By Jim Verdonik
I'm an attorney with Ward and Smith PA. I also write a column about business and law for American Business Journals , have authored multiple books and teach an eLearning course for entrepreneurs. You can reach me at JFV@WardandSmith.com.
Or you can check out my eLearning course at www.YouTube.com/eLearnSuccess
or purchase my books http://www.amazon.com/Jim-Verdonik/e/B0040GUBRW
or read my newspaper articles at
This article is one of 14 articles in a series of articles about Deal-Makers called:
LET'S MAKE A DEAL: REGULATING DEAL-MAKERS ON WALL STREET, MAIN STREET AND IN SILICON VALLEY IN THE CROWDFUNDING ERA
In article (11) of this series of articles, we examined "dealers" and why most issuers do not have to register as either a "broker" or as a "dealer" under Section 15 (a) (1) of the Exchange Act.
There are many kinds of issuers. Most issuers are not in the securities business. They sell securities to raise capital to conduct businesses that have nothing to do with buying or selling securities. What distinguishes investment funds like venture capital, private equity and hedge funds is that such investment funds are issuers that use the money they raise to purchase and eventually re-sell securities, entire businesses, real estate and other investments.
Such investment funds have to comply with the Securities Act when they sell securities to raise capital just like other issuers. But investment funds also have to comply with other securities laws, because their primary business involves securities. That means we have to deal with special securities issues whenever we deal with investment funds and the people who manage or advise investment funds. These issues include:
· How do we apply the broker-dealer rules we have been discussing to these investment funds?
· How do other laws like the Investment Company Act and the Investment Advisers Act apply to these investment fund deal makers?
· How are the JOBS Act, other regulatory reforms and technology changing the role of investment funds and their advisers, managers and general partners?
· In particular, how are special purpose entities that are organized to make a single investment or to purchase a single business becoming more powerful players by using technology to change the deal-making world and what regulations apply to their activities?
· If anyone can organize an investment fund, can issuers be proactive in helping someone to organize an investment fund that is dedicated to investing in the securities of that issuer?
· How can issuers use these changes to their advantage by taking an active role in organizing an investment fund to do their transaction?
· How can unregistered finders reduce their regulatory risks and expenses by changing their roles from being an agent to being a principal in securities transactions by organizing and managing special purpose investment funds that invest in or purchase one business?
· What legal issues do special purpose investment funds that invest in or purchase one business have to navigate?
Broker-Dealer Registration Issues for Investment Funds
The first regulatory issues are what the words "for the account of others" mean and what benefits you are permitted to derive from a securities transaction when you are acting for the account of others or for your own account.
All of the exemptions from requirements to register as a broker we discussed in earlier articles in this series of articles deal with the issues of:
- The fees you can charge, if you act as an agent or provide other services in connection with the offer, purchase or sale of securities?
- What services are you allowed to provide to issuers and investors?
Let's review the general rules about compensation we have discussed:
- You cannot charge a "success fee" in connection with the sale of securities, unless you are a registered broker, unless you rely on court cases that say that introducing investors to issuers is not the same as "effecting transactions" in securities.
other transaction based compensation that is not a "success fee"
can trigger broker registration requirements, if the services you provide
constitute "effecting transactions" in securities.
Now, let's discuss the roles people play when they earn fees.
Success fees are paid to agents for arranging a transaction between two or more principals – usually the principals are an issuer of securities and one or more investors. To be an agent, you do not have to have the power to make decisions. Most brokers in private placements and other investment transactions act as advisers and do not have discretionary power to act on behalf the principals. Essentially, being an agent means that you provide services.
But, what if you are not an "agent" at all? What if you don't provide services? What if you are a principal in the deal? What if you are making decisions about how you will invest the money of an investment fund of which you are a part owner? Do broker registration rules apply to people and entities that invest in securities and the people who manage the purchasers who are not paid a fee by issuers that sell securities?
Investment Funds and Their Managers
Now, let's compare the roles investment funds and their managers play and the benefits they receive more closely match issuers and the owners of issuers who engage in a business other than investing in securities or are the roles and benefits of investment funds and their managers more like the roles brokers play and the benefits brokers receive.
