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Washington State to Regulate Venture Fund Managers

by Joe Wallin on May 20, 2013 in Financings with No comments

This article is appearing simultaneously on The Venture Alley and on Startup Law Blog. Readers may feel free to re-post this content elsewhere as well.

The world is changing for venture funds and similar funds in Washington State, and not necessarily for the better.  It used to be the case that managers of venture or other private funds did not need to file anything with the SEC or state securities regulators (other than Forms D incident to their fundraisings).  Dodd-Frank changed all that – but provided that investment advisers solely to venture capital or other small private funds may be exempt (based on Congress’ belief that these funds posed no systemic risk to the nationwide financial system).

There are now SEC regulations that define the new exemptions for the managers of venture funds and for the managers of private funds with less than $150M management.  Even if exempt, however, managers of venture funds and private funds with AUM of less than $150M now must publicly report certain high-level information, which becomes publicly available.  For example, here is the exempt reporting adviser Form ADV for Union Square Ventures.

These rules settled out a few years ago.  Right now, the bigger issue is with state regulators.  State regulatory regimes need to be updated in order to conform to Dodd-Frank.  The North American Securities Administrators Association (NASAA) created model rules for state regulators to follow, which adopted the same venture capital and private fund exemptions.  Many states, including California, have now adopted the NASAA model rules.

In Washington State, the Securities Division (Division) of the Washington State Department of Financial Institutions (DFI) is in the process of updating its rules to conform to Dodd-Frank.  Unfortunately for fund managers, DFI does not believe the SEC and NASAA Model Rules are enough regulation.  Their proposed rules provide that, if you don’t fall within the definition of a “venture capital fund” (as defined in the federal rule), you will generally have to register as an investment advisor in Washington State unless you are managing funds comprised only of super accredited investors (think $5M instead of $1M for individuals) – known as “qualified purchasers”.  This is going to create significant problems for funds that don’t fit the narrow confines of the “venture capital fund” definition (below).  We are actively trying to get these proposed rules changed before they are adopted, urging conformity with the federal rules, but so far the DFI has not agreed to make this change.

Here is more information on the Washington State proposed rules, from the DFI website:

Rulemaking: Investment Adviser Rules

The Securities Division is soliciting comments on proposed amendments to the investment adviser rules set forth in Chapter 460-24A WAC.

The proposed amendments would update various provisions of the investment adviser rules, including the rules regarding financial reporting requirements, custody, books and records, and unethical practices. The proposed amendments would add new rule sections addressing proxy voting, advisory contracts, and compliance procedures and practices, and would create exemptions from registration for certain private fund advisers and venture capital fund advisers. Many of these changes would make Washington’s rules consistent with current federal law and NASAA model rules.

Please find a copy of the proposed rule making notice and the text of the proposed rules below.

Public Hearing – May 21, 2013 – 1 PM

A hearing will be held on the proposed rulemaking on May 21, 2013 at 1:00 pm at the Department of Financial Institutions office in Tumwater, Washington. See:Directions to DFI.

Documents

Submit Your Comments

If you have any questions or comments, please contact Jill Vallely at (360) 902-8801 or by email at jill.vallely@dfi.wa.gov.

Below is the relevant text from the Washington proposed rules, and a summary of the federal rules and filing requirements.

Proposed Washington Regulations

Here is the relevant WAC provision in the proposed rules regarding exemption for venture capital fund managers:

WAC 460-24A-072 Registration exemption for investment advisers to venture capital funds.

(1)  Exemption for venture capital fund advisers. You are exempt from the registration requirements for investment advisers in RCW 21.20.040 if you are exempt from registration under Section 203(l) of the Investment Advisers Act of 1940, 15 U.S.C. 80b-3(l), and Rule 203(l)-1 adopted thereunder, 17 C.F.R. 275.203(l)-1, provided you satisfy each of the following conditions:

(a) Neither you nor any of your advisory affiliates are subject to a disqualification as described in WAC 460-44A-505(2)(d); and

(b) You file with the division each report and amendment thereto that an exempt reporting adviser is required to file with the Securities and Exchange Commission pursuant to Securities and Exchange Commission Rule 204-4, 17 C.F.R. 275.204-4.

