Background

Investment managers of private funds (”Private Fund Managers”) such as venture capital, private equity, real estate and hedge funds (i.e., funds not registered under the Investment Company Act of 1940, as amended (the “Act”)) have been greatly concerned about the regulations in the Dodd-Frank Act requiring such managers to register with the SEC as investment advisers.  In the past, Private Fund Managers were mostly exempt from investment adviser registration at both the federal and state levels.  The Dodd-Frank Act eliminated the exemptions Private Fund Managers relied on previously and requires Private Fund Managers with assets under management of $150 million or more to register with the SEC as investment advisers, subject to certain exceptions which were left to the SEC to clarify.

Private Fund and VC Exemptions

On June 22, 2011, the SEC adopted final rules under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) to implement the provisions of the Dodd-Frank Act relating to investment advisers.  These rules require most Private Fund Managers to register under the Advisers Act as investment advisers prior to March 30, 2012.  The SEC also adopted two exemptions from the registration requirements:

1. the “private fund adviser exemption,” which exempts managers who advise only private funds (managers who manage private funds plus managed accounts may not use the private fund or the VC fund exemption and therefore must determine whether they are required to register at the state or federal level) and whose assets under management are less than $150 million (measure annually) (the “Private Fund Exemption”); and
2. the “venture capital exemption” which exempts managers who manage only venture capital funds as the SEC has defined such term (the “Venture Capital Exemption”).  The second exemption is of particular interest to the venture capital community (as well as the private equity and real estate communities) because it allows managers of venture capital funds to manage in excess of $150 million but remain exempt from registration and (most of) the requirements of the Advisers Act.

What is a “venture capital fund” (according to the SEC)?

Under the Venture Capital Exemption, a “venture capital fund” is a private fund that:

• Represents to investors and potential investors that it pursues a venture capital strategy;
• Invests at least 80% of its committed capital in “qualifying investments” (but may invest up to 20% in any other type of investment);
• Does not use leverage (including guarantees) in excess of 15% of the fund’s committed capital; and
• Does not provide any redemption rights to investors (except in extraordinary circumstances).

“Qualifying investments” are equity investments (which include convertible securities) in qualifying portfolio companies or equity securities issued in exchange for such equity investments made in qualifying portfolio companies by such portfolio company or any successor.  A “qualifying portfolio company” means any company (not funds or pools) that (i) is not an SEC reporting company or traded in the U.S. or abroad (nor controlled by any SEC reporting company or company traded in the U.S. or abroad), and (ii) does not issue debt in connection with the investment by the private fund and distribute the proceeds of such debt issuance to the private fund in exchange for the private fund investment (the SEC is excluding leveraged buyout funds from the venture capital fund definition).

The definition of venture capital fund did not change significantly from the proposed definition in November 2010, despite the SEC receiving over 70 comment letters on this definition alone.  The biggest change in the final rules was allowing venture capital fund managers to invest up to 20% of their capital in non-qualifying investments.  This will allow venture capital funds some flexibility to invest in what the SEC considers to be non-venture capital investments (such as bridge notes, leveraged transactions, IPO allocations, PIPEs, etc.), so long as the 20% limit is not exceeded.  The 20% limit is measured at the time of each non-qualifying investment based on value (at either cost or fair market value, whichever has been used by the fund since inception) of all non-qualifying investments as compared to committed capital (including uncalled capital) of the fund.

Are Exempt Managers Really Exempt?

Managers who meet either the Venture Capital Exemption or the Private Fund Exemption (”Exempt Managers”) will not have to register with the SEC and be subject to all of the rules, regulations and other requirements of the Advisers Act.  However, the SEC did not let Exempt Managers entirely off the hook.  Exempt Managers will still have to file a Form-ADV with the SEC, which is the same form that non-exempt managers have to file, though Exempt Managers only have to fill out certain specified parts of the ADV.  Exempt Managers will also have to pay a filing fee, be subject to certain record keeping requirements and be subject to SEC examination.  Additionally, as was the case prior to Dodd-Frank, all investment managers, whether registered or not, are subject to the anti-fraud rules of the Advisers Act.

