[Federal Register Volume 76, Number 129 (Wednesday, July 6, 2011)]
[Rules and Regulations]
[Pages 39646-39703]
[FR Doc No: 2011-16118]

Vol. 76

Wednesday,

No. 129

July 6, 2011

Part IV

Securities and Exchange Commission

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17 CFR Part 275

Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers
With Less Than $150 Million in Assets Under Management, and Foreign
Private Advisers; Final Rule

Federal Register / Vol. 76 , No. 129 / Wednesday, July 6, 2011 /
Rules and Regulations

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 275

[Release No. IA-3222; File No. S7-37-10]
RIN 3235-AK81

Exemptions for Advisers to Venture Capital Funds, Private Fund
Advisers With Less Than $150 Million in Assets Under Management, and
Foreign Private Advisers

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission (the ``Commission'') is
adopting rules to implement new exemptions from the registration
requirements of the Investment Advisers Act of 1940 for advisers to
certain privately offered investment funds; these exemptions were
enacted as part of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (the ``Dodd-Frank Act''). As required by Title IV of the
Dodd-Frank Act--the Private Fund Investment Advisers Registration Act
of 2010--the new rules define ``venture capital fund'' and provide an
exemption from registration for advisers with less than $150 million in
private fund assets under management in the United States. The new
rules also clarify the meaning of certain terms included in a new
exemption from registration for ``foreign private advisers.''

DATES: Effective Date: July 21, 2011.

FOR FURTHER INFORMATION CONTACT: Brian McLaughlin Johnson, Tram N.
Nguyen or David A. Vaughan, at<PHONE_NUMBER> or<EMAIL_ADDRESS>
Division of Investment Management, U.S. Securities and Exchange
Commission, 100 F Street, NE., Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION: The Commission is adopting rules 203(l)-1,
203(m)-1 and 202(a)(30)-1 (17 CFR 275.203(l)-1, 275.203(m)-1 and
275.202(a)(30)-1) under the Investment Advisers Act of 1940 (15 U.S.C.
80b) (the ``Advisers Act'').\1\
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    \1\ Unless otherwise noted, all references to rules under the
Advisers Act will be to Title 17, Part 275 of the Code of Federal
Regulations (17 CFR 275).
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Table of Contents

I. Background
II. Discussion
A. Definition of Venture Capital Fund
1. Qualifying Investments
2. Short-Term Holdings
3. Qualifying Portfolio Company
4. Management Involvement
5. Limitation on Leverage
    6. No Redemption Rights
    7. Represents Itself as Pursuing a Venture Capital Strategy
    8. Is a Private Fund
    9. Application to Non-U.S. Advisers
    10. Grandfathering Provision
    B. Exemption for Investment Advisers Solely to Private Funds
With Less Than $150 Million in Assets Under Management
    1. Advises Solely Private Funds
    2. Private Fund Assets
    3. Assets Managed in the United States
    4. United States Person
    C. Foreign Private Advisers
    1. Clients
    2. Private Fund Investor
    3. In the United States
    4. Place of Business
    5. Assets Under Management
    D. Subadvisory Relationships and Advisory Affiliates
III. Certain Administrative Law Matters
IV. Paperwork Reduction Analysis
V. Cost-Benefit Analysis
VI. Regulatory Flexibility Certification
VII. Statutory Authority
Text of Rules

I. Background

    On July 21, 2010, President Obama signed into law the Dodd-Frank
Act,\2\ which, among other things, repeals section 203(b)(3) of the
Advisers Act.\3\ Section 203(b)(3) exempted any investment adviser from
registration if the investment adviser (i) had fewer than 15 clients in
the preceding 12 months, (ii) did not hold itself out to the public as
an investment adviser and (iii) did not act as an investment adviser to
a registered investment company or a company that has elected to be a
business development company (the ``private adviser exemption'').\4\
Advisers specifically exempt under section 203(b) are not subject to
reporting or recordkeeping provisions under the Advisers Act, and are
not subject to examination by our staff.\5\
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    \2\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Public Law 111-203, 124 Stat. 1376 (2010).
    \3\ In this Release, when we refer to the ``Advisers Act,'' we
refer to the Advisers Act as in effect on July 21, 2011.
    \4\ 15 U.S.C. 80b-3(b)(3) as in effect before July 21, 2011.
    \5\ Under section 204(a) of the Advisers Act, the Commission has
the authority to require an investment adviser to maintain records
and provide reports, as well as the authority to examine such
adviser's records, unless the adviser is ``specifically exempted''
from the requirement to register pursuant to section 203(b) of the
Advisers Act. Investment advisers that are exempt from registration
in reliance on other sections of the Advisers Act (such as sections
203(l) or 203(m) which we discuss below) are not ``specifically
exempted'' from the requirement to register pursuant to section
203(b), and thus the Commission has authority under section 204(a)
of the Advisers Act to require those advisers to maintain records
and provide reports and has authority to examine such advisers'
records.
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    The primary purpose of Congress in repealing section 203(b)(3) was
to require advisers to ``private funds'' to register under the Advisers
Act.\6\ Private funds include hedge funds, private equity funds and
other types of pooled investment vehicles that are excluded from the
definition of ``investment company'' under the Investment Company Act
of 1940 \7\ (``Investment Company Act'') by reason of section 3(c)(1)
or 3(c)(7) of such Act.\8\ Section 3(c)(1) is available to a fund that
does not publicly offer the securities it issues \9\ and has 100 or
fewer beneficial owners of its outstanding securities.\10\ A fund
relying on section 3(c)(7) cannot publicly offer the securities it
issues \11\ and generally must limit the owners of its outstanding
securities to ``qualified purchasers.'' \12\
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    \6\ See S. Rep. No. 111-176, at 71-3 (2010) (``S. Rep. No. 111-
176''); H. Rep. No. 111-517, at 866 (2010) (``H. Rep. No. 111-
517''). H. Rep. No. 111-517 contains the conference report
accompanying the version of H.R. 4173 that was debated in
conference. While the Senate voted to exempt private equity fund
advisers in addition to venture capital fund advisers from the
requirement to register under the Advisers Act, the Dodd-Frank Act
exempts only venture capital fund advisers. Compare Restoring
American Financial Stability Act of 2010, S. 3217, 111th Cong. Sec.
408 (2010) (as passed by the Senate) with The Wall Street Reform and
Consumer Protection Act of 2009, H.R. 4173, 111th Cong. (2009) (as
passed by the House) (``H.R. 4173'') and Dodd-Frank Act (2010),
supra note 2.
    \7\ 15 U.S.C. 80a.
    \8\ Section 202(a)(29) of the Advisers Act defines the term
``private fund'' as ``an issuer that would be an investment company,
as defined in section 3 of the Investment Company Act of 1940 (15
U.S.C. 80a-3), but for section 3(c)(1) or 3(c)(7) of that Act.''
    \9\ Interests in a private fund may be offered pursuant to an
exemption from registration under the Securities Act of 1933 (15
U.S.C. 77) (``Securities Act''). Notwithstanding these exemptions,
the persons who market interests in a private fund may be subject to
the registration requirements of section 15(a) under the Securities
Exchange Act of 1934 (``Exchange Act'') (15 U.S.C. 78o(a)). The
Exchange Act generally defines a ``broker'' as any person engaged in
the business of effecting transactions in securities for the account
of others. Section 3(a)(4)(A) of the Exchange Act (15 U.S.C.
78c(a)(4)(A)). See also Definition of Terms in and Specific
Exemptions for Banks, Savings Associations, and Savings Banks Under
Sections 3(a)(4) and 3(a)(5) of the Securities Exchange Act of 1934,
Exchange Act Release No. 44291 (May 11, 2001) [66 FR 27759 (May 18,
2001)], at n.124 (``Solicitation is one of the most relevant factors
in determining whether a person is effecting transactions.'');
Political Contributions by Certain Investment Advisers, Investment
Advisers Act Release No. 3043 (July 1, 2010) [75 FR 41018 (July 14,
2010)], n.326 (``Pay to Play Release'').
    \10\ See section 3(c)(1) of the Investment Company Act
(providing an exclusion from the definition of ``investment
company'' for any ``issuer whose outstanding securities (other than
short-term paper) are beneficially owned by not more than one
hundred persons and which is not making and does not presently
propose to make a public offering of its securities.'').
    \11\ See supra note 9.
    \12\ See section 3(c)(7) of the Investment Company Act
(providing an exclusion from the definition of ``investment
company'' for any ``issuer, the outstanding securities of which are
owned exclusively by persons who, at the time of acquisition of such
securities, are qualified purchasers, and which is not making and
does not at that time propose to make a public offering of such
securities.''). The term ``qualified purchaser'' is defined in
section 2(a)(51) of the Investment Company Act.

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    Each private fund advised by an adviser has typically qualified as
a single client for purposes of the private adviser exemption.\13\ As a
result, investment advisers could advise up to 14 private funds,
regardless of the total number of investors investing in the funds or
the amount of assets of the funds, without the need to register with
us.\14\
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    \13\ See rule 203(b)(3)-1(a)(2) as in effect before July 21,
2011.
    \14\ See Staff Report to the United States Securities and
Exchange Commission, Implications of the Growth of Hedge Funds, at
21 (2003), http://www.sec.gov/news/studies/hedgefunds0903.pdf
(discussing section 203(b)(3) of the Advisers Act as in effect
before July 21, 2011). Concern about this lack of Commission
oversight led us to adopt a rule in 2004 extending registration to
hedge fund advisers. See Registration Under the Advisers Act of
Certain Hedge Fund Advisers, Investment Advisers Act Release No.
2333 (Dec. 2, 2004) [69 FR 72054 (Dec. 10, 2004)] (``Hedge Fund
Adviser Registration Release''). This rule was vacated by a Federal
court in 2006. Goldstein v. Securities and Exchange Commission, 451
F.3d 873 (D.C. Cir. 2006) (``Goldstein'').
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    In Title IV of the Dodd-Frank Act (``Title IV''), Congress
generally extended Advisers Act registration to advisers to hedge funds
and many other private funds by eliminating the private adviser
exemption.\15\ In addition to removing the broad exemption provided by
section 203(b)(3), Congress amended the Advisers Act to create three
more limited exemptions from registration under the Advisers Act.\16\
These amendments become effective on July 21, 2011.\17\ New section
203(l) of the Advisers Act provides that an investment adviser that
solely advises venture capital funds is exempt from registration under
the Advisers Act (the ``venture capital exemption'') and directs the
Commission to define ``venture capital fund'' within one year of
enactment.\18\ New section 203(m) of the Advisers Act directs the
Commission to provide an exemption from registration to any investment
adviser that solely advises private funds if the adviser has assets
under management in the United States of less than $150 million (the
``private fund adviser exemption'').\19\ In this Release, we will refer
to advisers that rely on the venture capital and private fund adviser
exemptions as ``exempt reporting advisers'' because sections 203(l) and
203(m) provide that the Commission shall require such advisers to
maintain such records and to submit such reports ``as the Commission
determines necessary or appropriate in the public interest or for the
protection of investors.'' \20\
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    \15\ Section 403 of the Dodd-Frank Act amended section 203(b)(3)
of the Advisers Act by repealing the prior private adviser exemption
and inserting a ``foreign private adviser exemption.'' See infra
Section II.C. Unlike our 2004 rule, which sought to apply only to
advisers of ``hedge funds,'' the Dodd-Frank Act requires that,
unless another exemption applies, all advisers previously eligible
for the private adviser exemption register with us regardless of the
type of private funds or other clients the adviser has.
    \16\ Title IV also created exemptions and exclusions in addition
to the three discussed at length in this Release. See, e.g.,
sections 403 and 409 of the Dodd-Frank Act (exempting advisers to
licensed small business investment companies from registration under
the Advisers Act and excluding family offices from the definition of
``investment adviser'' under the Advisers Act). We are adopting a
rule defining ``family office'' in a separate release (Family
Offices, Investment Advisers Act Release No. 3220 (June 22, 2011)).
    \17\ Section 419 of the Dodd-Frank Act (specifying the effective
date for Title IV).
    \18\ See section 407 of the Dodd-Frank Act (exempting advisers
solely to ``venture capital funds,'' as defined by the Commission).
    \19\ See section 408 of the Dodd-Frank Act (directing the
Commission to exempt private fund advisers with less than $150
million in aggregate assets under management in the United States).
    \20\ See sections 407 and 408 of the Dodd-Frank Act.
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    Section 203(b)(3) of the Advisers Act, as amended by the Dodd-Frank
Act, provides an exemption for certain foreign private advisers (the
``foreign private adviser exemption'').\21\ The term ``foreign private
adviser'' is defined in new section 202(a)(30) of the Advisers Act as
an investment adviser that has no place of business in the United
States, has fewer than 15 clients in the United States and investors in
the United States in private funds advised by the adviser,\22\ and less
than $25 million in aggregate assets under management from such clients
and investors.\23\
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    \21\ Advisers specifically exempt under section 203(b) are not
subject to reporting or recordkeeping provisions under the Advisers
Act, and are not subject to examination by our staff. See supra note
5.
    \22\ Subparagraph (B) of section 202(a)(30) refers to the number
of ``clients and investors in the United States in private funds,''
while subparagraph (C) refers to the assets of ``clients in the
United States and investors in the United States in private funds''
(emphasis added). We interpret these provisions consistently so that
only clients in the United States and investors in the United States
should be included for purposes of determining eligibility for the
exemption under subparagraph (B).
    \23\ The exemption is not available to an adviser that ``acts
as--(I) an investment adviser to any investment company registered
under the [Investment Company Act]; or (II) a company that has
elected to be a business development company pursuant to section 54
of [that Act], and has not withdrawn its election.'' Section
202(a)(30)(D)(ii). We interpret subparagraph (II) to mean that the
exemption is not available to an adviser that advises a business
development company. This exemption also is not available to an
adviser that holds itself out generally to the public in the United
States as an investment adviser. Section 202(a)(30)(D)(i).
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    These new exemptions are not mandatory.\24\ Thus, an adviser that
qualifies for any of the exemptions could choose to register (or remain
registered) with the Commission, subject to section 203A of the
Advisers Act, which generally prohibits most advisers from registering
with the Commission if they do not have at least $100 million in assets
under management.\25\
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    \24\ An adviser choosing to avail itself of an exemption under
section 203(l), 203(m) or 203(b)(3), however, may be required to
register as an adviser with one or more state securities
authorities. See section 203A(b)(1) of the Advisers Act (exempting
from state regulatory requirements any adviser registered with the
Commission or that is not registered because such person is excepted
from the definition of an investment adviser under section
202(a)(11)). See also infra note 488 (discussing the application of
section 222 of the Advisers Act).
    \25\ Section 203A(a)(1) of the Advisers Act generally prohibits
an investment adviser regulated by the state in which it maintains
its principal office and place of business from registering with the
Commission unless it has at least $25 million of assets under
management. Section 203A(b) preempts certain state laws regulating
advisers that are registered with the Commission. Section 410 of the
Dodd-Frank Act amended section 203A(a) to also prohibit generally an
investment adviser from registering with the Commission if the
adviser has assets under management between $25 million and $100
million and the adviser is required to be registered with, and if
registered, would be subject to examination by, the state security
authority where it maintains its principal office and place of
business. See section 203A(a)(2) of the Advisers Act. In each of
subparagraphs (1) and (2) of section 203A(a), additional conditions
also may apply. See Implementing Adopting Release, infra note 32, at
section II.A.
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    On November 19, 2010, the Commission proposed three rules that
would implement these exemptions.\26\ First, we proposed rule 203(l)-1
to define the term ``venture capital fund'' for purposes of the venture
capital exemption. Second, we proposed rule 203(m)-1 to implement the
private fund adviser exemption. Third, in order to clarify the
application of the foreign private adviser exemption, we proposed new
rule 202(a)(30)-1 to define several terms included in the statutory
definition of a foreign private adviser as defined in section
202(a)(30) of the Advisers Act.\27\ On the same day, we