· Transaction Roles: Like issuers, investment funds and their managers make decisions and exchange cash for securities. They do not provide advice to other participants in the securities transaction or act as an agent like brokers do.
· Post-Transaction Roles. Like issuers, investment funds and their managers are beginning a relationship with the other party to the securities transaction – the issuer. The investment fund and its manager do not walk away from the relationship like a broker does. The relationship lasts as long as the investment fund owns the issuer's securities. The investment fund's managers often serve on the issuer's Board of Directors or otherwise provide advice or assistance to the issuer to help increase the investment's value.
· Transaction Benefits: The investment fund's managers usually earn nothing or very little, unless the securities they purchase appreciate in value. The people who manage investment funds usually earn a carried interest (a percentage of the investment fund's future profits, if any, from the investment) and may collect periodic management fees (usually a small percentage of the investment fund's value). Management fees are usually large enough to pay expenses and salaries, but are usually small enough that they do not constitute the manager's primary economic benefit if the investment is a success. The carried interest is worthless, if the deal does not make money for investors. This gives investment fund managers a vested interest in making the deal work for all the investors. The fund mangers' upside interest is also usually a long-term proposition - especially if the investment is in an issuer whose securities are not publicly traded. Unlike a broker-dealer, investment fund managers do not usually walk away from the closing table with an immediate profit.
So, if unregistered deal makers want to earn a long-term success fee, they could form a limited liability company or other entity to purchase a business or to invest in a capital‑raising offering. Then, the limited liability company could raise capital to buy the business or invest. In that case, the deal maker who manages the buyer would then be a principal instead of an agent.
Neither the investment fund nor the investment fund's manager would be required to register as a broker-dealer under Section 15 (a) (1) of the Exchange Act.
Competition Between Blind Pool Funds and Brokers
Now, let's focus on project finance and single purpose investment funds and how they differ from other investment funds.
Most investment funds we are familiar with invest in pools of securities. Because the contents of the pool are unknown at the time investors invest in the pool, we call them "blind pools." For example, a venture capital fund might invest in the securities of a dozen or two dozen securities over the course of a ten-year period. The venture fund's managers might tell investors that they intend to focus investments on one or more industries, or on investments in a specific geographic area or on investments in businesses that have reached a specified size or stage of development, but investors do not know the specific businesses the investment fund will invest in when they write checks to invest in the blind pool investment fund.
The managers of investment fund blind pools and registered brokers often compete with one another for the business of institutional investors and high net worth individuals. Investing in a blind pool is not the only way to achieve diversification. Brokers could provide investors with the diversification investment funds offer by selling investors offerings from multiple issuers. The primary difference is that with a blind pool the investor makes one investment decision instead of multiple investment decisions when they buy investments in multiple issuers from brokers.
Project Finance and Single Purpose Investment Funds
So far, most of the things we have discussed about investment funds would apply to both blind pools and special purpose entities.
Some of the people who invest in investment funds are institutional money managers who owe fiduciary duties to their clients, because they invest other peoples' money - like pension funds and insurance companies. How is investing in a "blind pool" consistent with anyone's "fiduciary duties?"
What motivates people (especially fiduciaries) to invest in "bind pools?"
Blind pools are usually sold based on the reputations of the investment fund's managers. If the managers have managed other funds in the past, the ROI they earned for investors in their prior funds is usually used to sell new funds to investors. This historic ROI is used despite the fact that the SEC requires disclosure to investors that "past performance in not a guaranty of future results." Like many things the SEC requires people to tell investors, investors routinely ignore these warnings about past performance and future results.
What business strategies do most "blind pools" pursue? Most blind pools tell investors that their investment is safer than investing in a specific identified issuer, because the investment fund's managers will:
· Diversify risk across a number of unknown businesses in the portfolio.
· Be able to capitalize on good investment opportunities by being able to invest quickly instead of trying to sell investors on each portfolio company.
· Add value to portfolio companies through advice and management.