The Form-ADV filed by Exempt Managers will be available publicly (like all Form-ADVs) and disclose basic identification details (such as name, address, contact information, form of organization, and who controls the adviser), provide details regarding other business activities in which the adviser and its affiliates are engaged, require advisers to disclose the disciplinary history of the adviser and its employees, and require disclosure information regarding each private fund.

An additional concern to Exempt Managers is how state securities regulators will look at private fund managers that fall below the federal threshold or are otherwise exempt.  Congress and the SEC delegated oversight of “mid-size advisers” (those with AUM between $25 and $100 million) to the states.  Many state securities laws and regulations previously exempted managers of private funds by relying on the federal exemptions that the Dodd-Frank Act repealed.  So it remains to be seen if private fund managers not required to register with the SEC, who in the past were also exempt at the state level, will now have to be registered with one or more states.

Conclusion

All Private Fund Managers will now have to assess where they fall in the spectrum of investment adviser registration rules (including at the state level) and whether they can avail themselves of either the Private Fund or Venture Capital Exemption.  Those that are not exempt will have to fully register, make necessary disclosures and deliveries to clients, put into place a full compliance program, name a chief compliance officer (CCO), and make themselves subject to routine SEC examinations.  Even those federally exempt advisers will have to file a shorter version of Form ADV (and update annually), pay a fee, and be subject to possible SEC exams.  Exempt Managers will also need to determine whether state registration will be required.

If you would like to review the SEC releases relating to these new investment adviser rules, you can access them under the Resources heading here.

Keith Marlowe, Esq., is the founder and managing partner of Marlowe Legal Advisors, LLC, a corporate and securities boutique law firm based in suburban Philadelphia, PA, which covers a wide range of corporate and securities matters.  A portion of Marlowe Legal Advisors’ practice is devoted to advising private funds (venture capital, private equity, real estate and hedge funds) on all aspects of their business.

Here are some of the articles that popped up since my last piece:

• What’s Really Going on in the VC Industry?  What Does it Mean for Startups? (Mark Suster) – I put this post first for a reason.  In Mark’s usual style, it kicks ass.  He covers so many valid, timely points that I’d rather just link to it than have written about them on my own.
• Angel Investor Ron Conway:  Every Entrepreneur Should Get Funded (Anthony Ha – VentureBeat) – Ron believes there still aren’t enough angels out there.  On the other hand, Mike Arrington was quoted as saying that angels are training “an entire generation of entrepreneurs who are building dipsh*$ companies” that sell to Google for $25M.  This division shows that not everyone agrees with the direction the market is taking.  I can see one of the points that Arrington was making and it is going to be the basis for my next post on the “fat/lean” start-up and how all the talk on that subject hasn’t necessarily filtered down to the entrepreneurs in the correct way.
• It’s Still Expensive to Build a Great Product (Redfin) – I like this article because it helps give some context to the capital efficiencies everyone keeps talking about.  I’ve heard the saying lately (which I think can be attributed either to Brad Feld or Fred Wilson) that it’s cheaper to start a company today (I’d re-phrase this piece to limit that to Web 2.0-type tech companies) but it costs the same amount to grow it.  This article helps flush out that issue.
• Moneyball for Startups:  Invest Before Product/Market Fit, Double-Down After (Dave McClure) – Dave hits many issues using his lively fonts, colors and language.  What I like about Dave’s posts is that you know where he stands, which you cannot say about most people.  Part of his post is devoted to his assertion that the traditional VC model is dead and that the super-seed/super-angel model will prevail.  I hate saying anything is dead, because there are no certainties in life, just cycles in my experience but Dave has some valid points.
• The Buzz on Angel and Seed Investing Continues (Brad Feld).
• Thoughts on the Seed Fund Phenomenon (Fred Wilson).
• The Rush to Early Stage Seed . . . (John Boyd).
• Understanding a VC’s Seed Funding Policy is Crucial (Mark Suster) – this is an important article to read for those of you debating between super-angel funds and raising full-on VC funding but at the seed stage.  If a VC fund puts a small seed investment into your company in order to preserve a “toe-hold” for down the line, understand that if that fund opts not to do a follow-on investment with you it could be the kiss-of-death.  Others will wonder what the VC fund (being a current investor) knows about the company that others don’t and why they opted not to invest.  They might have opted out for the most mundane of reasons, but the crowd will assume the worst and it could hurt your fundraising.  Of course, the same might be said of super-angel funds unless people begin to believe that some of those funds just don’t have the bandwidth to follow-on in all the deals they would like to.
• Why Micro-VCs are so Damn Friendly (Gregory Huang – Xconomy).
• Y Combinator’s Paul Graham:  Say Goodbye to Traditional Venture Rounds (Anthony Ha – VentureBeat) – again, I don’t believe in the “this is dead” assertion, but I do see many changes in the works.