also proposed rules to implement other amendments made to the Advisers
Act by the Dodd-Frank Act, which included reporting requirements for
exempt reporting advisers.\28\
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    \26\ Exemptions for Advisers to Venture Capital Funds, Private
Fund Advisers with Less than $150 Million in Assets under
Management, and Foreign Private Advisers, Investment Advisers Act
Release No. 3111 (Nov. 19, 2010) [75 FR 77190 (Dec. 10, 2010)]
(``Proposing Release'').
    \27\ Proposed rule 202(a)(30)-1 included definitions for the
following terms: (i) ``Client;'' (ii) ``investor;'' (iii) ``in the
United States;'' (iv) ``place of business;'' and (v) ``assets under
management.'' See discussion in section II.C of the Proposing
Release, supra note 26. We proposed rule 202(a)(30)-1, in part,
pursuant to section 211(a) of the Advisers Act, which Congress
amended to explicitly provide us with the authority to define
technical, trade, and other terms used in the Advisers Act. See
section 406 of the Dodd-Frank Act.
    \28\ Rules Implementing Amendments to the Investment Advisers
Act of 1940, Investment Advisers Act Release No. 3110 (Nov. 19,
2010) [75 FR 77052 (Dec. 10, 2010)] (``Implementing Proposing
Release'').
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    We received over 115 comment letters in response to our proposals
to implement the new exemptions.\29\ Most of these letters were from
venture capital advisers, other types of private fund advisers, and
industry associations or law firms on behalf of private fund and
foreign investment advisers.\30\ We also received several letters from
investors and investor groups.\31\ Although commenters generally
supported the various proposed rules, many suggested modifications
designed to expand the breadth of the exemptions or to clarify the
scope of one or more elements of the proposed rules. Commenters also
sought interpretative guidance on certain aspects of the scope of each
of the rule proposals and related issues.
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    \29\ The comment letters on the Proposing Release (File No. S7-
37-10) are available at: http://www.sec.gov/comments/s7-37-10/s73710.shtml. We also considered comments submitted in response to
the Implementing Proposing Release that were germane to the rules
adopted in this Release.
    \30\ See, e.g., Comment Letter of Biotechnical Industry
Organization (Jan. 24, 2011) (``BIO Letter''); Comment Letter of
Coalition of Private Investment Companies (Jan. 28, 2011) (``CPIC
Letter''); Comment Letter of European Private Equity and Venture
Capital Association (Jan. 24, 2011 (``EVCA Letter''); Comment Letter
of O'Melveny & Myers LLP (Jan. 25, 2011) (``O'Melveny Letter'');
Comment Letter of Norwest Venture Partners (Jan. 24, 2011)
(``Norwest Letter'').
    \31\ See, e.g., Comment Letter of the American Federation of
Labor and Congress of Industrial Organizations (Jan. 24, 2011)
(``AFL-CIO Letter''); Comment Letter of Americans for Financial
Reform (Jan. 24, 2011) (``AFR Letter''); Comment Letter of The
California Public Employees Retirement System (Feb. 10, 2011)
(``CalPERS Letter''). See also, e.g., Comment Letter of Adams Street
Partners (Jan. 24, 2011); Comment Letter of Private Equity
Investors, Inc. (Jan. 21, 2011) (``PEI Funds Letter'') (letters from
advisers of funds that invest in other venture capital and private
equity funds).
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II. Discussion

    Today, the Commission is adopting rules to implement the three new
exemptions from registration under the Advisers Act. In response to
comments, we have made several modifications to the proposals. In a
separate companion release (the ``Implementing Adopting Release'') we
are adopting rules to implement other amendments made to the Advisers
Act by the Dodd-Frank Act, some of which also concern certain advisers
that qualify for the exemptions discussed in this Release.\32\
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    \32\ Rules Implementing Amendments to the Investment Advisers
Act of 1940, Investment Advisers Act Release No. 3221 (June 22,
2011).
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A. Definition of Venture Capital Fund

    We are adopting new rule 203(l)-1 to define ``venture capital
fund'' for purposes of the new exemption for investment advisers that
advise solely venture capital funds.\33\ In summary, the rule defines a
venture capital fund as a private fund that: (i) Holds no more than 20
percent of the fund's capital commitments in non-qualifying investments
(other than short-term holdings) (``qualifying investments'' generally
consist of equity securities of ``qualifying portfolio companies'' that
are directly acquired by the fund, which we discuss below); (ii) does
not borrow or otherwise incur leverage, other than limited short-term
borrowing (excluding certain guarantees of qualifying portfolio company
obligations by the fund); (iii) does not offer its investors redemption
or other similar liquidity rights except in extraordinary
circumstances; (iv) represents itself as pursuing a venture capital
strategy to its investors and prospective investors; and (v) is not
registered under the Investment Company Act and has not elected to be
treated as a business development company (``BDC'').\34\ Consistent
with the proposal, rule 203(l)-1 also ``grandfathers'' any pre-existing
fund as a venture capital fund if it satisfies certain criteria under
the grandfathering provision.\35\ An adviser is eligible to rely on the
venture capital exemption only if it solely advises venture capital
funds that meet all of the elements of the definition or funds that
have been grandfathered.
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    \33\ Rule 203(l)-1.
    \34\ Rule 203(l)-1(a).
    \35\ Rule 203(l)-1(b).
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    The proposed rule defined the term venture capital fund in
accordance with what we believed Congress understood venture capital
funds to be, as reflected in the legislative materials, including the
testimony Congress received.\36\ As we discussed in the Proposing
Release, the proposed definition of venture capital fund was designed
to distinguish venture capital funds from other types of private funds,
such as hedge funds and private equity funds, and to address concerns
expressed by Congress regarding the potential for systemic risk.\37\
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    \36\ See Proposing Release, supra note 26, at n.38 and
accompanying and following text.
    \37\ See, e.g., Proposing Release, supra note 26, discussion at
section II.A. and text accompanying nn.43, 60, 61, 82, 99, 136.
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    We received over 70 comment letters on the proposed venture capital
fund definition, most of which were from venture capital advisers or
related industry groups.\38\ A number of commenters supported the
Commission's efforts to define a venture capital fund,\39\ citing the
``thoughtful'' approach taken and the quality of the proposed rule.\40\
Commenters representing investors and investor groups and others
generally supported the rule as proposed,\41\ one of which stated that
the proposed definition ``succeeds in clearly defining those private
funds that will be exempt.''\42\ Some of these commenters expressed
support for a definition that is no broader than necessary in order to
ensure that only advisers to ``venture capital funds, and not other
types of private funds, are able to avoid the new mandatory
registration requirements.'' \43\
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    \38\ The National Venture Capital Association submitted a
comment letter, dated January 13, 2011 (``NVCA Letter'') on behalf
of its members, and 27 other commenters expressed their support for
the comments raised in the NVCA Letter.
    \39\ See BIO Letter; Comment Letter of Charles River Ventures
(Jan. 21, 2011) (``Charles River Letter''); NVCA Letter.
    \40\ See, e.g., Comment Letter of Abbott Capital Management, LLC
(Jan. 24, 2011) (``Abbott Capital Letter''); Comment Letter of DLA
Piper LLP (Jan. 24, 2011) (``DLA Piper VC Letter''); Comment Letter
of InterWest General Partners (Jan. 21, 2011) (``InterWest
Letter''); NVCA Letter; Comment Letter of Oak Investment Partners
(Jan. 24, 2011) (``Oak Investment Letter''); Comment Letter of Pine
Brook Road Advisors, LP (Jan. 24, 2011) (``Pine Brook Letter'').
    \41\ See AFR Letter; AFL-CIO Letter; EVCA Letter; Comment Letter
of U.S. Senator Carl Levin (Jan. 25, 2011) (``Sen. Levin Letter'').
    \42\ AFL-CIO Letter.
    \43\ Sen. Levin Letter. Although they did not object to the
approach taken by the proposed rule, several commenters cautioned us
against defining venture capital fund more broadly than necessary to
preclude advisers to other types of private funds from qualifying
under the venture capital exemption. See AFR Letter; CalPERS Letter;
Sen. Levin Letter (``a variety of advisers or funds are likely to
try to seek refuge from the registration requirement by urging an
overbroad interpretation of the term `venture capital fund' * * * It
is important for the Commission to define the term narrowly to
ensure that only venture capital funds, and not other types of
private funds, are able to avoid the new mandatory registration
requirement.'').
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    Generally, however, our proposal prompted vigorous debate among
commenters on the scope of the definition. For example, a number of
commenters wanted us to take a different approach from the proposal and
supported two alternatives. Two commenters urged us to rely on the
California definition of ``venture capital

operating company.''\44\ These commenters did not, however, address our
concern, discussed in the Proposing Release, that the California
definition includes many types of private equity and other private
funds, and thus incorporation of this definition would not appear
consistent with our understanding of the intended scope of section
203(l).\45\ Our concern was acknowledged in a letter we received from
the current Commissioner for the California Department of Corporations,
stating that ``we understand the [Commission] cannot adopt verbatim the
California definition of [venture capital fund]. Congressional
directives require the [Commission] to exclude private equity funds, or
any fund that pivots its investment strategy on the use of debt or
leverage, from the definition of [venture capital fund].''\46\ For
these reasons and the other reasons cited in the Proposing Release, we
are not modifying the proposal to rely on the California
definition.\47\
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    \44\ Comment Letter of Lowenstein Sandler PC (Jan. 4, 2011)
(``Lowenstein Letter''); Comment Letter of Keith Bishop (Jan. 17,
2011).
    \45\ See Proposing Release, supra note 26, at n.72 and
accompanying and preceding text.
    \46\ Comment Letter of Preston DuFauchard, Commissioner for the
California Department of Corporations (Jan. 21, 2011) (``DuFauchard
Letter'') (further stating that ``while regulators might have an
interesting discussion on whether private equity funds contributed
to the recent financial crisis, in light of the Congressional
directives such a dialogue would be academic.'').
    \47\ See Proposing Release, supra note 26, at n.72 and
accompanying and preceding text.
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    Several other commenters favored defining a venture capital fund by
reference to investments in ``small'' businesses or companies, although
they disagreed on the factors that would deem a business or company to
be ``small.''\48\ As discussed in the Proposing Release, we considered
defining a qualifying fund as a fund that invests in small companies,
but noted the lack of consensus for defining such a term.\49\ We also
expressed the concern in the Proposing Release that defining a
``small'' company in a manner that imposes a single standardized metric
such as net income, the number of employees, or another single factor
test could ignore the complexities of doing business in different
industries or regions. This could have the potential result that even a
low threshold for a size metric could inadvertently restrict venture
capital funds from funding otherwise promising young small
companies.\50\ For these reasons, we are not persuaded that the tests
for a ``small'' company suggested by commenters address these concerns.
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    \48\ See Comment Letter of National Association of Small
Business Investment Companies and Small Business Investor Alliance
(Jan. 24, 2011) (``NASBIC/SBIA Letter'') (supported a definition of
``small'' company by reference to the standards set forth in the
Small Business Investment Act regulations). But cf. Lowenstein
Letter; Comment Letter of Quaker BioVentures (Jan. 24, 2011)
(``Quaker BioVentures Letter''); Comment Letter of Venrock (Jan. 23,
2011) (``Venrock Letter'') (each of which supported a definition of
small company based on the size of its public float). See also
Comment Letter of Georg Merkl (Jan. 25, 2011) (``Merkl Letter'')
(referring to ``young, negative EBITDA [earnings before interest,
taxes, depreciation and amortization] companies'').
    \49\ See Proposing Release, supra note 26, at section II.A.1.a.
and n.69 and accompanying and following text.
    \50\ See Proposing Release, supra note 26, at n.69 and
accompanying and preceding text.
---------------------------------------------------------------------------

