Defining The “Threat Level” Of A VC Fund

Much has been written recently about whether venture capital and/or private equity funds should be regulated. The general idea behind proposed regulation is that any entity that could pose a risk to the nation’s financial network should be regulated to try to ensure that we avoid the messes that got us into this current recession.

So the question then is, “Who presents a possible threat?” The arguments coming out of the VC world are essentially “Not us for a bunch of reasons.”

Congress seems to agree. The proposed regulations have new language that would exempt venture capitalists. It says:

‘‘(l) EXEMPTION OF AND REPORTING BY VENTURE CAPITAL FUND ADVISERS.—The Commission shall identify and define the term ‘venture capital fund’ and shall provide an adviser to such a fund an exemption from the registration requirements under this section. The Commission shall require such advisers to maintain such records and provide to the Commission such annual or other reports as the Commission determines necessary or appropriate in the public interest or for the protection of investors.’’

Good. So how do we define “venture capital fund?”

Dan Primack recently asked this question, especially in light of recent transactions like the Skype deal. The Skype deal had a mix of buyers, both PE firms and traditional VCs, and the deal included some leverage. Once VCs start venturing into deals like Skype or PIPEs or other similar transactions, the door is opened to the possibility that maybe venture investing isn’t so risk free to the public or that funds or activities exempt from registration need to be more carefully defined than simply carving out VCs generally.

Primack suggests a 90/90/90 rule on which funds would be exempt if they (i) invest 90% or more of their capital in equity-only deals, (ii) invest 90% or more of their capital in private companies, or (iii) hold 90% of their investments for 3+ years.

I believe the exemption should have a few options. Just as you can be exempt from needing to register a sale of securities if you fall under any of a number of rules promulgated by the SEC, I think a fund should be exempt from regulatory burdens if it meets any of a number of tests, which could include the following:

1. The fund and its affiliated entities manage under $1 billion. If you manage under $1B, you’re not a threat to the overall economy no matter what you do.

2. Any of Primack’s suggested 90/90/90 tests on their own. This should be three separate exemptions rather than having to meet all three. Each alone should provide adequate safety. For purposes of clarification, I’m assuming the first test would include a requirement that the purchases of equity securities not be leveraged. Note, however, I’m note sure how you can assume you’d meet the third test. For instance, if a fund made investments that it assumed would be held for 5+ years but happened to have earlier than anticipated exits on those investments, would it blow its exemption?

3. The fund raises at least a certain percentage of its money from Qualified Purchasers that do not resell their interest in the fund within a 3 year period. The assumption with this one would be that the fund doesn’t really need to be regulated by the government if Calpers, Harvard and the like are its only LPs. Those LPs should have the muscle and intelligence to provide more than sufficient oversight of the fund’s operations. We would need the restriction on resales to avoid the mess that happened with mortgages not being held by the initial investor or lender (and therefore arguably being sloppy about investment criteria because they knew they wouldn’t have any long term skin in the game), but this exemption should otherwise provide enough safety.


Paul Koenig is co-founder and managing director of Shareholder Representative Services (, which serves as a professional shareholder representative following the acquisition of a VC-backed portfolio company.