· Retain money for follow on rounds in portfolio companies.
This is an efficient system for the managers of blind pools. The investment fund managers have a lot of investment discretion and the managers spend less time raising money, because in one offering they usually raise all the money they need for five or more years. But let's compare blind pools and single purpose investment funds from the perspective of investors.
Remember the investors? Securities laws are supposed to protect investors while investors try to achieve their investment goals. So, the important questions are how do special purpose entities compare to blind pool investment funds:
- In promoting investor ROI goals?
- Increasing or decreasing investor risk?
- Increasing or decreasing investor management and transaction costs?
The primary difference between doing specific project financing and raising a pool of money in advance to invest in a dozen portfolio companies over time is that investors lose the diversification of an investment pool like a traditional venture, hedge or private equity fund. But single purpose investment transactions offer investors other advantages in exchange for not providing diversification:
· Investors can invest in a "pure play."
· Investors know what they are investing in.
· Investors are not required to commit large amounts of capital over long periods of time without knowing when the capital will be invested.
· Investors receive more detailed disclosures when they are not investing in a blind pool, because a single purpose fund knows more about what it is investing in or purchasing.
Given these advantages to investors, the SEC should have no legitimate interest in squelching the growth of this type of special purpose entity investment vehicle by placing unnecessary road blocks in the way of special purpose entities competing with blind pools for investors.
Technology and Regulatory Change Cause Changes in Special Purpose Entity Market
Of course, such "pure play" investment vehicles have been legal for many years. They have been used most often in the real estate and oil and gas drilling industries, where developers and drillers describe specific properties the investment proceeds will be used to develop or drill.
What has changed is that deal makers are now permitted to use Rule 506 (c) to advertise their deals and the Internet provides a fast and cost efficient way to solicit investors to invest in specific deals in many different industries.
This combination of technology and regulatory change is creating an industry of online venture capital funds and online buyout funds that solicit investors to invest only after the fund identifies a specific deal. The investment fund's website describes the specific investment opportunity in the same way that a real estate developer would describe a specific project.
Being able to advertise to investors can reduce the time it takes to raise capital. Since the ability to use a pool of money to invest quickly is one of the primary advantages offered by traditional "blind pool" funds, the ability to solicit many investors through advertising has substantially reduced the value of one of the primary advantages blind pool funds provide to both investors and issuers trying to raise capital or people trying to sell their business.
This reduction in value is the financial equivalent of increases in how quickly software can be developed now compared to the past. By reducing the lead time to market advantage that a first market entrant has over follow-on competitors, all software became less valuable. Investors increasingly value software companies on the basis of how many users the software attracts. The software's features are less important now than in the past, because it has become much faster and cheaper to develop features now than a decade ago. So, investors expect you to have users at an earlier stage. Even if the initial product is free, users demonstrate the product has some market appeal. Investors in software businesses generally do not like to wait long periods for market reality tests when it's quick and easy to test the market with a product that will evolve over time. Likewise, tying money up in blind pools has become less attractive to investors, now that deals can be quickly sold over the Internet.
Blind pools run counter to human nature. Most people don't buy something unless you tell them what you are selling. So, blind pools have a burden of proving to investors that the advantages they offer outweigh the risks of not knowing what you are investing in.
Blind pools will always play a role, because some investors (especially large financial institutions) will prefer making one investment decision over making ten investment decisions to deploy the same amount of money. But some money that went into blind pools in the past will be diverted to special purpose investment entities by investors who want to build their own investment portfolios one piece at a time instead of relying on blind pool managers.
As technology platforms for Rule 506 offerings evolve, these deal-specific investment funds will also use technology platforms that host multiple offerings. We are likely to see offerings being made by managed deal-specific investment funds that compete side-by-side on the same technology platforms with direct unmanaged investments in offerings made by issuers that are not investment funds.
Competition Between Registered Brokers and Special Purpose Entities
Thus far, we have talked about competition between blind pools and special purpose entities and between blind pools and brokers. Now, let's shift to talking about how special purpose entities will compete with both unregistered finders and registered brokers.