Not only does it appear that super-angel (or micro- or super-seed) funds are filling some of the gaps and taking early stage investors off the endangered list, it may be that the pendulum is swinging back in the other direction.  Some are now forecasting a seed-stage bubble in the near future.  See the article by Liz Gannes on GigaOm, the article by Gary Whitehill, the article by Paul Kedrosky and the article by Chris Yeh at VentureBeat.  The theory goes that if too many companies receive seed stage funding, there will not be enough VC funding down the road to move those companies along to the next level and thus they will flame out due to lack of follow-on funding.  This is very similar to the bubble that occurred in the early 2000’s as a result of the ramp-up in VC funding that occurred mid-90’s to end of the 1990’s.

Comments and questions welcomed.  Thanks.

 Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-up and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups,  early-stage and emerging growth and middle market companies.

Gil Beyda, originally from Los Angeles, has Dave Morgan to thank for bringing him to Philadelphia.  When Beyda and Morgan founded Real Media in 1995, they chose to locate the online ad serving company in Fort Washington because of the cheap office space available there.  After selling the company to 24 /7 Media, the duo teamed up again in 2001 to create Tacoda, a behavioral advertising company that they then sold to AOL in 2007.  With two exits under his belt, Beyda was ready to try something new.

Read the rest here on Technically Philly. . .

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-up and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups,  early-stage and emerging growth and middle market companies.

This early stage gap is a problem that desperately needs a solution.  According to Bloomsberg Businessweek, in the 1st Quarter ‘09, venture investments plummeted to $3B (down 61%), and only $169M of that total number went to companies raising seed stage financing.  The longer this early stage gap continues without a workable solution, the greater chance the institutional venture funds and growth capital players will see a widening gap in the number of companies that reach their respective stage of investment.

The reasons for this widening gap are numerous and varied.  It’s complex, to say the least.  Here are some of the contributing factors, in my opinion:

