ERISA is a U.S. federal statute which regulates, among other things, the management and investment of assets of employee benefit plans (such as U.S. pension plans, 401(k) plans and their related trusts). Importantly, ERISA’s regulations cover not just the employee benefit plans themselves, but also any entity deemed to hold “plan assets.” As a manager of a venture capital fund, you will want to structure your fund to avoid holding “plan assets” (as described further below). If your fund “holds plan assets”, then, you as manager of that fund are deemed to be an “fiduciary” under ERISA (and ERISA places strict restrictions on conduct in which a fiduciary to a plan can and cannot engage) and you will also be subject to a number of rather intrusive “prohibited transaction” rules that could severely impede your ability to operate your fund. Provisions of the U.S. tax code also place similar prohibited transaction restrictions on the investment of IRA assets. Perhaps most importantly, under most fund documents, a withdrawal right for ERISA investors will be triggered if the fund is deemed to hold plan assets.
In short, it is generally not practicable or possible for a typical venture capital fund manager to manage and operate an ERISA “plan assets” fund. Luckily, the path to avoiding holding ERISA plan assets is generally pretty clear and potentially self-executing for many venture capital funds. There are two primary ways venture capital funds generally avoid holding “plan assets”: (1) by ensuring that less than 25% of the fund’s commitments are held by “benefit plan investors”(the so called “25% test,” see below for how this is calculated) or (2) by operating as a “venture capital operating company” (VCOC, for short, also described below).
For purposes of the 25% test, three primary categories of prospective LPs will be “benefit plan investors” included in the numerator: (1) private U.S. pension funds (i.e., IBM’s retirement fund for its U.S. employees), (2) LPs investing through IRAs and other similar personal retirement vehicles, and (3) funds of funds which themselves have over 25% of their assets held by “benefit plan investors.” Amounts invested by LPs in categories (1) and (2) will count 100% towards the 25% test, whereas amounts invested by LPs in category (3) will only be counted on a look-through basis. For example, assume a venture capital fund has $100 million in aggregate capital commitments, IBM’s U.S. retirement fund subscribes for $10 million and a fund of funds which itself is 30% ERISA capital subscribes for $5 million. In this event, the aggregate investment by benefit plan investors will equal the full amount of IBM’s U.S. retirement fund’s $10 million commitment plus 30% of the fund of fund’s $5 million capital commitment ($1.5 million), or $11.5 million. Participation in this $100 million fund by benefit plan investors will be 11.5%, and the fund will satisfy the 25% test. Note that if the aforementioned fund of funds itself had 20% ERISA capital, it would not identify as or be treated as a benefit plan investor subject to ERISA and would not be counted at toward the 25% test at all. It is also important to note that for purposes of this 25% test, capital committed by the fund’s sponsor or its affiliates will be disregarded (from the numerator and denominator), unless such commitment is made by an affiliated benefit plan investor (such as the sponsor’s retirement plan). Finally, while this is not ordinary for most VC funds, if there are different classes of interests, this 25% test will be applied on a class by class basis and the fund will be deemed to hold plan assets if any one class of equity interest of the fund exceeds this 25% limit.
There are two types of non-ERISA investors that, while not actually counted towards the 25% test may still cause ERISA-related concern for fund managers: first, non-U.S. pension plans (i.e., Siemens retirement fund for its German employees) and second, U.S. governmental or public pension plans (i.e., CalPERS for California public employees). While not technically included in the 25% test, these investors may however, seek similar protections and covenants as ERISA investors that are so included.
In our experience, a majority of funds will be able to meet the 25% test and avoid holding plan assets in this manner. However, if your fund exceeds this 25% limit, then you will need to structure your fund in order to qualify and operate as a VCOC. You may also want to qualify as a VCOC if benefit plan investor commitments are close to the 25% limit, if you desire to preserve flexibility to accept additional ERISA commitments in subsequent closings and/or accommodate transfers to U.S. pension plans later in your fund’s life, or if you are contractually obligated to do so pursuant to an agreement with an ERISA investor.
In order to qualify as a VCOC, on each measurement date, more than 50% of the fund’s assets, valued at cost, must be invested in “operating companies” and the fund must hold “management rights” with respect to such operating companies, and actually exercise such management rights in the ordinary course of business. This 50% of assets test is measured initially on the date of the fund’s first long term investment and then annually during a fixed 90-day period, typically commencing on each anniversary of the first investment. If the fund does not qualify as a VCOC on such first investment date, the fund cannot later obtain VCOC status.
For VCOC purposes, an “operating company” is an entity that is engaged in the production or sale of a product or service, other than investment of capital – a requirement should easily be satisfied by most fund portfolio company investments. To have “management rights” the fund must have a direct contractual right to participate in or substantially influence the company’s management. A typical way to satisfy this requirement is secure the right to appoint a member of the company’s board of directors. however, it is also possible to satisfy this requirement holding lesser management rights, such as a board observer right, consultation, inspection and informational rights, rights to talk to management, etc. These lesser rights are sometimes encapsulated in a “management rights letter” and many fund managers as a matter of practice ask to obtain such a letter in the course of every investment (whether or not they intend to comply as a VCOC). Fund sponsors may in fact find that the board seat or lesser management rights are an attractive thing to gain and dovetail with their investment strategy and can leverage their fund’s ERISA compliance obligations to ask for such item(s). Obtaining a NVCA-type management rights letter has become standard operating procedure for venture investments.
Some ERISA investors may ask for a legal opinion from fund counsel to the effect that the fund qualifies as a VCOC as of the fund’s first investment, and the ERISA investor will not be required to fund their capital commitment until this opinion is delivered. In order to support a legal opinion, you will want the strongest suite of management rights possible for your first portfolio company investment, which under DOL guidance involves the right of the fund to appoint at least one member of the company’s board of directors.
As noted above, many venture capital funds will easily satisfy the 25% test or be able to qualify as a VCOC in the ordinary course of the fund’s business and should therefore be able to avoid holding “plan assets.” However, it is important to be aware of your LP base and invest in an approach and plan for ERISA compliance at the outset. Managing ERISA compliance upfront can be straightforward and painless, but, if caught off guard, retroactive compliance or correction can be arduous if possible at all.