As single purpose investment vehicles and crowdfunding proliferate, it will quickly become apparent that the primary difference between investment funds dedicated to investing in a specific company and an investment banker who charges a fee to invest in specific deals is the form of compensation:
· Short-term success fees for broker-dealers, who are acting as agents for the seller.
· Longer-term "carried interests" for fund managers, who are acting as principals.
Venture funds, private equity, hedge funds and other funds that invest in businesses for which there is no public trading market and their managers generally are not brokers, because they act as principals and not for the account of others, which is a primary part of the definition of the term "broker."
Likewise, such funds and their managers are not "dealers" for either securities law or tax purposes. Such investment funds invest to capture of the appreciation of the securities they purchase. Usually, there is no trading market to measure short-term gains or losses. Dealers on the other hand primarily focus on profiting from shorter term fluctuations in prices where there is an established trading market.
To compete with investment bankers and registered brokers without the same regulatory burden, online venture capital funds, buyout funds and the managers of other special purpose entities must be careful to model their activities and compensation arrangements on how traditional blind pool venture funds, private equity and hedge funds operate.
As we discuss in article (11) of this series of articles, "persons associated with an issuer" can be deemed to be subject to regulation as brokers. SEC Rule 3a4-7 provides a safe harbor for persons associated with issuers, including persons associated with special purpose entities.
We will not fully discuss Rule 3a4-7 here, because we covered it in article (11) of this series of articles. Generally any special purpose entity investment fund should avoid paying internal salesmen or owners any form of compensation that resembles a success fee for selling securities, although they can pay outside registered broker-dealers commissions to sell securities for them like any other issuer can. Venture fund managers sell securities to investors and are not compensated for selling securities, because they perform many functions, including identifying portfolio investments and managing portfolio companies by serving on Boards of Directors. Online venture funds and other special purpose entities should have their personnel perform similar functions to avoid broker registration requirements for their managers.
Equity Compensation for Deal Makers
The line between compensation for registered brokers and compensation for managers of special purpose entities becomes further blurred when broker-dealers take equity interests as all or part of their success fees.
A broker who is paid a commission in stock or warrants instead of cash does benefit from the future appreciation of the securities the broker receives the same way a fund manager benefits from the appreciation of the fund manager's carried interest. So, what is the difference between a "success fee" paid in securities to a broker and the carried interest of a fund manager?
The primary difference is that the broker's securities have a definable value on the day the broker receives the securities. Investors in the deal for which the commission was earned paid real money for the same securities. The broker might be speculating that the securities it receives will have a greater value later than on the closing date, but the securities the broker receives have the same value as the securities sold at the closing that investors receive.
Investment fund compensation for managers is usually structured so that the investment fund manager's equity interest has no value of the date the manager receives the equity interest or on the date the fund purchases securities. This is accomplished by giving fund managers a "carried interest," which is also called a "profits interest" for tax purposes. That means that although the fund manager can benefit from future profits, the fund manager's carried interest has no real value on the date the fund manager receives the carried interest. If the investment fund were immediately liquidated, the fund manager's carried interest would not entitle the fund manager to receive any distributions. All distributions would go to the investors whose capital was contributed to the investment fund.
This lack of immediate value is the reason the fund manager does not have a taxable event when the manager receives the carried interest. The broker on the other hand is taxed on the value of the securities the broker receives in the year the securities are earned by the broker. This difference in tax treatment demonstrates that there are real economic differences between the compensation systems for brokers and fund managers.
Of course, anything that might entitle someone to receive a payment at a later date has some value. The value is never reduced to zero. Both the time period until the value is realized and the level of risk that the investment might not appreciate in value affect how you would calculate that value.
That's why the IRS is skeptical of carried interests in entities that purchase real estate or other assets that can be quickly flipped for a profit or that generate predictable income streams. The more concrete, certain and quantifiable the value is, the less economic justification there is for saying a carried interest has no current value. Time and risk might not eliminate all value, but they can reduce value substantially. For example, even a lottery ticket has some value until the lottery occurs and it is determined that the ticket did not win. A winning lottery ticket might be worth $1 million dollars on the date the lottery is held, but it's only worth $1 dollar when you purchase the ticket. For tax purposes, the fund's carried interest is deemed to be worth less than a lottery ticket. Brokers, on the other hand, have to report the value of the securities received as a fee as taxable income to the broker.