The tricky thing here is the rules surrounding what constitutes a venture capital fund. There are mathematical tests, prohibitions on leverage, redemption prohibitions, etc.:

Venture Capital Fund Defined

Under the SEC’s regulations, a venture capital fund is any private fund that:

(1) Represents to investors and potential investors that it pursues a venture capital strategy;

(2) Immediately after the acquisition of any asset, other than “qualifying investments” (see definition below) or short-term holdings, holds no more than 20 percent of the amount of the fund’s aggregate capital contributions and uncalled committed capital in assets (other than short-term holdings) that are not qualifying investments, valued at cost or fair value, consistently applied by the fund;

(3) Does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15 percent of the private fund’s aggregate 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, except that any guarantee by the private fund of a qualifying portfolio company’s obligations up to the amount of the value of the private fund’s investment in the qualifying portfolio company is not subject to the 120 calendar day limit;

(4) Only issues securities the terms of which do not provide a holder with any right, except in extraordinary circumstances, to withdraw, redeem or require the repurchase of such securities but may entitle holders to receive distributions made to all holders pro rata; and

(5) Is not registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), and has not elected to be treated as a business development company pursuant to section 54 of that Act (15 U.S.C. 80a-53).

A lot of funds in the area are going to be what can be thought of as so-called “hybrid” funds. Those funds are going to be in a tough spot under the new proposed rules if they have plain old fashioned “accredited investor” LPs, since they will not qualify as managers of “qualifying private funds” and may have to register as investment advisors in Washington State.

Here is the relevant WAC provision in the proposed rules regarding exemption for qualifying private fund managers:

WAC 460-24A-071 Registration exemption for investment advisers to private funds. (1) Exemption for private fund advisers. You are exempt from the registration requirements for investment advisers in RCW 21.20.040 if you are a private fund adviser as defined in WAC 460-24A-005 and you satisfy each of the following conditions:

(a) Neither you nor any of your advisory affiliates are subject to a disqualification as described in WAC 460-44A-505 (2)(d); and

(b) You file with the division each report and amendment thereto that an exempt reporting adviser is required to file with the Securities and Exchange Commission pursuant to Securities and Exchange Commission Rule 204-4, 17 C.F.R. 275.204-4.

WAC 460-24A-005 Definitions. For purposes of this chapter:   *   *   *

(8) “Private fund adviser” means an investment adviser who provides advice solely to one or more qualifying private funds.

(9) “Qualifying private fund” means a private fund that meets the definition of a qualifying private fund in Securities and Exchange Commission Rule 203(m)-1, 17 C.F.R. 275.203(m)-1, other than a private fund that qualifies for the exclusion from the definition of “investment company” provided in section 3(c)(1) of the Investment Company Act of 1940, 15 U.S.C. 80a-3(c)(1).

Exempt Reporting Adviser

Under the Washington proposed rules, even if you meet the above definition, you will still have to file report as an exempt reporting adviser.

Conclusion

We should know more in the coming weeks but please contact us if you share our concerns with the proposed rules or would like more information on how to provide comments.

Asher Bearman asher.bearman@dlapiper.com

Joe Wallin JoeWallin@dwt.com

How Dilution Works

by Joe Wallin on March 13, 2013 in Financings, Startup Law with 7 Comments

How Dilution WorksSometimes founders will ask me the following question:

    “The founders stock will be equally diluted when we bring in new investment money, right?”

And sometimes they will ask me:

    “When the company raises money, do we give some of our shares back to the company? How does it work?”

Let me show you an example of how it works:

Bill and Paul form a software company. Bill gets 60% of the shares, Paul gets 40%.

They plan to issue 1,200,000 shares to Bill, and 800,000 shares to Paul.

Their lawyer also told them at the outset to adopt a stock option plan, representing 10-15% of the issued and outstanding shares, to get the adoption of the plan out of the way, and to have it available right away so that when they started hiring employees and independent contractors and board advisors they can grant options. They did that, and put 300,000 shares in the plan.