• Angels groups, and some individual angels, are now co-investing in larger deals or later stage companies – a portion of the early stage gap (i.e., $100k – $500K) used to be purely the realm of angels (for a description of angels, see my earlier post).  In th0se early days, you’d fill in an angel round like with 1-10 individual angel investors.  Recently, however, angels have begun to form groups or networks in order to better source and diligence deals – this made finding angels a lot easier.  The law of unintended consequences though has intervened.  These groups are now easier to find, but they are also now banding together with venture funds, and in some cases individual angels, and doing syndicated rounds.  Syndicated rounds used to be the realm of just institutional funds or large private equity houses.  According to the Angel Capital Association, in 2008 the greater majority of angel groups or networks looked to invest between $250K – $500K, with $0 – $250K running a close second.  Now, two years later, rather than have one angel group put $250K in an early stage company and run the risk that such company couldn’t raise any more money down the road, angel groups are now co-investing with other angel groups or venture funds so that the total round is more like $1m or $2m or more.  With that much money, and the fact that most of these syndicated deals are occurring with expansion stage companies rather than in the early stage gap, the angel groups are able to significantly reduce at least one of the risks inherent in these deals – the company running out of money and not being able to raise more.  As I mentioned, this method of co-investing has trickled down to individual angels also.  A perfect, recent example is Swipely, a company still at the invitation-only beta stage.  Swipely recently raised $7.5M from both venture funds (First Round Capital, Greylock Partners and Index Ventures) as well as several well-known angel investors (Ron Conway, Chris Sacca and others).  What does all of this mean?  Well, the angels (both individuals and groups) that used to be putting $100K or more into a company in the early stage gap are no longer doing so.  Couple that with the fact that there is no one to step in and fill that role, and you have a significant reduction in companies being funded at the early stage gap phase.  Having angels invest at such an early stage was crucial.  Even Harvard reports that they’ve gathered evidence that angel-funded firms are less likely to kick the bucket and that improvements of 30-50% can be seen within businesses funded by sophisticated angels.  Talent like this is really needed in that early stage gap.
• It is hard to raise true early stage funds in today’s economy - it’s not the mid-90’s any more when, historically, the most venture money was being raised by old and new funds.  A lot of that money was put to use in ways that produced zero results.  In the early to mid-2000’s, many venture funds got hosed and, in turn, their limited partners got hosed too.  Limited partners, like pension funds, endowments, insurance companies, started to realize that the late 90’s bubble produced some very heady exits, but for the most part also produced a large number of duds.  It also took 8-10 years to figure out which were duds and which weren’t if you had invested at an early stage.  Nowadays, limited partners are hesitant to back true early stage funds because they don’t want to wait 8-10 years to find out where the investment is going.  Later stage funds that may only have to wait 2-3 years for an exit aren’t having those same money-raising problems.  Without limited partners supporting early stage funds, those funds are disappearing at a fast clip and with them goes what were, historically, core investors in the early stage gap. 
• There is a lot of competition right now trying to raise money in that early stage space – given the fact that this early stage gap exists, and given the fact that the creation of start-ups hasn’t seemed to wane, the competition for raising money in the early stage gap is increasing at an alarming rate.  There are lots of deals chasing very little money in that early stage gap right now. 

So – how do we fix this?  I don’t believe that a silver bullet exists (it never does), but here are some of the self-executing solutions popping up in the marketplace: 

