Fears Of SEC Registration Disappear, But Venture Firms May Face New Record Keeping Demands

Most venture capital firms will not have to register with the Securities and Exchange Commission under rules the commissioners adopted on June 22.

This appears to be the consensus of attorneys and other experts who have had time to comb through 208 pages of regulatory details that the SEC released late last week.

But that doesn’t mean this complex set of regulations won’t have an impact on the industry. They could in fact trigger changes in overseas investing and in the internal record keeping procedures that firms follow.

The rules set out the exemption from registration the Dodd-Frank Act granted the venture industry. It does so by defining what qualifies as a venture capital fund and a qualifying fund investment.

For the most past, these guidelines are simpler and more flexible than an initial set of regulations proposed in November. They state that a venture capital fund must put its money in qualifying investments, generally defined as equity deals made with private companies.

Firms cannot borrow or issue debt obligations of more than 15% of a fund’s resources and borrowing is restricted to not more than 120 days. Funds similarly cannot provide redemption or liquidity rights to LPs, except in extraordinary situations, and don’t necessarily have to provide management assistance to a portfolio company for an investment to qualify.

Most importantly, they give funds the freedom to deploy up to 20% of their total capital, including uncalled commitments, in non-qualifying investments, such as company shares purchased on the secondary markets, debt instruments or post IPO shares, or PIPEs. These non-qualifying investments are valued at cost or fair market value, as long as they are done consistently.

The result is that most venture firms will not have to register with the SEC under the new rules, says Jonathan Axelrad, partner at Goodwin Procter. (Here is a client alert from the Goodwin Procter.)

However, that doesn’t mean the definition will be easy to adhere to or cost free. “These new rules, while they are greatly improved relative to the proposed rules, are still complex,” says Axelrad. “There will be a number of open questions about how they apply.”

For instance, VCs investing abroad could see a significant impact on their operations. VCs deploying capital in countries such as India and China frequently invest in companies that have gone public, since many startups float shares earlier than startups do in the United States. These would be defined as non-qualifying investments.

VCs also face pressures for new record keeping and reporting capabilities. The SEC at any time could decide to examine a firm’s compliance with the new rules, and firms need to have the appropriate records to prove they are toeing the line. For smaller firms with fewer resources, this could be a significant burden.

Firms also have new reporting requirements on Form ADV Part I. (Detail is available here.)

While the new rules offer firms a sigh of relief, they come with demands that could have GPs reaching deeper into their pockets.