Although these valuation principles relate primarily to tax issues, online venture capital funds and other special purpose entities risk being considered brokers, if the economic argument that their compensation is different from brokers who receive equity instead of cash erodes.
The other difference between a broker and an investment fund manager is that when the deal closes, the broker's job has been completed. The broker usually has no further duties to the business that issued the securities. For the broker, the "closing" usually signals the end of the relationship and he end of the broker's work. The investment fund manager on the other hand must continue to manage the investment fund to earn value through the carried interest. For the fund manager, the closing is usually just the beginning of a long-term relationship with investors and with the portfolio company in which the find invests.
Increased Competition between Brokers and Special Purpose Entity Investment Funds
What will the SEC do when online venture capital funds and other special purpose entities compete with registered broker-dealers to sell deals?
Will the SEC side with the regulated investment bankers over the less regulated online venture capital funds and require them to register as broker-dealers?
Or will the SEC recognize that online venture funds and other single purpose funds offer investors greater protection, because:
- Online venture capital funds represent the interests of investors because their compensation contract is with investors.
- The nature of the compensation structure aligns the online venture capital industry with investors, because the managers of online venture capital funds will only make money if their investors make money.
So far, we have discussed three primary factors that distinguish the emerging online venture capital industry from brokers who are required to register under Section 15 (a) (1) of the Exchange Act:
- Acting as a principal and not as an agent.
- Not receiving a short-term success fee for closing the transaction.
- The ongoing duties of a fund manager begin after the investment transaction closes.
Now, let's consider how the other regulations that apply to investment funds and their managers will apply to special purpose entities that are online venture capital and buy-out funds.
Investment Company Act and Investment Advisers Act Issues
Investment funds established to invest in securities offerings or to purchase businesses and the people who manage these funds must carefully navigate the Investment Advisers Act and the Investment Company Act. Both statutes regulate the investment industry.
Generally, the Investment Company Act regulates the entities that hold the money and investments, while the Investment Advisers Act regulates the people and entities that make investment decisions on behalf of the investment entity.
Investment Company Act Exclusions from Definition of Investment Company
Although most of the entities regulated by the Investment Company Act are traditional blind pools, the same laws apply to special purpose entities, including online venture capital finds and buy-out entities. The Investment Company Act contains a number of exclusions from the definition of the term "investment company." Many investment funds use the following exclusions:
· Section 3 (c) (1) of the Investment Company Act excludes investment funds that have fewer than 100 owners from the definition of "investment company."
· Section 3 (c) (7) of the Investment Company Act excludes from the definition of "investment company" investment funds that have any number of owners from registering as an investment company, if all the investors who purchase the investment fund's securities are "Qualifying Purchasers." Qualifying Purchasers include (i) individuals or married couples with at least $5 million of investments; (ii) a company owned by two or more related natural persons that has at least $5 million of investments; (iii) certain trusts that are formed by and managed by qualifying purchasers, if the trust was not formed for the purpose of investing in this particular investment and (iv) institutional investors with at least $25 million of investments.
Dodd-Frank Act Changes
The Dodd-Frank Act of 2010 amended the Investment Company Act to provide that investment funds that are excluded from the definition of "investment company" under Section 3 (c) (1) or Section 3 (c) (7) of the Investment Company Act are "private funds." The term "private fund" is important, because two exemptions from the requirement that fund managers register with the SEC as investment advisers pursuant to Section 203 (a) of the Investment Advisers Act are available only if the fund managers solely manage one of the two types of "private funds."