• Capital efficiency – capital efficiency is all about doing more with less.  Don’t confuse this though with bootstrapping mentioned below.  Whereas bootstrapping generally implies that no outside money has been raised, in a capital efficient business model companies still raise outside money, but they deploy the money in a model that uses that capital efficiently.  By that, I don’t mean that the officers of that company sit around pontificating the best use of their dollars but, rather, I mean that the company uses technology to reduce their operating costs.  Recent improvements in open source software, the outsourcing of development and reduced customer acquisition costs have allowed capital efficiency to thrive in certain sectors.  It is these advancements in technology that allow companies to achieve the same level of performance but for less money.  Not everyone is a fan of capital efficiency, however.  In this article, the author does a good job critiquing capital efficiency and arguing that it does not deliver.  Eric Wiesen, a partner at RRE Ventures, argues in his article that capital efficiency leads to building incremental products with no real innovation. 
• Super-angel funds- Paul Graham, co-founder of Y Combinator, says it well on his blog when he writes “instead of making one $2M investment, [venture funds should] make five $400K investments.”  In essence, he is describing the super-angel model employed by First Round Capital, Founders Collective and Mike Maples’ new fund Floodgate.  First Round Capital’s current fund is approximately $125M (which is much smaller than some of its competitors which have $500M funds).  Nevertheless, First Round did 41 deals in 2009 which made it the 4th most active investor.  Typically, First Round’s initial investment is only $500K – $600K.  These funds are referred to as super-angels because they invest amounts reminiscent of angel investing but they are doing this out of funds that clearly exceed any angel fund in terms of overall size (e.g., First Round’s $125M fund).  Super-angel funds attempt to spread the money around in a large number of start-ups.  But super-angels also provide more than just a check.  As this article makes clear, super-angels offer at least one of three values:  (i) a networking mastermind, (ii) geniuses ability-usually in the technology arena, and (iii) deep expertise in certain fields that would simply take years to replicate.  In my opinion, super-angel funds are really trying to take seed and early stage investing back to its roots.
• Incubators – incubators can be a very effective way to bridge the funding gap because they provide free resources that can help reduce an early stage company’s overhead.  Examples of well-known incubators include TechStars, Y Combinator, and DreamIt Ventures.  States also frequently create incubators to deploy state money and resources with the main focus being the creation and retention of jobs.  The best known, and most successful, in Pennsylvania is Ben Franklin Technology Partners.  However, incubators generally deal with companies in their earliest stages, as that is the time that incubators can deliver the most value.  Some incubators provide money (either in the form of a stipend or in the form of a loan with warrant coverage), whereas others provide free access to office or lab space, office supplies and advisory resources like legal and accounting (which can be just as good as money).  Some provide both.  However, the later stage you are, the more “real” money you’ll need - it becomes less about free office space and more about being able to hire competent workers and pay them a salary.  So the incubator model certainly helps, but it only goes so far.
• Bootstrap – as mentioned above, bootstrapping a company means not raising any outside money and essentially growing the company at a pace set by retained earnings.  Bootstrapping is all about getting a lot done on very little cash.  For instance, the software industry has come up with bootstrapping methods such as minimum viable product and microtesting.  For a good article on bootstrapping see this one by the Kauffman Foundation.  Or see Guy Kawasaki’s tips on bootstrapping.  Taken to the extreme, however, bootstrapping can seriously restrict a company at a time when that company could be hitting it out of the park.  Bootstrapping can be very effective if the timing is right and if it is used early in the company’s history to overcome the initial financing hurdles.  If the company really needs to grow at a later stage then outside financing will most likely be needed.  If you are still bootstrapping a company after 5 or 10 years, it’s more likely you are running a lifestyle business that cannot even support a revolving line of credit from a bank.  For companies entering that early stage gap, bootstrapping can be an effective way to bridge that gap and reach a level where serious expansion money can be raised.  It just might take you longer to get there.

In my humble opinion, super-angel funds and incubators currently have the best opportunities to solve the early stage gap, with capital efficiencies and bootstrapping helping out in other limited area.  Questions and comments welcomed.  Thanks.

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-ups and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups,  early-stage and emerging growth and middle market companies.