    Unlike the commenters who suggested these alternative approaches,
most commenters representing venture capital advisers and related
groups accepted the approach of the proposed rule, and many of them
acknowledged that the proposed definition would generally encompass
most venture capital investing activity that typically occurs.\51\
Several, however, also expressed the concern that a venture capital
fund may, on occasion, deviate from its typical investing pattern with
the result that the fund could not satisfy all of the definitional
criteria under the proposed rule with respect to each investment all of
the time.\52\ Others explained that an investment fund that seeks to
satisfy the definition of a venture capital fund (a ``qualifying
fund'') would desire flexibility to invest small amounts of fund
capital in investments that would not meet the criteria under the
proposed rule, such as shares of other venture capital funds,\53\ non-
convertible debt,\54\ or publicly traded securities.\55\ Both groups of
commenters urged us to accommodate them by broadening the definition
and modifying the proposed criteria.
---------------------------------------------------------------------------

    \51\ See, e.g., Comment Letter of the Committee on Federal
Regulation of Securities of the American Bar Association (Jan. 31,
2011) (``ABA Letter''); ATV Letter; BIO Letter; NVCA Letter; Comment
Letter of Proskauer LLP (Jan. 23, 2011); Comment Letter of Union
Square Ventures, LLC (Jan. 24, 2011) (``Union Square Letter'').
    \52\ See, e.g., Comment Letter of Advanced Technology Ventures
(Jan. 24, 2011) (``ATV Letter''); BIO Letter; NVCA Letter; Comment
Letter of Sevin Rosen Funds (Jan. 24, 2011) (``Sevin Rosen
Letter''). One commenter argued that the rule ``should not bar the
occasional, but also quite ordinary, financial activities'' of a
venture capital fund. Charles River Letter.
    \53\ See, e.g., Comment Letter of Dechert LLP (Jan. 24, 2011)
(``Dechert General Letter''); Comment Letter of First Round Capital
(Jan. 24, 2011) (``First Round Letter''); Sevin Rosen Letter.
    \54\ See, e.g., Comment Letter of BioVentures Investors (Jan.
24, 2011) (``BioVentures Letter''); Charles River Letter; Comment
Letter of Davis Polk & Wardwell LLP (Jan. 24, 2011) (``Davis Polk
Letter''); Merkl Letter.
    \55\ See, e.g., Comment Letter of Cardinal Partners (Jan. 24,
2011) (``Cardinal Letter''); Davis Polk Letter; Comment Letter of
Gunderson Dettmer Stough Villeneuve Franklin & Hachigian (Jan. 24,
2011) (``Gunderson Dettmer Letter''); Merkl Letter.
---------------------------------------------------------------------------

    Commenters wanted advisers seeking to be eligible for the venture
capital exemption to have greater flexibility to operate and invest in
portfolio companies and to accommodate existing (and potentially
evolving) business practices that may vary from what commenters
characterized as typical venture capital fund practice.\56\ Some argued
that a limited basket for such atypical investing activity could
facilitate job creation and capital formation.\57\ They were also
concerned that the multiple detailed criteria of the proposed rule
could result in ``inadvertent'' violations of the criteria under the
rule.\58\ Some expressed concern that a Commission rule defining a
venture capital fund by reference to investing activity would have the
result of reducing an adviser's investment discretion.\59\
---------------------------------------------------------------------------

    \56\ See, e.g., NVCA Letter; Comment Letter of Bessemer Venture
Partners (Jan. 24, 2011) (``Bessemer Letter''); Oak Investment
Letter. See also supra note 51.
    \57\ See, e.g., NVCA Letter (stating that a low level of 15%
would ``allow innovation and job creation to flourish within the
venture capital industry''); Sevin Rosen Letter (a 20% limit would
be ``flexible enough not to severely impair the operations of bona
fide [venture capital funds], a critically important resource for
American innovation and job creation'').
    \58\ See, e.g., NVCA Letter (``Because of the consequence (i.e.,
Federal registration) of having even one inadvertent, non-qualifying
investment, allowance for unintended or insignificant deviations, or
differences in interpretations, is appropriate.''); Comment Letter
of SV Life Sciences (Jan. 21, 2011) (``SV Life Sciences Letter'')
(the ``lack of flexibility and ambiguity in certain definitions * *
* could cause our firm or other venture firms to inadvertently hold
non-qualifying investments''). See also ATV Letter.
    \59\ DuFauchard Letter (``Only the VC Fund advisers/managers are
in a position to determine what best form `down-round' financing
should take. Whether that should be new capital, project finance, a
bridge loan, or some other form of equity or debt, is neither a
question for the regulators nor should it be a question of strict
regulatory control.''); ESP Letter (``There is no way a single
regulation can determine what the appropriate level of leverage
should be for every portfolio company.''); Merkl Letter (``The
Commission should not regulate from whom the [portfolio company]
securities can be acquired or how the [company's] capital can be
used.'').
---------------------------------------------------------------------------

    We are sensitive to commenters' concerns that the definition not
operate to foreclose investment funds from investment opportunities
that would benefit investors but would not change the character of a
venture capital fund.\60\ On the other hand, we are troubled that the
cumulative effect of revising the rule to reflect all of the
modifications supported by commenters could permit reliance on the
exemption by advisers to other types of private funds and thus

expand the exemption beyond what we believe was the intent of
Congress.\61\ A number of commenters argued that defining a venture
capital fund by reference to multiple detailed criteria could result in
``inadvertent'' violations of the definitional criteria by a qualifying
fund.\62\ Another commenter acknowledged that providing de minimis
carve-outs to the multiple criteria under the proposed rule could be
``cumbersome,''\63\ which could lead to the result, asserted by some
commenters, that an overly prescriptive rule could invite further
unintentional violations of the registration provisions of the Advisers
Act.\64\
---------------------------------------------------------------------------

    \60\ See, e.g., Oak Investment Letter; Sevin Rosen Letter.
    \61\ For example, one commenter suggested that the definition of
venture capital fund include a fund that incurs leverage of up to
20% of fund capital commitments without limit on duration and
invests up to 20% of fund capital commitments in publicly traded
securities and an additional 20% of fund capital commitments in non-
conforming investments. Charles River Letter. Under these
guidelines, it would be possible to structure a fund that borrows up
to 20% of the fund's ``capital commitments'' to acquire highly
leveraged derivatives and publicly traded debt securities. If the
fund only calls 20% of its capital, fund indebtedness would equal
100% of fund assets, all of which would be in derivative instruments
or publicly traded debt securities.
    \62\ See supra note 58.
    \63\ First Round Letter.
    \64\ See, e.g., generally NVCA Letter. See also Merkl Letter.
---------------------------------------------------------------------------

    To balance these competing considerations, we are adopting an
approach suggested by several commenters that defines a venture capital
fund to include a fund that invests a portion of its capital in
investments that would not otherwise satisfy all of the elements of the
rule (``non-qualifying basket'').\65\ Defining a venture capital fund
to include funds engaged in some amount of non-qualifying investment
activity provides advisers to venture capital funds with greater
investment flexibility, while precluding an adviser relying on the
exemption from altering the character of the fund's investments to such
extent that the fund could no longer be viewed as a venture capital
fund within the intended scope of the exemption. To the extent an
adviser uses the basket to invest in some non-qualifying investments,
it will have less room to invest in others, but the choice is left to
the adviser. While the definition limits the amount of non-qualifying
investments, it allows the adviser to choose how to allocate those
investments. Thus, one venture capital fund may take advantage of some
opportunities to invest in debt whereas others may seek limited
opportunities in publicly offered securities. The definition of
``business development company'' under the Advisers Act contains a
similar basket for non-qualifying investments.\66\
---------------------------------------------------------------------------

    \65\ See, e.g., Abbott Capital Letter; ATV Letter; Bessemer
Letter; BioVentures Letter; Cardinal Letter; Charles River Letter;
Comment Letter of CompliGlobe Ltd. (Jan. 24, 2011) (``CompliGlobe
Letter''); Davis Polk Letter; First Round Letter; NVCA Letter;
Comment Letter of PTV Sciences (Jan. 24, 2011) (``PTV Sciences
Letter''); Quaker BioVentures; Comment Letter of Sant[eacute]
Ventures (Jan. 24, 2011) (``Sant[eacute] Ventures Letter''); Sevin
Rosen Letter; SV Life Sciences; Comment Letter of U.S. Venture
Partners (Jan. 24, 2011) (``USVP Letter''); Venrock Letter.
    \66\ Advisers Act section 202(a)(22) (defining a ``business
development company'' as any company that meets the definition set
forth in section 2(a)(48) of, and complies with section 55 of, the
Investment Company Act, except that a BDC under the Advisers Act is
defined to mean a company that invests 60% of its total assets in
the assets specified in section 55 of the Investment Company Act).
---------------------------------------------------------------------------

    Commenters suggested non-qualifying baskets ranging from 15 to 30
percent of a fund's capital commitments, although many of these same
commenters wanted us to expand the other criteria of the proposed
rule.\67\ Several commenters in favor of a non-qualifying basket
asserted that setting the level for non-qualifying investments at a
sufficiently low threshold would preclude advisers to other types of
private funds from relying on the venture capital exemption while
providing venture capital advisers the flexibility to take advantage of
investment opportunities.\68\ These commenters properly framed the
question before us. We did not, however, receive specific empirical
analysis regarding the venture capital industry as a whole that would
help us determine the appropriate size of the basket.\69\ Many of those
supporting a 15 percent non-qualifying basket also supported expanding
some of the other elements of the definition, and thus it is unclear
whether a 15 percent non-qualifying basket alone would satisfy their
needs.\70\ On the other hand, those supporting a much larger basket did
not, in our view, adequately address our concern that an overly
expansive definition would provide room for advisers to private equity
funds to remain unregistered, a consequence several commenters urged us
to avoid.\71\
---------------------------------------------------------------------------

    \67\ See, e.g., NVCA Letter (more than 25 comment letters
expressed general support for the comments raised in the NVCA
Letter). Two commenters expressed support for a 30% basket for non-
qualifying investments. See Comment Letter of Shearman & Sterling
LLP (Jan. 24, 2011) (``Shearman Letter'') (citing, in support of
this position, the BDC definition under the Investment Company Act,
which specifies a threshold of 30% for non-qualifying activity);
Quaker BioVentures Letter (citing, in support of this position, the
BDC definition under the Investment Company Act and the BDC
definition under the Advisers Act which increased the non-qualifying
activity threshold to 40%).
    \68\ Norwest Letter; Sevin Rosen Letter (noting that a 20% limit
is ``low enough to ensure that only true [venture capital funds] are
able to qualify for the [venture capital] exemption.''). See also
NVCA Letter.
    \69\ We did, however, receive much anecdotal evidence of
particular advisers' experiences with non-qualifying investments.
See, e.g., Cardinal Letter (``In a very limited number of cases, it
has been necessary for us to purchase securities from current
shareholders of the portfolio company in order for the financing to
be completed. However, in NO case have purchases from existing
shareholders ever exceeded 15% of the total investment by Cardinal
in a proposed financing.''); Charles River Letter (``The vast
majority of our investments are in the form of Convertible Preferred
Stock. * * * However, very rarely--but more often than never--- we
invest in the form of a straight, non-convertible Demand Note.'');
Pine Brook Letter (``Our fund documents provide for investments
outside of our core investing practice of up to 25% of our committed
capital.''). But cf. Mesirow Financial Private Equity Advisors, Inc.
(Jan. 24, 2011) (``Mesirow Letter'') (a Commission-registered
adviser that advises funds that invest in other venture capital and
private equity funds stated that ``[s]ince the main purpose of
[venture capital funds] is to invest in and help build operating
companies, we believe their participation in non-qualifying activity
will be rare.'').
    \70\ See supra note 67.
    \71\ See supra note 43.
---------------------------------------------------------------------------