Title IV of the Dodd-Frank Act substantially changed how venture-capital funds, hedge funds, private equity and their managers are regulated under the Investment Advisers Act. Before the Dodd-Frank Act, many investment fund managers relied on the exemption from registration as an investment adviser afforded by Section 203 (b) (3) of the Investment Advisers Act, which had provided an exemption from registration for advisers who managed 14 or fewer clients, including 14 or fewer investment funds if the funds are not registered under the Investment Company Act, provided the fund managers did not hold themselves out to the public as investment advisers.
Investment Advisers Act Exemptions from Registration for Managers of Private Funds
Section 202 (a) (11) of the Investment Advisers Act defines "investment adviser" as any person who:
· "for compensation
· engages in the business
· of advising others . . . as to the value of securities or as to the advisability of investing in, purchasing or selling securities. . . ."
If you manage a "private fund" as described above, you are an "investment adviser" under the Investment Advisers Act even if you own part of the investment fund or other entity for which you are providing investment advice, but you may have an exemption from registration as an investment adviser, if you qualify for one of the Investment Advisers Act's exemptions for certain "private fund managers.".
It is important to note that the "private funds manager" exemptions are exemptions from the requirement to register as an investment adviser. The Investment Company Act provisions discussed above are exclusions from the definition of an "investment company."
This difference between an exclusion from the definition vs. an exemption from registration is important, because some provisions of the Investment Advisers Act apply to people who fall within the definition of "investment adviser" – even if they are exempt from registration. These two important exemptions for managers of certain types of "private funds" apply to managers of:
· Venture capital funds under Section 203 (l) of the Investment Advisers Act.
· And to managers of "qualifying private funds" that have in the aggregate less than $150 million of total assets under Section 203 (m) of the Investment Advisers Act.
Before we examine the venture capital manager exemption under Section 203 (l)and the qualifying private fund manager exemption under Section 203 (m) note that:
· Neither exemption limits the number of private funds someone can manage.
· For managers of venture capital funds under Section 203 (l) there is no dollar limit like there is for other types of private funds under Section 203 (m).
Let's discuss the venture capital fund exemption first.
Section 203 (l) of the Investment Advisers Act exempts from registration any adviser to one or more "venture capital funds," which under SEC Rule 275.203 (l) – 1 (issued in July 2011 in SEC Release IA-3222) means any "private fund" that:
· Represents to investors that it "pursues a venture capital strategy."
· Holds no more that 20% of its assets in non-qualifying investments.
· Does not borrow in excess of prescribed amounts of its capital.
· Does not give owners redemption rights, except in "extraordinary circumstances."
· And has not registered as an investment company or elected to be treated as a "business development company."
"Qualifying investments" referred to in Section 203 (l) of the Investment Advisers Act are generally equity securities of companies that:
- Are not public reporting companies or foreign traded companies (or an affiliate of a public reporting company or foreign traded company) when the fund makes its investment.
- Do not engage in certain prohibited borrowing and distributions.
- And are not "investment companies" or "private funds" or certain other prohibited entities.
The SEC rule also limits the amount of qualifying investments the venture fund is allowed to purchase from securities owners. In SEC Release IA-3222 (July 2011), the SEC indicates that one of the primary distinctions between venture capital funds and hedge funds or private equity is that venture capital investments are used to grow businesses not to buy out existing owners of businesses.
Now, let's discuss the "qualifying private funds" exemption provided by Section 203 (m) of the Investment Advisers Act.
Section 203 (m) of the Investment Advisers Act exempts from registration any adviser who only advises one or more "qualifying private funds" and has less than $150 million of private funds assets under management in the US. SEC Rule 275.203 (m) – 1 (d) defines "qualifying private funds" as any "private fund" that is not registered under the Investment Company Act and has not elected to be treated as a "business development company."
In navigating these rules, investment funds and their managers should consider beneficial ownership, integration, aggregation and other rules that might cause funds to exceed the limits imposed by exemptions under the Investment Company Act and under the Investment Advisers Act. The business model of online venture funds and their managers requires them to organize multiple investment funds. Managing multiple funds requires greater care to assure that beneficial ownership, integration, aggregation and other rules do not cause them to fail to comply with these exemption rules. For example, individuals may be regulated under the Investment Advisers Act, if they are an "associated person "of an investment adviser.
