Washington State to Regulate Venture Fund Managers

pile_on_side(1)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.


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.


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

Thank you, Andrew Kinzer, for the image.

Posted in Financings | Tagged , , , , , , | 2 Comments

SEC Fires Another Salvo in the “Finder” Debate

FindersThe SEC recently issued orders against two individuals and a company and, in doing so, continued the debate over what conduct requires someone acting as a “finder” to be registered as a broker or dealer or associated with a registered broker or dealer.  This new guidance makes clear that the SEC takes a hard-line position on unregistered finders who receive transaction-based consideration, under facts and circumstances where such finders take an active role in securities transactions.

In the words of the SEC, “[t]he federal securities laws require that an individual who solicits investments in return for transaction-based compensation be registered as a broker.”

What is the New Development?  The SEC’s new action is an order instituting alternative cease-and-desist proceedings against the individuals and their company.  You can find a copy of the order and associated SEC press release.

What are the take-aways from the SEC orders?

Don’t do the following if you aren’t either a registered securities broker or associated with a registered securities broker:

  • As an independent consultant,
  • Actively solicit investors on behalf of a company,
  • Receive in return transaction based compensation, and
  • Include in your solicitation efforts sending PPMs, subscription documents and due diligence materials to potential investors.

If you do the above, under the order, you may become the subject of an SEC action.

What About SEC vs. Kramer?

In 2011, a Florida federal trial court in SEC vs. Kramer shot down the SEC’s position on what is a finder, holding that the “finder” question requires analysis of at least six factors, not merely whether there was transaction-based compensation paid to the finder.  “In the absence of a statutory definition enunciating otherwise, the test for broker activity must remain cogent, multifaceted, and controlled by the Exchange Act.”  The SEC appealed that decision, but the appeal was dismissed on procedural grounds.

The “finder” question remains unresolved, but prudence would suggest that any person who regularly engages in the business of finding investors and who receives transaction-based compensation should register as a broker-dealer.

What Does Form D Say?

In addition, you should be aware of the following:  Companies raising funds are almost always required to file a Form D with the SEC and state securities regulators.  The Form D requires disclosure of sales compensation, including the name of the recipient and whether the recipient has or doesn’t have a Central Registry Number (which licensed broker-dealers have).  In addition the form requires sales commissions and “Finders’ Fees” to be separately broken out and reported.

What Does California Say?

California has a statute governing finders.  Corporations Code Section 25501.5 provides purchasers of securities a rescission right for purchasers who purchased securities from a broker-dealer that were required to be licensed and were not.


The securities regulators don’t like finders.  If you are a company raising funds, be extremely cautious if you are approached by someone who wants to act as an unregistered finder.

Posted in Federal Law & Regulation | Tagged , , , , , | 8 Comments

Young Entrepreneur Social Charity Auction

YESDo you want to make a local impact right now?

Are you someone interested in encouraging young entrepreneurs and leaders here in Seattle?

Or, are you a young leader yourself who is interested in building a better community locally?

On June 6th, the Young Entrepreneur Social is hosting a charity auction at the Bellevue Arts Museum in support of an innovative online platform that will incentivize young leaders to connect, share resources, mentor and volunteer to make a difference in their local communities.

YES, a local non-profit supporting young entrepreneurs and leaders, believes this platform will have a profound impact on creating resources, community and support for Seattle entrepreneurs and get these young leaders giving back at a much younger age than they normally would to support local non-profits and provide a more vibrant Seattle community.

So, please come join us at 7:30 on June 6th for this red-carpet affair where you will have full access to the Bellevue Arts Museum, drinks, hors d’oeuvres, entertainment, great networking and a host of exciting silent auction items to help support our cause. Tickets are available at Shindigg.com/YESExp and donations are also accepted.

Get your ticket by Monday, May 20th, and save 33% with our early bird special!

The event has been fully funded by our event sponsors so 100% of proceeds from ticket sales, donations, and silent auction items will go directly to funding the YESLeaders.org platform, which a prototype of the platform will be unveiled for the first time to attendees of this event.