    On balance, and after giving due consideration to the approaches
suggested by commenters, we are adopting a limit of 20 percent of a
qualifying fund's capital commitments for non-qualifying investments.
We believe that a 20 percent limit will provide the flexibility sought
by many venture capital fund commenters while appropriately limiting
the scope of the exemption. We note that several commenters recommended
a non-qualifying basket limit of 20 percent.\72\
---------------------------------------------------------------------------

    \72\ See, e.g., ATV Letter; Charles River Letter; Sevin Rosen
Letter. At least one commenter stated that the minimum threshold
limit for the non-qualifying basket should be 20%. Charles River
Letter (``we believe anything less than 20% would be inadequate'').
---------------------------------------------------------------------------

    We considered adopting a 40 percent basket for non-qualifying
investments by analogy to the Advisers Act definition of BDC.\73\ That
basket was established by Congress rather than the Commission, and it
strikes us as too large in light of our task of implementing a
statutory provision that does not specify a basket.\74\ We find a
better analogy in a rule we adopted in 2001 under the Investment
Company Act. Under rule 35d-1 of that Act, commonly referred to as the
``names rule,'' an investment company with a name suggesting that it
invests in certain investments is limited to investing no more than 20
percent of its assets in other types of investments (i.e.,

non-qualifying investments).\75\ In adopting that rule, we explained
that ``if an investment company elects to use a name that suggests its
investment policy, it is important that the level of required
investments be high enough that the name will accurately reflect the
company's investment policy.'' \76\ We noted that having a registered
investment company hold a significant amount of investments consistent
with its name is an important tool for investor protection,\77\ but
setting the limit at 20 percent gives the investment company management
flexibility.\78\ While our policy goal today in defining a ``venture
capital fund'' is somewhat different from our goal in prescribing
limitations on investment company names, the tensions we sought to
reconcile are similar.\79\
---------------------------------------------------------------------------

    \73\ See supra note 66.
    \74\ A larger non-qualifying basket of 40% could have the result
of changing the fundamental underlying nature of the investments
held by a qualifying fund, such as for example increasing the extent
to which non-qualifying investments may contribute to the returns of
the fund's portfolio.
    \75\ Rule 35d-1(a)(2) under the Investment Company Act (``a
materially deceptive and misleading name of a [registered investment
company] includes * * * [a] name suggesting that the [registered
investment company] focuses its investments in a particular type of
investment or investments, or in a particular industry or group of
industries, unless: (i) The [registered investment company] has
adopted a policy to invest, under normal circumstances, at least 80%
of the value of its [total assets] in the particular type of
investments, or in investments in the particular industry or
industries, suggested by the [registered investment company's] name
* * *''). 17 CFR 270.35d-1(a)(2).
    \76\ Investment Company Names, Investment Company Act Release
No. 24828 (Jan. 17, 2001) [66 FR 8509, 8511 (Feb. 1, 2001),
correction 66 FR 14828 (Mar. 14, 2001)] (``Names Rule Adopting
Release'').
    \77\ Names Rule Adopting Release, supra note 76, at text
accompanying n.3 and text following n.7.
    \78\ See Names Rule Adopting Release, supra note 76, at text
accompanying n.14. See also NVCA Letter; Sevin Rosen Letter (citing
rule 35d-1 in support of recommending that the rule adopt a non-
qualifying basket); Quaker BioVentures Letter (citing the approach
taken by the staff generally limiting an investment company excluded
by reason of section 3(c)(5)(C) of the Investment Company Act to
investing no more than 20% of its assets in non-qualifying
investments).
    \79\ A number of commenters recommended that the rule specify a
range for the non-qualifying basket, arguing that this approach
would provide advisers to venture capital funds with better
flexibility to manage their investments over time. See, e.g., DLA
Piper VC Letter; DuFauchard Letter; Norwest Letter; Oak Investment
Letter. As we discuss in greater detail below, the non-qualifying
basket is determined as of the time immediately following each
investment and hence a range is not necessary.
---------------------------------------------------------------------------

1. Qualifying Investments
    Under the rule, to meet the definition of venture capital fund, the
fund must hold, immediately after the acquisition of any asset (other
than qualifying investments or short-term holdings), no more than 20
percent of the fund's capital commitments in non-qualifying investments
(other than short-term holdings).\80\ Thus, as discussed above, a
qualifying fund could invest without restriction up to 20 percent of
the fund's capital commitments in non-qualifying investments and would
still fall within the venture capital fund definition.
---------------------------------------------------------------------------

    \80\ Rule 203(l)-1(a)(2). The rule specifies that ``immediately
after the acquisition of any asset (other than qualifying
investments or short-term holdings)'' no more than 20% of the fund's
aggregate capital contributions and uncalled committed capital may
be held in assets (other than short-term holdings) that are not
qualifying investments.'' See infra Section II.A.1.c. for a
discussion on the operation of the 20% limit.
---------------------------------------------------------------------------

    For purposes of the rule, a ``qualifying investment,'' which we
discuss in greater detail below, generally consists of any equity
security issued by a qualifying portfolio company that is directly
acquired by a qualifying fund and certain equity securities exchanged
for the directly acquired securities.\81\
---------------------------------------------------------------------------

    \81\ See Sections II.A.1.b.
---------------------------------------------------------------------------

a. Equity Securities of Portfolio Companies
    Rule 203(l)-1 defines a venture capital fund as a private fund
that, excluding investments in short-term holdings and non-qualifying
investments, generally holds equity securities of qualifying portfolio
companies.\82\
---------------------------------------------------------------------------

    \82\ Rule 203(l)-1(a)(2) (specifying the investments of a
venture capital fund); (c)(3) (defining ``qualifying investment'');
and (c)(6) (defining ``short-term holdings'').
---------------------------------------------------------------------------

    We proposed to define ``equity security'' by reference to the
Exchange Act.\83\ Commenters did not generally object to our proposal
to do so, although many urged that we expand the definition of venture
capital fund to include investments in other types of securities.\84\
Commenters asserted that venture capital funds may invest in securities
other than equity securities (including debt securities) for various
business reasons, including to provide ``bridge'' financing to
portfolio companies between equity financing rounds,\85\ for working
capital needs \86\ or for tax or structuring reasons.\87\ Many of these
commenters recommended that the rule also define a venture capital fund
to include funds that invest in non-convertible bridge loans of a
portfolio company,\88\ interests in other pooled investment funds
(including other venture capital funds) \89\ and publicly offered
securities.\90\ Commenters argued that these types of investments
facilitate access to capital for a company's expansion,\91\ offer
qualifying funds flexibility to structure investments in a manner that
is most appropriate for the fund (and its investors), including for
example to obtain favorable tax treatment, manage risks (such as
bankruptcy protection), maintain the value of the fund's equity
investment or satisfy the specific financing needs of a portfolio
company,\92\ and enable a portfolio company to seek such financing from
venture capital funds if the company is unable to obtain financing from
traditional lending sources.\93\
---------------------------------------------------------------------------

    \83\ Proposed rule 203(l)-1(c)(2).
    \84\ Several commenters opposed any restriction on the
definition of equity security. See, e.g., Bessemer Letter; ESP
Letter; NVCA Letter.
    \85\ ATV Letter; NVCA Letter.
    \86\ Comment Letter of Cook Children's Health Care Foundation
Investment Committee (Jan. 20, 2011) (``Cook Children's Letter'');
Comment Letter of Leland Fikes Foundation, Inc. (Jan. 21, 2011)
(``Leland Fikes Letter'').
    \87\ Bessemer Letter; Merkl Letter.
    \88\ See, e.g., Comment Letter of CounselWorks LLC (Jan. 24,
2011); ESP Letter; Comment Letter of McGuireWoods LLP (Jan. 24,
2011) (``McGuireWoods Letter''); NVCA Letter; Oak Investment Letter.
See also BioVentures Letter (supported venture capital fund
investments in non-convertible debt without a time limit); Cook
Children's Letter; Leland Fikes Letter (each of which expressed
general support). One commenter indicated that the proposed
condition limiting investments in portfolio companies to equity
securities was too narrow. See Pine Brook Letter.
    \89\ See, e.g., Cook Children's Letter; Leland Fikes Letter; PEI
Funds Letter; Comment Letter of SVB Financial Group (Jan. 24, 2011)
(``SVB Letter'').
    \90\ See, e.g., ATV Letter; BIO Letter (noted that investments
by venture capital funds in ``PIPEs'' (i.e., ``private investments
in public equity'') are ``common'').
    \91\ See, e.g., Lowenstein Letter; Comment Letter of John G.
McDonald (Jan. 21, 2011) (``McDonald Letter''); Quaker BioVentures
Letter; Comment Letter of Trident Capital (Jan. 24, 2011) (``Trident
Letter'').
    \92\ See, e.g., Merkl Letter; Oak Investments Letter; Sevin
Rosen Letter; Comment Letter of Vedanta Capital, LP (Jan. 24, 2011)
(``Vedanta Letter'').
    \93\ NVCA Letter; Trident Letter.
---------------------------------------------------------------------------

    We recognize that a venture capital fund may, on occasion, make
investments other than in equity securities.\94\ Under the rule, as
discussed above, a venture capital fund may make these investments (as
well as other types of investments that commenters may not have
suggested) to the extent there is room in the fund's non-qualifying
basket. Hence, we are adopting the definition of equity security as
proposed.
---------------------------------------------------------------------------

    \94\ See, e.g., ESP Letter; Leland Fikes Letter; McGuireWoods
Letter; NVCA Letter; Oak Investment Letter. See also supra Section
II.A.
---------------------------------------------------------------------------

    The final rule incorporates the definition of equity security in
section 3(a)(11) of the Exchange Act and rule 3a11-1 thereunder.\95\
Accordingly,

equity security includes common stock as well as preferred stock,
warrants and other securities convertible into common stock in addition
to limited partnership interests.\96\ Our definition of equity security
is broad. The definition includes various securities in which venture
capital funds typically invest and provides venture capital funds with
flexibility to determine which equity securities in the portfolio
company capital structure are appropriate for the fund. Our use of the
definition of equity security under the Exchange Act acknowledges that
venture capital funds typically invest in common stock and other equity
instruments that may be convertible into equity common stock but does
not otherwise specify the types of equity instruments that a venture
capital fund could hold in deference to the business judgment of
venture capital funds.
---------------------------------------------------------------------------

    \95\ Rule 203(l)-1(c)(2) (equity security ``has the same meaning
as in section 3(a)(11) of the Securities Exchange Act of 1934 (15
U.S.C. 78c(a)(11)) and Sec.  240.3a11-1 of this chapter.''). See 15
U.S.C. 78c(a)(11) (defining ``equity security'' as ``any stock or
similar security; or any security future on any such security; or
any security convertible, with or without consideration, into such a
security, or carrying any warrant or right to subscribe to or
purchase such a security; or any such warrant or right; or any other
security which the Commission shall deem to be of similar nature and
consider necessary or appropriate, by such rules and regulations as
it may prescribe in the public interest or for the protection of
investors, to treat as an equity security.''); rule 3a11-1 under the
Exchange Act (17 CFR 240.3a11-1) (defining ``equity security'' to
include ``any stock or similar security, certificate of interest or
participation in any profit sharing agreement, preorganization
certificate or subscription, transferable share, voting trust
certificate or certificate of deposit for an equity security,
limited partnership interest, interest in a joint venture, or
certificate of interest in a business trust; any security future on
any such security; or any security convertible, with or without
consideration, into such a security, or carrying any warrant or
right to subscribe to or purchase such a security; or any such
warrant or right; or any put, call, straddle, or other option or
privilege of buying such a security from or selling such a security
to another without being bound to do so.'').
    \96\ See rule 3a11-1 under the Exchange Act (17 CFR 240.3a11-1)
(defining ``equity security'' to include any ``limited partnership
interest'').
---------------------------------------------------------------------------

b. Capital Used for Operating and Business Purposes
    Rule 203(l)-1 defines a venture capital fund as a private fund that
holds no more than 20 percent of the fund's capital commitments in non-
qualifying investments (other than short-term holdings). Under the
final rule, qualifying investments are generally equity securities that
were acquired by the fund in one of three ways that suggest that the
fund's capital is being used to finance the operations of businesses
rather than for trading in secondary markets. As discussed in greater
detail below, rule 203(l)-1 defines a ``qualifying investment'' as: (i)
Any equity security issued by a qualifying portfolio company that is
directly acquired by the private fund from the company (``directly
acquired equity''); (ii) any equity security issued by a qualifying
portfolio company in exchange for directly acquired equity issued by
the same qualifying portfolio company; and (iii) any equity security
issued by a company of which a qualifying portfolio company is a
majority-owned subsidiary, or a predecessor, and that is acquired by
the fund in exchange for directly acquired equity.\97\
---------------------------------------------------------------------------

