed by the investment manager are not “clients”. Generally speaking (and with few exceptions), a client is a “U.S. client”, and an investor is a ‘U.S. investor”, if that client or investor is a “U.S. person” as defined under Rule 902(k) of Regulation S promulgated under the Securities Act.
 Being a “private fund” has to do with the investment fund’s status under the Investment Company Act. Simply speaking, to rely on the foreign private adviser exemption, all clients of the manager must be (i) investment funds (i.e., they cannot be managed account clients) and (ii) exempt from registration with the SEC as an “investment company” either in reliance of Section 3(c)(1) of the Investment Company Act (which limits the number of investors to 100) or (ii) Section 3(c)(7) of the Investment Company Act (which limits the investors to “qualified investors” as defined under the Investment Company Act). Details around these important exemptions under the Investment Company Act are complex and will be covered in a separate article.
 In many cases, funds for U.S. investors are organized as Delaware limited partnerships.
 Borrowing cannot exceed 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.
 Meeting this requirement depends on facts and circumstances as to how the fund describes its strategy to investors, but does not require the use of “venture capital” in the fund’s Name.
 This includes common stock as well as preferred stock, warrants and other securities convertible into common stock in addition to limited partnership interests.
 The Rules provides that the company is not “a reporting or foreign traded company” and does not have a control relationship with a reporting or foreign traded company. Note that the investment is permitted if the portfolio company becomes a reporting company after the Investment.
 See https://www.sec.gov/divisions/investment/guidance/im-guidance-2013-13.pdf. The SEC further recently amended the venture capital exemption to clarify that “small business investment companies” are “venture capital funds”: https://www.sec.gov/investment/secg-rules-203-l-1-and-203-m-1-ia40