        Thursday, June 6, 2013
        7:30 PM


        Bellevue Arts Museum
        510 Bellevue Way NE
        Bellevue, WA 98004

Made possible by Flowroute, the best way to route wholesale VOIP.

And with thank you to BECU, Mark Wright & King 5 News, the Miss Washington USA organization, 1Hundred Bistro & Bar, Classic Helicopter Corporation and Shiatsu Balance for additional support.


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Incentive Stock Options vs. Nonqualified Stock Options

ISO vs NQOCompanies and service providers to companies frequently confront this question. Which is better: an Incentive Stock Option (aka a statutory stock option) (an “ISO”) or a Nonqualified Stock Option (aka a Nonstatutory Stock Option) (an “NQO”)?

What are the differences between ISOs and NQOs?

The table below summarizes the primary differences:

Eligibility Limitations: Only employees (so, a nonemployee member of the board of directors can’t receive an ISO). Employees and independent contractors are both eligible.
Options taxable upon receipt? No – as long as priced at FMV at grant. No – as long as priced at FMV at grant.
Options taxable upon vesting? No – as long as priced at FMV at grant. No – as long as priced at FMV at grant.
Option taxable upon exercise? Not for ordinary income tax purposes; but spread is taxable for alternative minimum tax purposes (“AMT”). Exercise NOT subject to employment tax withholding. Yes for ordinary income tax purposes, and is subject to income and employment tax withholding. No AMT consequences.
Employment tax on exercise? No Yes
Annual limitation? Yes; only up to $100,000 in stock underlying ISOs can become exercisable in any calendar year. No
Special rule for greater than 10% shareholders? Yes; options to greater than 10% shareholders must be priced at least 110% of FMV and not be exercisable after the expiration of 5 years from the date of grant. No
Alternative Minimum Tax Applicable? Yes, on the spread on exercise. No
Character of income on sale of stock? Long-term capital gain, IF the two holdings periods are met. You have to have held the stock for 1 year after exercise, and for at least 2 years after the grant of the option. If you don’t meet these two holding periods, then the income is a mix of ordinary and long-term or short-term capital gain, depending on the spread at the time of exercise and appreciation (if any) and length of time between exercise and sale. Either long term or short term capital gain, depending on how long the stock was held after exercise.
Spread on Exercise Deductible to the company? No Yes


I recommend NQOs over ISOs for the reasons I summarized in the article Should I Grant ISOs or NQOs?

To reiterate my arguments in favor of NQOs over ISOs briefly:

  1. ISOs are more complex and difficult to understand for a variety of reasons, including (a) the two holding periods, (b) the annual limitation, (c) the eligibility restriction, (d) the greater than 10% shareholder rule, (e) complexities associated with disqualifying dispositions, but most significantly because of the AMT consequences on exercise when there is a spread.
  2. It is easier for companies to simply have one type of award to explain to their service providers – NQOs.
  3. Most employees don’t meet the holding period requirements of ISOs in any event – because they wait to exercise until there is a liquidity event – so the primary benefit of ISOs – capital gain on sale of the stock – is not obtained.
  4. NQOs are more transparent than ISOs because the tax withholding on exercise is more easily calculated.
  5. The spread on the exercise of NQOs is deductible to the employer.
Posted in Business/Corporate Law, Startup Jargon/Definitions | Tagged , , , | 7 Comments

Valuation of Emerging Technology Companies: What You Need To Know

Valuation of Emerging Technology CompaniesAre valuations art or science?

Why aren’t all valuations the same?

How much is common stock worth relative to preferred stock?

The answers to these and many other pressing questions will be answered when Greg Endicott, Managing Director of Strategic Value Group, LLC, brings his 20 years of experience and knowledge to Davis, Wright, Tremaine for this valuable meetup.

This will be a free forum discussion.

Some of the issues discussed will be:

  • The different reasons for valuations of early-stage companies
  • Valuation methodologies utilized at the various stages of development
  • The why, who and when of 409A valuations


    Monday, May 20th, 2013
    7:30 am


Davis Wright Tremaine LLP

    John Davis Conference Room
    1201 Third Avenue, Suite 2200
    Seattle, WA 98101
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