    \97\ Rule 203(l)-1(c)(3). A security received as a dividend by
virtue of the fund's holding of a qualifying investment would also
be a qualifying investment. See generally infra note 480.
---------------------------------------------------------------------------

    In the Proposing Release we explained that one of the features of
venture capital funds that distinguish them from hedge funds and
private equity funds is that they invest capital directly in portfolio
companies for the purpose of funding the expansion and development of
the companies' business rather than buying out existing security
holders.\98\ Thus, we proposed that, to meet the definition, at least
80 percent of a fund's investment in each portfolio company must be
acquired directly from the company, in effect limiting a venture
capital fund's ability to acquire secondary market shares to 20 percent
of the fund's investment in each company.\99\
---------------------------------------------------------------------------

    \98\ Proposing Release, supra note 26, at text accompanying
n.104.
    \99\ Proposed rule 203(l)-1(a)(2).
---------------------------------------------------------------------------

    A few commenters objected to any limitation on secondary market
purchases of a qualifying portfolio company's shares,\100\ but did not
address the critical role this condition played in differentiating
venture capital funds from other types of private funds, such as
leveraged buyout funds, which acquire controlling equity interests in
operating companies through the ``buyout'' of existing security
holders.\101\ Nor did they offer an alternative method in lieu of the
direct acquisition criterion to distinguish venture capital funds from
the buyout funds that are considered private equity funds. We continue
to believe that the limit on secondary purchases is an important
element for distinguishing advisers to venture capital funds from
advisers to the types of private equity funds for which Congress did
not provide an exemption.\102\ Therefore, we are not modifying the
definition of qualifying investment to broadly include equity
securities acquired in secondary transactions.
---------------------------------------------------------------------------

    \100\ See, e.g., ESP Letter; Merkl Letter.
    \101\ See also Proposing Release, supra note 26, at section
II.A.1.d.
    \102\ See id., at n.112 and accompanying text.
---------------------------------------------------------------------------

    We are, however, making two changes in this provision in response
to commenters. First, we have eliminated the 20 percent limit for
secondary market transactions that we included in this provision in our
proposal in favor of the broader 20 percent limit for assets that are
not qualifying investments.\103\ Most commenters addressing the limit
on secondary market acquisitions supported changing the threshold from
80 percent of the fund's investment in each portfolio company to either
50 percent in each portfolio company,\104\ or 80 percent of the fund's
total capital commitments.\105\ These commenters argued that secondary
acquisitions provide liquidity to founders, angel investors and
employees/former employees or align the interests of a fund with those
of a portfolio company.\106\
---------------------------------------------------------------------------

    \103\ Cf. proposed rule 203(l)-1(a)(2) and rule 203(l)-1(a)(2).
    \104\ See DLA Piper VC Letter; Davis Polk Letter; Sevin Rosen
Letter (each supported lowering the direct purchase requirement from
80% to 50% of each qualifying portfolio company's equity
securities); Dechert General Letter (argued that the 20% allowance
for secondary purchases should be increased to 45%, consistent with
rules 3a-1 and 3c-5 under the Investment Company Act). See also ABA
Letter (supported lowering the threshold from 80% to 70%); NVCA
Letter; Mesirow Letter; Oak Investments Letter. Several commenters
disagreed with the proposed direct acquisition criterion and
recommended that venture capital fund investments in portfolio
company securities through secondary transactions should not be
subject to any limit. See, e.g., ESP Letter; Merkl Letter.
    \105\ ATV Letter; Bessemer Letter; Charles River Letter; Davis
Polk Letter; First Round Letter; Gunderson Dettmer Letter; InterWest
Letter; Mesirow Letter; Norwest Letter; NVCA Letter; Oak Investment
Letter; Sevin Rosen Letter; SVB Letter; Union Square Letter; Vedanta
Letter. See also Comment Letter of Alta Partners (Jan. 24, 2011)
(``Alta Partners Letter''); USVP Letter.
    \106\ See, e.g., Bessemer Letter; Norwest Letter; Sevin Rosen
Letter.
---------------------------------------------------------------------------

    We believe that the limit on secondary purchases remains an
important element for distinguishing advisers to venture capital funds
from advisers to the types of private equity funds for which Congress
did not provide an exemption.\107\ However, as discussed above, a
venture capital fund may purchase shares in secondary markets to the
extent it has room for such securities in its non-qualifying basket.
---------------------------------------------------------------------------

    \107\ See Proposing Release, supra note 26, at n.112 and
accompanying text.
---------------------------------------------------------------------------

    Second, the final rule defines qualifying investments as including
equity securities issued by the qualifying portfolio company that are
received in exchange for directly acquired equities issued by the same
qualifying portfolio company.\108\ This revision was suggested by a
number of

commenters to enable a qualifying fund to participate in the
reorganization of the capital structure of a portfolio company, which
may require the fund, along with other existing security holders, to
accept newly issued equity securities in exchange for previously issued
equity securities.\109\
---------------------------------------------------------------------------

    \108\ Under rule 203(l)-1(c)(3)(ii), ``qualifying investments''
include any equity security issued by a qualifying portfolio company
in exchange for an equity security issued by the qualifying
portfolio company that is directly acquired. See infra note 113.
    \109\ See, e.g., NVCA Letter. See also Sevin Rosen Letter.
Although we understand that the securities received in an exchange
are typically newly issued, the rule would also cover exchanges for
outstanding securities. See also infra note 113.
---------------------------------------------------------------------------

    The rule similarly treats as a qualifying investment any equity
security issued by another company in exchange for directly acquired
equities of a qualifying portfolio company, provided that the
qualifying portfolio company becomes a majority-owned subsidiary of the
other company or is a predecessor company.\110\ This provision enables
a qualifying fund to acquire securities in connection with the
acquisition (or merger) of a qualifying portfolio company by another
company,\111\ without jeopardizing the fund's ability to satisfy the
definition of venture capital fund. A venture capital fund's
acquisition of publicly offered securities in these circumstances may
not present the same degree of interconnectedness with the public
markets as secondary acquisitions through the open markets that are
typical of other types of leveraged buyout private funds.\112\ As a
result of the modification to the proposed rule, a venture capital fund
could hold equity securities of a company subject to reporting under
the Exchange Act, if such equity securities were issued to the fund in
exchange for directly acquired equities of a qualifying portfolio
company that became a majority-owned subsidiary of the reporting
company.\113\
---------------------------------------------------------------------------

    \110\ Under rule 203(l)-1(c)(3)(iii), ``qualifying investments''
include any equity security issued by a company of which a
qualifying portfolio company is a majority-owned subsidiary (as
defined in section 2(a)(24) of the Investment Company Act), or a
predecessor company, and that is acquired by the private fund in
exchange for an equity security described in paragraph (c)(3)(i) or
(c)(3)(ii) of the rule. See infra note 113.
     A ``majority-owned subsidiary'' is defined by reference to
section 2(a)(24) of the Investment Company Act, (15 U.S.C.
80a2(a)(24), which defines a ``majority-owned subsidiary'' of any
person as ``a company 50 per centum or more of the outstanding
voting securities of which are owned by such person, or by a company
which, within the meaning of this paragraph, is a majority-owned
subsidiary of such person.''
    \111\ See, e.g., Davis Polk Letter; Comment Letter of
Institutional Venture Partners (Jan. 24, 2011) (``IVP Letter'');
Mesirow Letter; PTV Sciences Letter. A number of commenters argued
that without this expanded definition, typical transactions enabling
a venture capital fund to restructure its investment in a portfolio
company, exit its investment or obtain liquidity for itself and its
investors, as well as profits, would be precluded. See, e.g., NVCA
Letter; PTV Sciences Letter.
    \112\ See, e.g., Davis Polk Letter. See also Mesirow Letter.
    \113\ Under the rule, a qualifying fund could separately
purchase additional securities pursuant to a public offering (or
recapitalization) from a company after it ceases to be a
``qualifying portfolio company'' (because for example such company
has become a reporting or foreign traded company), subject to the
non-qualifying basket.
---------------------------------------------------------------------------

c. Operation of the 20 Percent Limit
    Under the rule, to meet the definition of venture capital fund, a
qualifying fund must hold, immediately after the acquisition of any
asset (other than qualifying investments or short-term holdings), no
more than 20 percent of the fund's capital commitments in non-
qualifying investments (other than short-term holdings).\114\ Under
this approach, a fund need only calculate the 20 percent limit when the
fund acquires a non-qualifying investment (other than short-term
holdings); after the acquisition, the fund need not dispose of a non-
qualifying investment simply because of a change in the value of that
investment. A qualifying fund, however, could not purchase additional
non-qualifying investments until the value of its then-existing non-
qualifying investments fell below 20 percent of the fund's committed
capital.
---------------------------------------------------------------------------

    \114\ Rule 203(l)-1(a)(2). The calculation of the 20% limit
operates in a fashion similar to the diversification and ``Second
Tier Security'' tests of rule 2a-7 under the Investment Company Act.
17 CFR 270.2a-7(a)(24). See Revisions to Rules Regulating Money
Market Funds, Investment Company Act Release No. 18005 (Feb. 20,
1991) [56 FR 8113, 8118 (Feb. 27, 1991)].
---------------------------------------------------------------------------

    As discussed above, most commenters supporting a basket for non-
qualifying investments recommended a limit expressed as a percentage of
fund capital commitments.\115\ One commenter further suggested that the
value of investments included in the non-qualifying basket be
calculated at the time each investment is made to include only those
non-qualifying investments that are then held by the fund (thus
excluding liquidated assets); the commenter argued that this approach
would give funds certainty that a qualifying investment would not
become ``non-qualifying'' and simplify the test for compliance.\116\
---------------------------------------------------------------------------

    \115\ See supra note 67.
    \116\ Sevin Rosen Letter. See also BioVentures Letter (endorsing
the NVCA Letter supporting a non-qualifying basket determined as a
percentage of fund capital commitments, but also arguing in favor of
determining the basket ``at any point in time, rather than in the
aggregate over the life of the fund'').
---------------------------------------------------------------------------

    We are persuaded that the non-qualifying basket should be based on
a qualifying fund's total capital commitments, and the fund's
compliance with the 20 percent limit should be calculated at the time
any non-qualifying investment is made, based on the non-qualifying
investments then held in the fund's portfolio.\117\ We understand that
using a fund's capital commitments for determining investment
thresholds is generally consistent with existing venture capital fund
practice,\118\ and nearly all of the commenters requesting a basket
specified the basket as a percentage of the fund's capital
commitments.\119\ We expect that calculating the size of the non-
qualifying basket as a percentage of a qualifying fund's capital
commitments, which will remain relatively constant during the fund's
term, will provide advisers with a degree of predictability when
managing the fund's portfolio and determining how much of the basket
remains available for new investments.
---------------------------------------------------------------------------

    \117\ Capital commitments that have been called but returned to
investors and subject to a future call would be treated as uncalled
capital commitments. Capital commitments that are no longer subject
to a call by the fund would not be treated as uncalled capital
commitments.
    \118\ See generally infra notes 240-243 (discussing the use of a
qualifying fund's capital commitments to determine the fund's
compliance with the leverage criterion). See also DLA Piper VC
Letter.
    \119\ See generally supra note 67. For purposes of reporting its
``regulatory assets under management'' on Form ADV, an adviser would
include uncalled capital commitments of a private fund advised by
the adviser.
---------------------------------------------------------------------------

    We acknowledge that limiting non-qualifying investments to a
percentage of fund capital commitments could result in a qualifying
fund that invests its initial capital call in non-qualifying
investments; \120\ but that ability would be constrained by the
adviser's need to reconcile that investment with the fund's required
representation that it pursues a venture capital strategy.\121\ An
investment adviser that manages a fund in such a manner that renders
the representation to investors and potential investors that the fund
pursues a venture capital strategy an untrue statement of material fact
would violate the antifraud provisions of the Advisers Act.\122\ We
understand that a venture capital fund is not typically required to
call or fully draw down all of its capital commitments. However, only
bona fide capital commitments may be included in the calculation under
rule 203(l)-

1.\123\ For example, commitments made for the purpose of increasing the
non-qualifying basket and with an understanding with investors that
they will not be called cannot be included.\124\
---------------------------------------------------------------------------