Immediately after the founding of the company, the cap table looks like this:

Bill 1,200,000 52.17%

Paul 800,000 34.78%

Pool 300,000 13.04%

2,300,000

When they go to raise money, the company will issue new shares out of its “authorized but unissued” shares. The founders won’t give back any shares.

What are authorized but unissued shares? These are shares the company has authorized in its articles of incorporation but not issued. In the above example, the company would probably have 10 million shares authorized. In this instance the company has only issued 2 million, and reserved 300,000 for issuance under the pool. So it has plenty of shares to issue to the investor. If the company sold 200,000 to an investor, the cap table would look like this afterward.

Bill 1,200,000 48.00%

Paul 800,000 32.00%

Pool 300,000 12.00%

Investor 200,000 8.00%

2,500,000

What Would Derek Zoolander Say About Crowdfunding?

by Joe Wallin on February 25, 2013 in Federal Law & Regulation, Financings with 10 Comments

By Christina Chan & Joe Wallin

I don’t want to bring you back to your high school days (aren’t we all glad those days are over?), but remember when you sat down for a test and your teacher said “Remember to read the instructions before starting”?  Maybe you even had one of those particularly cruel teachers who actually put the answers in the instructions just to see who would read them. If you were anything like me, you probably rolled your eyes and ignored the advice.

When it comes to reading the new crowdfunding law under the JOBS Act, however, you would do well to listen to the words of your old high school teacher.  Before the JOBS Act was passed in March of 2012, there was a lot of excitement in the blogosphere anticipating the legalization of equity crowdfunding.  To the dismay of many in the startup world, the crowdfunding provisions in the JOBS Act  read like a list of what companies can’t do, rather than what they can.  (I’m reminded of that great scene in Zoolander when Derek is presented with a model of the ridiculously named “Derek Zoolander Center For Children Who Can’t Read Good And Wanna Learn To Do Other Stuff Good Too” and Derek’s response is angrily yelling “What is this?!”)

There are many limitations and qualifications on equity crowdfunding in the JOBS Act and it will be important to read and understand them all before embarking on an offering, when crowdfunding ultimately does become legal.

In this post I want to draw attention to a commonly misunderstood crowdfunding provision in the JOBS Act: the monetary limitations on how much investors can invest.

Section 302(a)[1] of the JOBS Act limits the aggregate amount an investor can invest in a company during a 12 month period through the following provision:

(B) the aggregate amount sold to any investor by an issuer, including any amount sold in reliance on the [crowdfunding] exemption provided under this paragraph during the 12-month period preceding the date of such transaction [must] not exceed —

(i) the greater of $2,000 or 5 percent of the annual income or net worth of such investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; and

(ii) 10 percent of the annual income or net worth of such investor.

This provision does not sound so onerous by itself; you might conclude that under this provision an investor can invest in a number of different crowdfunding offerings, as long as the investor does not exceed the cap with respect to any one issuer.

But keep on reading…

Section 302(b)[2] of the JOBS Act places certain requirements on persons acting as intermediaries in a crowdfunding transactions (a registered broker or funding portal).  This includes a requirement that the intermediary “make such efforts as the Commission determines appropriate, by rule, to ensure that no investor in a 12 month period has purchased securities offered pursuant to section 4(6) that in the aggregate, from all issuers, exceed the investment limits set forth in section 4(6)(B).” (emphasis added).

In other words, imposed on the intermediaries through which a company must conduct its crowdfunding offering[3] is an additional limitation to the dollar amounts investors can invest. The cap on investment described above applies to the aggregate crowdfunding investments made by an investor in a 12 month period, not just the investment made in a particular company.

It’s not clear how portals and brokers are going to coordinate keeping track of all the past crowdfunding investments made by a particular investor.  Nor is it clear yet what the SEC will actually require portals and brokers to do to ensure investors do not exceed the cap in the rule.  For now, just keep in mind Derek Zoolander.

 


[1] New Section 4(6) of the Securities Act of 1933.

[2] New Section 4A of the Securities Act of 1933.

[3] Remember under the new crowdfunding exemption, issuers can only sell stock through an intermediary: either a broker-dealer or registered crowdfunding portal. Section 302(a) of the JOBS Act (new Section 4(6)(C) of the Securities Act of 1933).

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