• Who at the strategic is actually responsible for the investment - operations?  corporate development?  corporate venture unit?  There is a reason that the VC model works (although many right now would argue that it is broken).  VC firms are designed to do one thing – deploy money, build and grow companies and then exit the investment (hopefully with a return).  Generally, you know where the VCs’ head is.  That’s not to say that some VCs don’t have their own agenda (see Mark Suster’s latest post “Choose Your VC Investor Carefully” - my favorite quote is “Beware of VC seagulls, who shit on you and then fly away”), but most are there for the right reason.  When it comes to most strategic investors, the reasons for investment go beyond just earning a return.  On a continuum, I would put most corporate venture units on the ends closest to the VCs.  I’d put the corporate development folks in the middle and the operations group on the opposing end.  If the operations group is running the show on the investment, I think you run more of a risk of countervailing priorities.  They may not be in the investment to grow a company, rather, they may be in it to test out a new product internally and maybe tinker with it to see if they can maximize it’s usefulness for their own good – not so much the greater good that earns top returns in the marketplace.  Follow your gut.  Also, the operations end of the continuum may have less sophistication in structuring an investment.  This may work to your favor in that there may be less valuation sensitivity.  As I’ve mentioned in earlier posts, however, if you structure that first round of outside money poorly, you run a great risk of complicating your later rounds of financing.
• Is this your first round of financing or have you already raised money?  To play off of my comments at the end of the prior bullet point, and to tie this in to the next bullet point, if the strategic is coming in on your first round and they are the only investor – beware how you structure the deal.  Don’t be penny-wise and pound foolish, you’ll live to regret it during your Series B round.  If, however, you’ve already raised some money (i.e., this is a later series round), then it is more likely that the strategic is just co-investing and thus the VCs are structuring the deal.
• Is this a group of strategics?  Is the strategic leading?  Or is the strategic investor just co-investing with a group of VCs?  One of my worst nightmares involved a company that I was representing in a $37 million Series C & D round, done simultaneously.  The company’s entire Series A round consisted of four extremely large strategic investors and industry heavyweights.  Part of the current deal involved taking out the entire Series A round.  I can only remember a few other deals that were tougher than this one because the internal folks at the strategics as well as their counsel were beyond difficult and lacked an understanding of how deals like this were structured.  When the other side suspects every move you make is suspicious (mainly out of ignorance), then getting the transaction done takes four times the amount of time (and paper).  A lot of effort, time, personnel and money resources went into getting that deal done because of the approach the strategics took.  Had they not controlled the entire round, maybe it would have been more efficient.
• Do the terms of the investment go beyond just money (i.e., are they offering to test out your product, to include it in their suite of technologies, to use it internally, are they looking to license it from you)?  In my opinion, the terms better go beyond just money, otherwise the strategic is nothing more than a VC and you are losing some potential to piggyback on the strategic’s platform.  Some strategics like to invest for reasons other than just the return.  They may be interested in the technology for their own internal use or they may think it is a great add-0n for their own suite of technologies.  Maybe they have testing or research facilities that you could not otherwise afford on your own.  Maybe all of this makes you think that this strategic ultimately may just buy your company for a huge multiple right out of the starting gate.  If the terms go beyond just money, try to forecast in your mind where those other terms may lead you.  Speak to other companies that have structured deals like that.  Speak to other portfolio companies of the strategic.  What happens if the internal champion of your product leaves the strategic and now no one internally wants to test out your product.  Can you say limbo?  Also, beware that aligning yourself with one or two particular strategics may limit the deals you can broker with other strategics due to anti-competitive concerns. 
• Is the strategic’s technology complimentary or competitive?  Are they a customer or a supplier?  This question is a good follow up question for the immediately preceding question.

Some other points to consider.  Early strategic investors don’t always participate in follow-on rounds.  They may not have the amount of dry powder that a fund has to continually participate in future financing rounds.  On the plus side, strategics may be able to provide superior name cache and credibility.  That can open doors and that is priceless. 

In retrospect, this article comes off negative on strategics.  Don’t get me wrong – I love strategic investors and I would never advise anyone to turn away money for that reason alone.  But the goal here is to size up the deal and put it all in perspective.  In my experience, the best approach is (i) don’t rely entirely on strategics – they are better served as co-investors, (ii) make sure that the deal with the strategic consists of more than just money – they bring a lot to the table and you want to leverage it as much as possible to make your company more valuable, and (iii) try to stick as much as possible with strategic partners that structure their investments through an internal corporate venture unit (although you should never walk solely because of this issue).

BFTP is a non-profit, early stage investor/incubator supported entirely by state funds.  BFTP also supports established companies and they’ve been doing it since 1982.   BFTP is tasked with creating jobs and to do this they split the state into four quadrants (I happen to be most familiar with the group responsible for BFTP-Northeast PA and they are some of the most solid people around).  A 60% cut in their budget will result in significant setbacks.  Some people support the notion that BFTP should not be viewed as an expense but as an investment – and a cheap one at that.  Technically Philly points out that some reports believe BFTP returns $3.50 for every dollar invested – investments in companies that agree to keep the jobs in PA.

I sincerely hope that Pennsylvania can get a budget passed and that they are able to preserve as much capital as possible for BFTP to deploy.  I mean, we are all focused on job creation right now and who better to continue its success in doing so but BFTP.   BFTP has issued a call to action and I hope you support it.