    \120\ See AFL-CIO Letter; AFR Letter (discussing issues
associated with specifying leverage as a percentage of fund capital
commitments).
    \121\ See infra Section II.A.7.
    \122\ The Commission does not need to demonstrate that an
adviser violating rule 206(4)-8 acted with scienter. See Prohibition
of Fraud by Advisers to Certain Pooled Investment Vehicles,
Investment Advisers Act Release No. 2628 (Aug. 3, 2007) [72 FR 44756
(Aug. 9, 2007)] (``Pooled Vehicles Release'').
    \123\ See also Investment Adviser Performance Compensation,
Investment Advisers Act Release No. 3198 (May 10, 2011) [76 FR 27959
(May 13, 2011)] at n.17 (in determining whether a person holds the
requisite amount of assets under management, an investment adviser
may include ``assets that a client is contractually obligated to
invest in private funds managed by the adviser. Only bona fide
contractual commitments may be included, i.e., those that the
adviser has a reasonable belief that the investor will be able to
meet.'').
    \124\ Similarly, fee waivers or reductions for the purpose of
inducing investors to increase the size of their capital commitments
with an understanding that they will not be called (and hence enable
the adviser to increase the size of the non-qualifying basket) would
indicate that the commitments are not bona fide. In addition, the
amount of capital commitments and contributions made by investors
and the investments made by the fund are indispensable to the
functioning of a venture capital fund, and we understand advisers to
venture capital funds typically maintain records reflecting them.
See generally supra note 5 (describing the Commission's authority to
examine the records of advisers relying on the venture capital
exemption). We note that a person claiming an exemption under the
Federal securities laws has the burden of proving it is entitled to
the exemption. See, e.g., SEC v. Ralston Purina Co., 346 U.S. 119,
126 (1953); Gilligan, Will & Co. v. SEC, 267 F.2d 461, 466 (2d Cir.
1959); Swenson v. Engelstad, 626 F.2d 421, 425 (5th Cir. 1980); SEC
v. Wall St. Transcript Corp., 454 F. Supp. 559, 566 (S.D.N.Y. 1978)
(stating that the defendant publisher ``must register unless it can
be shown that it is'' entitled to rely on an exclusion from the
definition of ``investment adviser'').
---------------------------------------------------------------------------

    Moreover, we believe that by applying the 20 percent limit as of
the time of acquisition of each non-qualifying investment, a fund is
able to determine prospectively how much it can invest in the non-
qualifying basket. We believe that this simpler approach to determining
the non-qualifying basket would better limit a qualifying fund's non-
qualifying investments and ease the burden of determining compliance
with the criterion under the rule.
    To determine compliance with the 20 percent limit, a venture
capital fund would, immediately after the acquisition of any non-
qualifying investment, excluding any short-term holdings,\125\
calculate the total value of all of the fund's assets held at that
time, excluding short-term holdings, that are invested in non-
qualifying investments, as a percentage of the fund's total capital
commitments.\126\ For this purpose, the 20 percent test is determined
based on the qualifying fund's non-qualifying investments after taking
into account the acquisition of any newly acquired non-qualifying
investment.\127\
---------------------------------------------------------------------------

    \125\ Rule 203(l)-1(c)(6) (``Short-term holdings'' means cash
and cash equivalents as defined in Sec.  270.2a51-1(b)(7)(i), U.S.
Treasuries with a remaining maturity of 60 days or less, and shares
of an open-end management investment company registered under
section 8 of the Investment Company Act of 1940 [15 U.S.C. 80a-8]
that is regulated as a money market fund under Sec.  270.2a-7 of
this chapter.'').
    \126\ A qualifying investment that is acquired as a result of an
exchange of equity securities provided by rule 203(l)-1(c)(3)(ii)
and (iii) would not result in a requirement to calculate the 20%
limit under rule 203(l)-1(a)(2).
    \127\ Rule 203(l)-1(a)(2).
---------------------------------------------------------------------------

    To determine if a fund satisfies the 20 percent limit for non-
qualifying investments, the fund may use either historical cost or fair
value, as long as the same method is applied to all investments of a
qualifying fund in a consistent manner during the term of the
fund.\128\ Under the rule, a venture capital fund could use either
historical cost or fair value, depending, for example, on the fund's
approach to valuing investments since the fund's inception. Under the
final rule, a qualifying fund using historical cost need not account
for changes in the value of its portfolio due to, for example, market
fluctuations in the value of a non-qualifying investment or the sale or
other disposition of a qualifying investment (including the associated
distribution of sale proceeds to fund investors). Requiring fair value
in this particular instance could make investment planning difficult
because the amount of dollars allocated to the non-qualifying basket
would vary depending on changes in the value of investments already
made. In addition, requiring fair value could complicate compliance for
those qualifying funds that make investments frequently, because each
investment would result in a requirement to value the fund's assets.
Because the rule specifies that the valuation method must be
consistently applied, this approach is designed to prevent a qualifying
fund, or its adviser, from alternating between valuation methodologies
in order to circumvent the 20 percent limit.
---------------------------------------------------------------------------

    \128\ Id.
---------------------------------------------------------------------------

    Our rule's approach to the valuation method, which allows the use
of historical cost in determining compliance with the non-qualifying
basket limit, is similar in this respect to rules under the Employee
Retirement Income Security Act of 1974 (``ERISA'') for funds qualifying
as ``venture capital operating companies,'' which generally specify
that the value of a fund's investments is determined on a cost
basis.\129\ Many commenters cited the ERISA rule in connection with
comments on other proposed criteria,\130\ and hence we believe
advisers' familiarity with the ERISA rule will facilitate compliance
with our approach to the 20 percent limit and reduce the burdens
associated with compliance.
---------------------------------------------------------------------------

    \129\ Under U.S. Department of Labor regulations, a venture
capital operating company (``VCOC'') is any entity that, as of the
date of the first investment (or other relevant time), has at least
50% of its assets (other than short-term investments pending long-
term commitment or distribution to investors), valued at cost,
invested in venture capital investments. 29 CFR 2510.3-101(d). See
also Proposing Release, supra note 26, at n.70.
    \130\ For example, a number of commenters urged us to adopt the
approach under ERISA that would determine whether or not a fund has
satisfied the managerial assistance criterion. See infra note 225.
---------------------------------------------------------------------------

2. Short-Term Holdings
    A qualifying fund may also invest in cash and cash equivalents,
U.S. Treasuries with a remaining maturity of 60 days or less and shares
of registered money market funds.\131\ A qualifying fund need not
include its investments in these short-term holdings when determining
whether it satisfies the 20 percent limit for non-qualifying
investments.\132\
---------------------------------------------------------------------------

    \131\ Rule 203(l)-1(c)(6).
    \132\ Rule 203(l)-1(a)(2). As proposed, a venture capital fund
would have been defined as a fund that invested solely in certain
investments, including specified cash instruments. Proposed rule
203(l)-1(a)(2)(ii). In the final rule, a venture capital fund is
defined as a fund that holds no more than 20% of its committed
capital in assets that are not qualifying investments, excluding for
this purpose short-term holdings (which is defined to include
specified cash instruments). Rule 203(l)-1(a)(2). The general focus
of both the proposal and the final rule is on the types of
investments in which a qualifying fund may invest. As a result of
the modifications to the rule to incorporate a non-qualifying
basket, we are excluding short-term holdings from the calculation of
qualifying and non-qualifying investments.
---------------------------------------------------------------------------

    Most commenters that addressed the cash element of the proposal did
not disagree with our approach to the cash element but urged us to
expand it to include money market funds,\133\ any U.S. Treasury without
regard to maturity,\134\ debt issued by foreign governments,\135\
repurchase agreements,\136\ and certain highly rated corporate
commercial paper.\137\ Many commenters did not provide a rationale,
other than business practice, for expanding the cash element to include
these other types of investments or discuss whether these changes would
also permit other types of funds to meet the definition. One commenter
did note, however, that short-term investments are typically held
during the period between a capital call and funding by

investors and invested in instruments that may provide higher returns
than the cash items identified in the proposed rule.\138\
---------------------------------------------------------------------------

    \133\ Comment Letter of Federated Investors, Inc. (Jan. 18,
2011); IVP Letter; Merkl Letter.
    \134\ See, e.g., Dechert General Letter; IVP Letter. See also
Shearman Letter; SVB Letter (also argued that Treasuries pose no
systemic risk issues).
    \135\ Dechert General Letter; Commenter Letter of European Fund
and Asset Management Association (Jan. 24, 2011) (``EFAMA Letter'');
Merkl Letter.
    \136\ IVP Letter; NVCA Letter.
    \137\ Sevin Rosen Letter.
    \138\ NVCA Letter.
---------------------------------------------------------------------------

    The Commission recognizes that a broader definition of short-term
holdings could yield venture capital funds greater returns.\139\ The
exclusion of short-term holdings from a qualifying fund's assets for
purposes of the 20 percent test, however, recognizes that such holdings
are not ordinarily held as part of the fund's investment portfolio but
as a cash management tool.\140\ Advisers to venture capital funds that
wish to invest in longer-term or higher yielding debt may make use of
the non-qualifying basket for such investments. We are, however,
modifying the definition to include as short-term holdings shares of
registered money market funds that are regulated under rule 2a-7 under
the Investment Company Act,\141\ which we understand are commonly held
for purposes of cash management.\142\
---------------------------------------------------------------------------

    \139\ See, e.g., NVCA Letter.
    \140\ We do not view investing in short-term holdings as being a
venture capital strategy; however, for purposes of the exemption, a
qualifying fund could invest in short-term holdings as part of
implementing its investment strategy. See also infra Section II.A.7.
    \141\ Rule 203(l)-1(c)(6).
    \142\ See, e.g., NVCA Letter.
---------------------------------------------------------------------------

    The rule defines short-term holdings to include ``cash and cash
equivalents'' by reference to rule 2a51-1(b)(7)(i) under the Investment
Company Act.\143\ We did not receive any comments on this aspect of the
proposal and are adopting it without modification. Rule 2a51-1,
however, is used to determine whether an owner of an investment company
excluded by reason of section 3(c)(7) of the Investment Company Act
meets the definition of a qualified purchaser by examining whether such
owner holds sufficient ``investments'' (generally securities and other
assets held for investment purposes).\144\ We are not defining a
venture capital fund's cash holdings by reference to whether the cash
is held ``for investment purposes'' or to the net cash surrender value
of an insurance policy. Furthermore, since rule 2a51-1 does not
explicitly include short-term U.S. Treasuries, which we believe would
be an appropriate form of cash equivalent for a venture capital fund to
hold pending investment in a portfolio company or distribution to
investors, our rule includes short-term U.S. Treasuries with a
remaining maturity of 60 days or less.\145\
---------------------------------------------------------------------------

    \143\ Rule 2a51-1(b)(7) under the Investment Company Act
provides that cash and cash equivalents include foreign currencies
``held for investment purposes'' and ``(i) [b]ank deposits,
certificates of deposit, bankers acceptances and similar bank
instruments held for investment purposes; and (ii) [t]he net cash
surrender value of an insurance policy.'' 17 CFR 270.2a51-1(b)(7).
    \144\ See generally sections 2(a)(51) and 3(c)(7) of the
Investment Company Act; 17 CFR 270.2a51-1(b) and (c).
    \145\ We have treated debt securities with maturities of 60 days
or less differently than debt securities with longer maturities
under our rules. In particular, we have recognized that the
potential for fluctuation in those shorter-term securities' market
value has decreased sufficiently that, under certain conditions, we
allow certain open-end investment companies to value them using
amortized cost value rather than market value. See Valuation of Debt
Instruments by Money Market Funds and Certain Other Open-End
Investment Companies, Investment Company Act Release No. 9786 (May
31, 1977) [42 FR 28999 (June 7, 1977)]. We believe that the same
consideration warrants treating U.S. Treasury securities with a
remaining maturity of 60 days or less as more akin to cash
equivalents than Treasuries with longer maturities for purposes of
the definition of venture capital fund.
---------------------------------------------------------------------------

3. Qualifying Portfolio Company
    Under the rule, qualifying investments generally consist of equity
securities issued by a qualifying portfolio company. A ``qualifying
portfolio company'' is defined as any company that: (i) Is not a
reporting or foreign traded company and does not have a control
relationship with a reporting or foreign traded company; (ii) does not
incur leverage in connection with the investment by the private fund
and distribute the proceeds of any such borrowing to the private fund
in exchange for the private fund investment; and (iii) is not itself a
fund (i.e., is an operating company).\146\ We are adopting the rule
substantially as proposed, with modifications to the leverage criterion
in order to address certain concerns raised by commenters. We describe
each element of a qualifying portfolio company below. We understand
each of the criteria to be characteristic of issuers of portfolio
securities held by venture capital funds.\147\ Moreover, collectively,
we believe these criteria would operate to exclude most private equity
funds and hedge funds from the definition.
---------------------------------------------------------------------------

    \146\ Rule 203(l)-1(c)(4). In the Proposing Release, we used the
defined term ``publicly traded'' company, but are modifying the rule
to use the defined term ``reporting or foreign traded'' company to
match more closely the defined term and to make clear that certain
companies that have issued securities that are traded on a foreign
exchange are covered by the definition. See proposed rule 203(l)-
1(c)(3) and (4).
    \147\ See Proposing Release, supra note 26, sections II.A.1.a.-
II.A.1.e.
---------------------------------------------------------------------------

a. Not a Reporting Company
    Under the rule, a qualifying portfolio company is defined as a
company that, at the time of any investment by a qualifying fund, is
not a ``reporting or foreign traded'' company (a ``reporting company'')
and does not control, is not controlled by or under common control
with, a reporting company.\148\ Under the definition, a venture capital
fund may continue to treat as a qualifying investment any previously
directly acquired equity security of a portfolio company that
subsequently becomes a reporting company.\149\ Moreover, after a
company becomes a reporting company, a qualifying fund could acquire
the company's publicly traded (or foreign traded) securities in the
secondary markets, subject to the availability of the fund's non-
qualifying basket.
---------------------------------------------------------------------------

