The Cooley fund group hears from clients with great frequency that an opportunity to make an attractive portfolio company investment – perhaps in a competitive deal, where access is limited – needs to be captured before the scheduled closing of their new venture capital fund. The dilemma comes up from both our established and our first-time fund managers. Whether the timeline to fund closing is lagging, or the deal pipeline is simply cranking out opportunities faster than the formation cycle can accommodate, the idea of missing out on a deal can put the entire GP team on edge. Don’t panic! There are several viable options to consider, yet also a few “gotchas” to avoid. The key considerations to balance include your Investment Advisers Act exemption, establishment of Venture Capital Operating Company status, locating and securing a suitable source of capital, limiting post-closing transfer mechanics and, of course, compliance with the fund’s limited partnership agreement.
Here is a quick rundown of why these issues matter:
Advisers Act Exemption. Most of our VC fund clients rely on an exemption under the Investment Advisers Act – known helpfully as the “venture capital fund exemption” – that essentially requires that at least 80% of capital be invested in primary transactions in qualifying portfolio company issuers. Hence, an important principle to staying inbounds in regard to this exemption is not to rely upon a warehousing solution that requires sale by some interim holder that would result in the transfer to the fund, once formed, to be a “secondary” transaction, as that would not count on the “good side” of the 80% rule. Recognizing that warehousing investments is an important tool for venture capital funds, the SEC in its December 2013 guidance stated that a warehoused investment would be deemed an investment directly acquired from the issuer if (i) the warehoused investment is initially acquired by the adviser (or a person wholly owned and controlled by the adviser) directly from a qualifying portfolio company solely for the purpose of acquiring the investment for a prospective venture capital fund that is actively fundraising; and (ii) the terms of the warehoused investment are fully disclosed to each investor in the venture capital fund prior to each investor committing to invest in the fund.
Secondly, there are also limitations on long term borrowing as part of these rules. The borrowing limit is 120 days, so even if your bank (or a third party) are willing to lend to facilitate the warehousing (perhaps by forming the fund early and borrowing to close the transaction), one has to be sure to repay the borrowing in time and this can sometimes be problematic if the fund formation transaction unexpectedly is delayed.
VCOC Status. If you will have limited partners in your fund that are subject to ERISA, you may need to establish and maintain Venture Capital Operating Company status. The first long term investment by a fund is a mandatory measurement point in the VCOC analysis. So whatever warehousing path you choose, you can’t forget to secure necessary management rights (e.g., a management rights letter) in the investment. A secondary sale to the fund as part of the warehousing process is not a problem per se, so long as the appropriate management rights are established directly with the fund (not just the interim warehousing entity).
Source of Capital. While “finding the money” to close the transaction is obviously more of a business point than a legal one, we would point out that the instinct to borrow the capital should be thoughtfully managed, as in addition to the 120 day limit mentioned above in regard to the VC Fund Exemption, you must also be mindful not to create a circumstance where a tax exempt LP in the fund would have “unrelated business taxable income” upon the disposition of the warehoused securities. So if the plan would be to form the fund with a strawman LP and to borrow the capital needed for the deal, UBTI is an issue that you must keep in mind – if the securities purchased are sold within one year of repayment of the borrowing, UBTI will be incurred by the fund and your tax exempt investor will be cross with the sponsor as it will likely have to pay corporate tax on such income. Finding an anchor (or simply friendly) LP willing to close on a fast track and fund a capital call on an expedited basis takes out the issues associated with borrowing – simple, but effective. We have also seen borrowing from the general partner or the management company used in various ways, but our take away was that such solutions were often administratively messy and potentially more expensive to execute with confidence.
Transfer Mechanics. Lots of warehousing solutions have some entity or person other than the new fund act as the purchaser of the shares, with intention to transfer the securities when the fund has its initial closing. In addition to the other issues that may present (above), don’t forget to account for the fact that such transfer will need to be processed by the portfolio company. Hot deals that you had to fight to get access to are not always situations where it is ideal to go back to the issuer asking for a small favor. And VC funds also need be mindful of ROFRs or other similar limitations on transfer that might lurk in the portfolio company securities purchase documents. Solutions that involve forming the fund entity “early” as discussed above are superior in this area, as title to shares need not transfer as the fund admits the full body of long term LP investors.
LP Agreement Compliance. Whatever solution is pursued, we recommend that the LPA clearly outline the terms of the warehouse investment program, including a schedule of warehouse investments, transfer price for the investments (usually at cost plus transaction fees), and timing for making the transfers (usually recommend within 60-90 days following the final closing to provide some flexibility).
Next, we recommend that when using an affiliate to warehouse the securities, you should avoid a contribution in-kind of the warehoused securities, but rather process the ultimate transfer to the fund as a purchase at cost. Some GPs will ask if they can just contribute the warehoused securities in-kind but this can complicate the fund’s accounting, cause issues if transferring at FMV (rather than cost) and is not expressly provided under the SEC guidance for warehousing (SEC guidance speaks to the transfer of the warehoused interests rather than contributions).
Finally, if the fund wishing to acquire the securities in question has a prior fund, careful thought should be given to investment allocation principles set forth in the LPAs. The agreements of both the prior fund and the current fund may speak to the obligation of the sponsor to present opportunities, and the warehouse transaction might violate such principles of one fund or the other, particularly if the prior fund is not quite finished making new first time investments or if the sponsor has in mind to split the investment between two generations of funds.