Primary Investment Advisers Act Compliance Issues
We won't attempt to cover all of the Investment Advisers Act and Investment Company Act here, but we will focus on some of the primary issues that the managers of "private funds" (including online venture capital and buyout funds) should consider:
· The same fund manager cannot rely on both Section 203 (l) and Section 203 (m) and cannot combine either of these exemptions with any other exemption. All your investment adviser activity has to fully comply with one of these exemptions, because both exemptions apply only to managers who solely manage one of the two types of "private funds."
· The fact that you might qualify for exemption under another provision of the Investment Advisers Act, however, does not preclude you from relying on these two exemptions as long as all the funds you advise comply with the same exemption from registration.
· Whether an investment fund that has only one investor is a fund covered by Section 203 (l) or Section 203 (m) depends on the circumstances, but the SEC indicated in release IA-3222 that it will be alert to advisers who create funds to advise individuals or clients that are really not funds and thereby avoid registration.
· One test for whether someone is managing a fund (instead of each of the owners of the fund) is whether investments are managed according to criteria designed for the fund or whether the manager uses investment criteria for fund owners. So, for example, if the circumstances of one or more of the fund's owners change, the fund manager may risk losing the exemption, if the manager changes the fund's investment criteria to suit the new circumstances of one or more owners of the fund.
· Both Section 203 (l) for "venture capital funds" managers and Section 203 (m) for "qualifying private funds" are exemptions from registration as investment advisers. Neither is an exemption from being an investment adviser.
· Some provisions of the Investment Advisers Act apply to investment advisers even if the investment adviser is not required to register.
· The SEC has the power to issue rules with respect to investment advisers that are exempt from registration under Section 203 (l) and Section 203 (m).
· Fund managers who rely on the venture-capital funds manager exemption from registration afforded by Section 203(l) or on the qualifying private funds manager exemption afforded by Section 203 (m) are required to file an abbreviated version of Form ADV with the SEC, must amend the Form ADV not less frequently than annually and are subject to periodic examinations of records by the SEC, compensation rules and certain anti-fraud rules.
As we discuss in more detail in article (12) of this series of articles, Section 203A (a) prohibits investment advisers are from registering with the SEC based on the dollar amount of the assets they manage. If an adviser (including a fund manager) manages assets that are less than $25 million in the aggregate for all funds and other clients, the adviser is prohibited from registering with the SEC, whether the adviser is subject to state regulation or not. If the value of the assets an adviser manages for all clients is between $25 million and $100 million, the adviser is prohibited from registering with the SEC, if the adviser is required to register with its home state and is subject to state examinations. Dollar amounts are measured annually.
Such advisers who are prohibited from registering with the SEC do not have to file Form ADV with the SEC and are not subject to SEC periodic examinations like advisers who are exempt from registration by reason of Section 203 (l) or Section 203 (m). Only the compensation and anti-fraud provisions and several other minor provisions of the Investment Advisers Act apply to advisers who are prohibited from registering with the SEC. For advisers under $25 million in states that do not require registration, the adviser has a regulatory free zone.
This "regulatory free zone" provides deal makers with flexibility to operate one or a series of small investment funds (whether special purposed entities or blind pools) that are under $25 million in total assets. The managers of online venture capital funds and other special purpose entities operate in this regulatory free zone.
One of the questions we raised at the beginning of this article was to what extent business owners who want to raise capital or sell their businesses can proactively use these rules to achieve their goals?
Nothing in the rules requires an owner to passively sit around waiting for an offer from a fund a blind pool manager or for someone to organize an online venture capital fund or other special purpose entity to invest in or purchase their business.
Issuers and their owners are free to encourage people to form funds and raise capital to invest or purchase their businesses as long as disclosures are made to investors and no compensation rules are violated.
If you would like to learn more, you can reach me at JFV@WardandSmith.com.
Or you can check out my eLearning course at www.YouTube.com/eLearnSuccess
or purchase my books at http://www.amazon.com/Jim-Verdonik/e/B0040GUBRW
or read my newspaper articles at