    \148\ Rule 203(l)-1(c)(4)(i); rule 203(l)-1(c)(5) (defining a
``reporting or foreign traded'' company as one that is subject to
the reporting requirements under section 13 or 15(d) of the Exchange
Act, or has a security listed or traded on any exchange or organized
market operating in a foreign jurisdiction). This definition is
similar to rule 2a51-1 under the Investment Company Act (defining
``public company,'' for purposes of the qualified purchaser
standard, as ``a company that files reports pursuant to section 13
or 15(d) of the Securities Exchange Act of 1934''), and rule 12g3-2
under the Exchange Act (conditioning a foreign private issuer's
exemption from registering securities under section 12(g) of the
Exchange Act if, among other conditions, the ``issuer is not
required to file or furnish reports'' pursuant to section 13(a) or
section 15(d) of the Exchange Act). 17 CFR 270.2a51-1; 17 CFR
240.12g3-2. Under the rule, securities of a ``reporting or foreign
traded company'' include securities of non-U.S. companies that are
listed on a non-U.S. market or non-U.S. exchange. Rule 203(l)-
1(c)(5).
    \149\ Rule 203(l)-1(c)(4)(i) (defining a qualifying portfolio
company as any company that at the time of any investment by a
venture capital fund is not a reporting or foreign traded company).
---------------------------------------------------------------------------

    As we discussed in the Proposing Release, venture capital funds
provide operating capital to companies in the early stages of their
development with the goal of eventually either selling the company or
taking it public.\150\ Unlike

other types of private funds, venture capital funds are characterized
as not trading in the public markets, but may sell portfolio company
securities into the public markets once the portfolio company has
matured.\151\ As of year-end 2010, U.S. venture capital funds managed
approximately $176.7 billion in assets.\152\ In comparison, as of year-
end 2010, the U.S. publicly traded equity market had a market value of
approximately $15.4 trillion,\153\ whereas global hedge funds had
approximately $1.7 trillion in assets under management.\154\ The
aggregate amount invested in venture capital funds is considerably
smaller.\155\ Congressional testimony asserted that these funds may be
less connected with the public markets and may involve less potential
for systemic risk.\156\ This appears to be a key consideration by
Congress that led to the enactment of the venture capital
exemption.\157\ As we discussed in the Proposing Release, the rule we
proposed sought to incorporate this Congressional understanding of the
nature of investments of a venture capital fund, and these principles
guided our consideration of the proposed venture capital fund
definition.\158\ The proposed rule would have required that a
qualifying fund invest primarily in equity securities of companies that
are not capitalized by the public markets.\159\
---------------------------------------------------------------------------

    \150\ See Testimony of James Chanos, Chairman, Coalition of
Private Investment Companies, July 15, 2009, at 4 (``[V]enture
capital funds are an important source of funding for start-up
companies or turnaround ventures.''); National Venture Capital
Association Yearbook 2010 (``NVCA Yearbook 2010''), at 7-8 (noting
that venture capital is a ``long-term investment'' and the ``payoff
[to the venture capital firm] comes after the company is acquired or
goes public.''); George W. Fenn, Nellie Liang and Stephen Prowse,
The Economics of the Private Equity Market, December 1995, 22, n.61
and accompanying text (``Fenn et al.'') (``Private sales'' are not
normally the most important type of exit strategy as compared to
IPOs, yet of the 635 successful portfolio company exits by venture
capitalists between 1991-1993 ``merger and acquisition transactions
accounted for 191 deals and IPOs for 444 deals.'' Furthermore,
between 1983 and 1994, of the 2,200 venture capital fund exits,
1,104 (approximately 50%) were attributed to mergers and
acquisitions of venture-backed firms.). See also Jack S. Levin,
Structuring Venture Capital, Private Equity and Entrepreneurial
Transactions, 2000 (``Levin'') at 1-2 to 1-7 (describing the various
types of venture capital and private equity investment business but
stating that ``the phrase `venture capital' is sometimes used
narrowly to refer only to financing the start-up of a new
business''); Anna T. Pinedo & James R. Tanenbaum, Exempt and Hybrid
Securities Offerings (2009), Vol. 1 at 12-2 (discussing the role
initial public offerings play in providing venture capital investors
with liquidity).
    \151\ See Testimony of Trevor Loy, Flywheel Ventures, before the
Senate Banking Subcommittee on Securities, Insurance and Investment
Hearing, July 15, 2009 (``Loy Testimony''), at 5 (``We do not trade
in the public markets.''). See also Testimony of Terry McGuire,
General Partner, Polaris Venture Partners, and Chairman, National
Venture Capital Association, before the U.S. House of
Representatives Committee on Financial Services, October 6, 2009
(``McGuire Testimony'') at 11 (``[V]enture capital funds do not
typically trade in the public markets and generally limit advisory
activities to the purchase and sale of securities of private
operating companies in private transactions''); Levin, supra note
150, at 1-4 (``A third distinguishing feature of venture capital/
private equity investing is that the securities purchased are
generally privately held as opposed to publicly traded * * * a
venture capital/private equity investment is normally made in a
privately-held company, and in the relatively infrequent cases where
the investment is into a publicly-held company, the [venture capital
fund] generally holds non-public securities.'') (emphasis in
original).
    \152\ National Venture Capital Association Yearbook 2011 (``NVCA
Yearbook 2011'') at 9, Fig. 1.0.
    \153\ Bloomberg Terminal Database, WCAUUS  Bloomberg
United States Exchange Market Capitalization).
    \154\ Credit Suisse, 2010 Hedge Fund Industry Review, Feb. 2011
(``Credit Suisse Report''), at 1.
    \155\ In 2010, investors investing in newly formed funds
committed approximately $12.3 billion to venture capital funds
compared to approximately $85.1 billion to private equity/buyout
funds. NVCA Yearbook 2011, supra note 152, at 20 at Fig. 2.02. In
comparison, hedge funds raised approximately $22.6 billion from
investors in 2010. Credit Suisse Report, supra note 154, at 1.
    \156\ See S. Rep. No. 111-176, supra note 6, at 74-5 (noting
that venture capital funds ``do not present the same risks as the
large private funds whose advisers are required to register with the
SEC under this title [IV]. Their activities are not interconnected
with the global financial system, and they generally rely on equity
funding, so that losses that may occur do not ripple throughout
world markets but are borne by fund investors alone. Terry McGuire,
Chairman of the National Venture Capital Association, wrote in
congressional testimony that `venture capital did not contribute to
the implosion that occurred in the financial system in the last
year, nor does it pose a future systemic risk to our world financial
markets or retail investors.' ''). See also Loy Testimony, supra
note 151, at 7 (noting the factors by which the venture capital
industry is exposed to ``entrepreneurial and technological risk not
systemic financial risk''); McGuire Testimony, supra note 151, at 6
(noting that the ``venture capital industry's activities are not
interwoven with U.S. financial markets''). See also Group of Thirty,
Financial Reform: A Framework for Financial Stability, January 15,
2009, at 9 (discussing the need for registration of managers of
``private pools of capital that employ substantial borrowed funds''
yet recognizing the need to exempt venture capital from
registration).
    \157\ See supra note 156.
    \158\ See Proposing Release, supra note 26, at n.43 and n.60 and
following text.
    \159\ Most commenters did not express any objection to our
proposed definition of ``publicly traded,'' although one commenter
did disagree with the proposed definition's approach to foreign
traded securities. This commenter argued that the proposed rule
should be modified to ``cover securities that have been publicly
offered to investors in a foreign jurisdiction and equity securities
that are widely held and traded over-the-counter in a foreign
jurisdiction.'' Merkl Letter. We decline to adopt this approach
because the definition would require us to define what constitutes a
``public offering'' notwithstanding the laws of foreign regulators
and legislatures.
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    Several commenters asserted that the definition should not exclude
securities of reporting companies.\160\ Most, however, did not object
to the rule's limitation on investments in non-reporting companies, but
instead sought a more flexible definition that would include some level
of investments in reporting companies under certain conditions. For
example, certain commenters supported venture capital fund investments
in reporting companies only if, at the time the company becomes a
reporting company, the fund continued to hold at least a majority of
its original investment made when the company was a non-reporting
company.\161\ Some of these commenters asserted that public offerings,
which trigger reporting requirements under the Federal securities laws,
were viewed as an additional financing round, with pre-existing venture
investors expected to participate.\162\ Alternatively, several
commenters recommended that a venture capital fund could limit its
investment in reporting companies, such as 15 or 20 percent of the
fund's capital commitments.\163\
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    \160\ See Bessemer Letter; IVP Letter (also suggested additional
conditions); Merkl Letter. One commenter also suggested that the
definition should not exclude investments in companies that may be
deemed to be ``controlled'' by a public company (or its venture
capital investment division). See Comment Letter of Berkeley Center
for Law, Business and the Economy (Feb. 1, 2011) (``BCLBE Letter'').
See also Dechert General Letter (argued that restricting the
application of the control element may be necessary because an
adviser to a venture capital fund could be controlled by a public
company, and might itself be deemed to control a portfolio company
as a result of its prior investments). Under our rule, a venture
capital fund could invest in such companies under the non-qualifying
basket.
    \161\ ATV Letter; BIO Letter; NVCA Letter. See also Davis Polk
Letter; InterWest Letter; McDonald Letter; Mesirow Letter; PTV
Sciences Letter. A number of commenters supported expanding the
proposed definition but without additional conditions. See, e.g.,
BioVentures Letter; ESP Letter; Quaker BioVentures Letter; SV Life
Sciences Letter.
    \162\ See, e.g., Alta Partners Letter; Gunderson Dettmer Letter;
InterWest Letter; McDonald Letter; NVCA Letter; Quaker BioVentures
Letter. See also Bessemer Letter; BIO Letter; Lowenstein Letter.
    \163\ Alta Partners Letter (supported limiting investments in
public companies to 15% of fund capital commitments); Gunderson
Dettmer Letter (supported limiting investments in public securities
to 20% of fund capital commitments). See also Davis Polk Letter
(supported limiting investments in public companies to 20% of fund
capital commitments provided the fund continues to hold a majority
of its original investment in the company when it was private); SVB
Letter (supported investments in public securities but did not
identify a percentage threshold).
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    We understand that venture capital funds seek flexibility to invest
in promising portfolio companies, including companies deemed
sufficiently profitable to become reporting companies or companies that
may be owned directly or indirectly by a public company. Rather than
modify the rule to impose additional criteria for investing in
reporting companies, however, we have adopted a limit of 20 percent for
non-qualifying investments, which may be used to hold securities of
reporting companies. We believe that the 20 percent limit appropriately
balances commenters' expressed desire for greater flexibility to
accommodate existing business practices while providing sufficient
limits on the extent of investments that would implicate Congressional
statements regarding the interconnectedness of venture capital funds
with the public markets.\164\
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    \164\ See supra Section II.A.1.b. One commenter argued that, in
addition to funds that would satisfy the proposed definition, a
venture capital fund should include any fund that invests at least
75% of its capital in privately held ``domestic small business'' as
defined in the Small Business Investment Act (the ``SBIA'')
regulations, regardless of the equity/debt nature of the investment.
See NASBIC/SBIA Letter. In the Proposing Release, we noted our
concerns with adopting a definition for a ``small'' company,
including reliance on the SBIA regulatory standards for treatment as
a ``small'' company, which generally imposes specific tests for net
worth, net income or number of employees for each type of company,
depending on its geographic location and industry classification.
See Proposing Release, supra note 26, at n.69 and accompanying and
following text. We have considered the issues raised in the NASBIC/
SBIA Letter and continue to believe that a qualifying portfolio
company should not be defined by reference to whether a company is
``small'' for the reasons cited in the Proposing Release.

---------------------------------------------------------------------------

    Under our rule, a qualifying portfolio company is defined to
include a company that is not a reporting company (and does not have a
control relationship with a reporting company) at the time of each fund
investment.\165\ However, one commenter observed that an existing
investment in a portfolio company that ultimately becomes a successful
venture capital investment (such as when the company issues its
securities in a public offering or becomes a reporting company) should
not result in the investment becoming a non-qualifying investment.\166\
We agree. Under the rule, such an investment would not become a non-
qualifying investment because the definition focuses on the time at
which the venture capital fund acquires the particular equity security
issued by a portfolio company and does not limit the definition of
qualifying portfolio company solely to companies that are and remain
non-reporting companies. Under this approach, an adviser could continue
to rely on the exemption even if the venture capital fund's portfolio
ultimately consisted entirely of securities that become securities of
reporting companies. We believe that our approach would give advisers
to venture capital funds sufficient flexibility to exercise their
business judgment on the appropriate time to dispose of portfolio
company investments--whether that occurs at a time when the company is
or is not a reporting company.\167\ Moreover, under the Federal
securities laws, a person, such as a venture capital fund, that is
deemed to be an affiliate of a company may be limited in its ability to
dispose of the company's securities.\168\ Under the final rule, a
qualifying fund would not be in the position of having to dispose of
securities of a qualifying portfolio company that subsequently becomes
a reporting company.
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    \165\ See rule 203(l)-1(c)(4)(i).
    \166\ PTV Sciences Letter (stating that following a merger or
public offering of a qualifying portfolio company's securities, the
shares held by the fund ``are turned into profits to our
investors'').
    \167\ See Proposing Release, supra note 26, at n.55 and
following text.
    \168\ See sections 2(a)(11) (defining ``underwriter'') and 5 of
the Securities Act. See also E.H. Hawkins, SEC Staff No-Action
Letter (June 26, 1997) (staff explained how the term ``underwriter''
in the Securities Act restricts resales of securities by affiliates
of issuing companies).
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b. Portfolio Company Leverage
    Rule 203(l)-1 defines a qualifying portfolio company for purposes
of the exemption as one that does not borrow or issue debt obligations
in connection with the venture capital fund's investment in the company
and distribute to the fund the proceeds of such borrowing or issuance
in exchange for the fund's investment.\169\ As a consequence, certain
types of funds that use leverage or finance their investments in
portfolio companies or the buyout of existing investors with borrowed
money (e.g., leveraged buyout funds, which are a different subset of
private equity funds) would not meet the rule's definition of a venture
capital fund.\170\ As discussed in greater detail below and in the
Proposing Release, we believe that Congress did not intend the venture
capital fund definition to apply to these types of private equity
funds.\171\
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    \169\ Rule 203(l)-1(c)(4)(ii).
    \170\ Leveraged buyout funds are private equity funds that will
``borrow significant amounts from banks to finance their deals--
increasing the debt-to-equity ratio of the acquired companies * *
*'' U.S. Govt. Accountability Office, Private Equity: Recent Growth
in Leveraged Buyouts Exposed Risks that Warrant Continued Attention
(2008) (``GAO Private Equity Report''), at 1. A leverage buyout fund
in 2005 typically financed a deal with 34% equity and 66% debt. Id.
at 13. See also Fenn et al., supra note 150, at 23 (companies that
have been taken private in a leveraged buyout (or ``LBO'')
transaction generally ``spend less on research and development,
relative to assets, and have a greater proportion of fixed assets;
their debt-to-assets ratios are high, above 60 percent, and are two
to four times those of venture-backed firms.'' Moreover, compared to
venture capital backed companies, LBO-private equity backed
companies that are taken public typically use proceeds from an IPO
to reduce debt whereas new venture capital backed firms tend to use
proceeds to fund growth.); Testimony of Mark Tresnowksi, General
Counsel, Madison Dearborn Partners, LLC, on behalf of the Private
Equity Council, before the Senate Banking Subcommittee on
Securities, Insurance and Investment, July 15, 2009, at 2
(indicating that portfolio companies in which private equity funds
invest typically have 60% debt and 40% equity).
    \171\ See discussion in section II.A.1.c. and d. of the
Proposing Release, supra note 26.
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    We proposed to define a qualifying portfolio company as a company
that does not borrow ``in connection'' with a venture capital fund
investment. We also proposed to define a qualifying portfolio company
as a company that does not participate in an indirect buyout involving
a qualifying fund (as a corollary to our proposed limitation on venture
capital fund acquisitions of portfolio company securities through
secondary transactions, i.e., direct buyouts).\172\ We proposed these
elements to distinguish between venture capital funds that provide
capital to portfolio companies for operating and business purposes (in
exchange for an equity investment) and leveraged buyout funds, which
acquire controlling equity interests in operating companies through the
``buyout'' of existing security holders or which finance such
investments or buyouts with borrowed money.\173\ We proposed these
elements of the qualifying portfolio company definition because of the
focus on leverage in the Dodd-Frank Act as a potential contributor to
systemic risk as discussed by the Senate Committee report,\174\ and the
testimony before Congress that stressed the lack of leverage in venture
capital investing.\175\
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    \172\ Proposed rules 203(l)-1(a)(2)(i); (c)(4)(ii) and
(c)(4)(iii).
    \173\ See generally Proposing Release, supra note 26, at
sections II.A.1.c. and d.
    \174\ See S. Rep. No. 111-176, supra note 6, at 74 (``The
Committee believes that venture capital funds, a subset of private
investment funds specializing in long-term equity investment in
small or start-up businesses, do not present the same risks as the
large private funds whose advisers are required to register with the
SEC under this title.''); id. at 75 (concluding that private equity
funds that use limited or no leverage at the fund level engage in
activities that do not pose risks to the wider markets through
credit or counterparty relationships).
    \175\ See Proposing Release, supra note 26, at n.100.
---------------------------------------------------------------------------

    Some commenters argued that defining a venture capital fund as a
fund that does not participate in buyouts was too restrictive or too
difficult to apply.\176\ Most of the commenters who addressed the issue
opposed a definition that excluded any buyouts of portfolio company
securities by venture capital funds.\177\ Some commenters argued that
because a venture capital fund could, under the proposed rule, acquire
up to 20 percent of portfolio company securities in secondary
transactions, indirect buyouts achieved at the portfolio company level
should not be precluded.\178\ Some commenters stated that buyouts are
an important means of providing liquidity to portfolio company
founders, employees, former employees and vendors/service
providers,\179\ while others argued that

buyouts occurring as a result of recapitalizations\180\ or conversions
of permissible bridge loans \181\ should not preclude a fund from
relying on the definition.\182\
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    \176\ See, e.g., McGuireWoods Letter; NVCA Letter; Pine Brook
Letter.
    \177\ One commenter sought interpretative guidance on which
buyout transactions would be considered to be ``in connection with''
a venture capital fund investment. Mesirow Letter. See also
McGuireWoods Letter; NVCA Letter (discussing some interpretative
issues with the ``in connection with'' language).
    \178\ ATV Letter; NVCA Letter. See also ABA Letter (also
recommending that the buyout bucket be increased to 30%); Charles
River Letter (supported a 20% buyout limit to accommodate the
increasing industry use of buyouts); First Round Letter (supported
25% buyout limit for each deal and a 20% limit for all fund
investments in order to facilitate liquidity to founders).
    \179\ See, e.g., Davis Polk Letter; ESP Letter; SVB Letter.
    \180\ Alta Partners Letter; BioVentures Letter.
    \181\ ATV Letter; NVCA Letter.
    \182\ See also Pine Brook Letter (suggesting ``careful
drafting'' that would not preclude transactions in the normal course
of business by defining a set of prohibited buyout transactions
(e.g., ``leveraged dividend recapitalizations'')).
---------------------------------------------------------------------------

    We have eliminated the proposed indirect buyout criterion in the
final rule. Because the non-qualifying basket does not exclude
secondary market transactions (or other buyouts of existing security
holders), it would be inconsistent to define a venture capital fund as
a fund that does not participate in a buyout.
    We are retaining and clarifying, however, the leveraged buyout
criterion as it relates to qualifying portfolio companies. We had
proposed to define a qualifying portfolio company as a company that,
among other things, does not borrow ``in connection'' with a venture
capital fund investment. As noted above, we proposed this element to
distinguish venture capital funds from leveraged buyout funds, and we
continue to believe that this remains an important distinction. We
believe that these differences (i.e., the use of buyouts and associated
leverage) distinguish venture capital funds from buyout private equity
funds for which Congress did not provide an exemption.\183\
---------------------------------------------------------------------------

    \183\ See supra note 174 and accompanying text.
---------------------------------------------------------------------------

    One of the distinguishing features of venture capital funds is
that, unlike many hedge funds and private equity funds, they invest
capital directly in portfolio companies for the purpose of funding the
expansion and development of the company's business rather than buying
out existing security holders, otherwise purchasing securities from
other shareholders, or leveraging the capital investment with debt
financing.\184\ Testimony received by Congress and our research suggest
that venture capital funds provide capital to many types of businesses
at different stages of development,\185\ generally with the goal of
financing the expansion of the company \186\ and helping it progress to
the next stage of its development through successive tranches of
investment (i.e., ``follow-on'' investments) if the company reaches
agreed-upon milestones.\187\
---------------------------------------------------------------------------

    \184\ See Loy Testimony, supra note 151, at 2 (``Although
venture capital funds may occasionally borrow on a short-term basis
immediately preceding the time when the cash installments are due,
they do not use debt to make investments in excess of the partner's
capital commitments or `lever up' the fund in a manner that would
expose the fund to losses in excess of the committed capital or that
would result in losses to counter parties requiring a rescue
infusion from the government.''). See also infra notes 189-191; Mark
Heesen & Jennifer C. Dowling, National Venture Capital Association,
Venture Capital & Adviser Registration (October 2010), materials
submitted in connection with the Commission's Government-Business
Forum on Small Business Capital Formation (summarizing the
differences between venture capital funds and buyout and hedge
funds), available at http://www.sec.gov/info/smallbus/2010gbforumstatements.htm.
    \185\ See, e.g., McGuire Testimony, supra note 151, at 1; NVCA
Yearbook 2010, supra note 150; PricewaterhouseCoopers/National
Venture Capital Association MoneyTree Report, Q4 2009/Full-year 2009
Report (providing data on venture capital investments in portfolio
companies); James Schell, Private Equity Funds: Business Structure
and Operations (2010), at Sec.  1.03[1] (``Schell''), at Sec.
1.03[1]; Paul A. Gompers & Josh Lerner, The Venture Capital Cycle,
at 459 (MIT Press 2004), at 178, 180 table 8.2 (displaying
percentage of annual venture capital investments by stage of
development and classifying ``early stage'' as seed, start-up, or
early stage and ``late stage'' as expansion, second, third, or
bridge financing).
    \186\ See McGuire Testimony, supra note 151, at 1; Loy
Testimony, supra note 151, at 3 (``Once the venture fund is formed,
our job is to find the most promising, innovative ideas,
entrepreneurs, and companies that have the potential to grow
exponentially with the application of our expertise and venture
capital investment.''). See also William A. Sahlman, The Structure
and Governance of Venture-Capital Organizations, Journal of
Financial Economics 27 (1990), at 473, 503 (``Sahlman'') (noting
venture capitalists typically invest more than once during the life
of a company, with the expectation that each capital investment will
be sufficient to take the company to the next stage of development,
at which point the company will require additional capital to make
further progress).
    \187\ See Sahlman, supra note 186, at 503; Loy Testimony, supra
note 151, at 3 (``[W]e continue to invest additional capital into
those companies that are performing well; we cease follow-on
investments into companies that do not reach their agreed upon
milestones.'').
---------------------------------------------------------------------------

    In contrast, private equity funds that are identified as buyout
funds typically provide capital to an operating company in exchange for
majority or complete ownership of the company,\188\ generally achieved
through the buyout of existing shareholders or other security holders
and financed with debt incurred by the portfolio company,\189\ and
compared to venture capital funds, hold the investment for shorter
periods of time.\190\ As a result of the use of the capital provided
and the incurrence of this debt, following the buyout fund investment,
the operating company may carry debt several times its equity and may
devote significant levels of its cash flow and corporate earnings to
repaying the debt financing, rather than investing in capital
improvement or business operations.\191\
---------------------------------------------------------------------------

    \188\ GAO Private Equity Report, supra note 170, at 8 (``A
private equity-sponsored LBO generally is defined as an investment
by a private equity fund in a public or private company (or division
of a company) for majority or complete ownership.'').
    \189\ See Annalisa Barrett et al., Prepared by the Corporate
Library Inc., under contract for the IRRC Institute, What is the
Impact of Private Equity Buyout Fund Ownership on IPO Companies'
Corporate Governance?, at 7 (June 2009) (``Barrett et al.'') (``In
general, VC firms provide funding to companies in early stages of
their development, and the money they provide is used as working
capital for the firm. Buyout firms, in contrast, work with mature
companies, and the funds they provide are used to compensate the
firm's existing owners.''); Ieke van den Burg and Poul Nyrup
Rasmussen, Hedge Funds and Private Equity: A Critical Analysis
(2007), at 16-17 (``van den Burg''); Sahlman, supra note 186, at
517. See also Tax Legislation: CRS Report, Taxation of Hedge Fund
and Private Equity Managers, Tax Law and Estate Planning Course
Handbook Series, Practicing Law Institute (Nov. 2, 2007) at 2
(noting that in a leveraged buyout ``private equity investors use
the proceeds of debt issued by the target company to acquire all the
outstanding shares of a public company, which then becomes
private'').
    \190\ Unlike venture capital funds, which generally invest in
portfolio companies for 10 years or more, private equity funds that
use leveraged buyouts invest in their portfolio companies for
shorter periods of time. See Loy Testimony, supra note 151, at 3
(citing venture capital fund investments periods in portfolio
companies of five to 10 years or longer); van den Burg, supra note
189, at 19 (noting that LBO investors generally retain their
investment in a listed company for 2 to 4 years or even less after
the company goes public). See also Paul A. Gompers, The Rise and
Fall of Venture Capital, Business And Economic History, vol. 23, no.
2, Winter 1994, at 17 (stating that ``an LBO investment is
significantly shorter than that of a comparable venture capital
investment. Assets are sold off almost immediately to meet debt
burden, and many companies go public again (in a reverse LBO) in a
very short period of time.'').