qualifying as a vcoc after a fund’s initial investment

Wilson Sonsini Goodrich & RosatiPROFESSIONAL CORPORATION

Qualifying as a VCOCAfter a Fund’s Initial Investment

Preliminary Report on an

Evolving Technique

June 2003

2274205


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Introduction

Venture firms that accept capital from pension and retirement plans regulated under ERISA (“ERISA Investors”) typically have three choices:

• Qualify the “General Partner” of each applicable fund (“Fund”) as an ERISA fiduciary and comply with fiduciary standards

• Limit ERISA Investor participation in each Fund to a level that is not significant (the “Significant Participation Test”)

• Qualify each Fund as a venture capital operating company (“VCOC”)


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Introduction

In general, a Fund can be a VCOC only if it qualifies no later than the date of its first portfolio investment

• Traditionally, this has meant that Funds which do not initially qualify as VCOCs must satisfy the Significant Participation Test

• This can be a big problem because a Fund may cease to satisfy the Significant Participation Test due to circumstances beyond the control of the General Partner


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Introduction

Under limited circumstances, it may be possible to restructure a Fund so that it can qualify as a VCOC even after its initial portfolio investment (a “VCOC Restructuring”)

• This presentation is a preliminary report on the evolving VCOC Restructuring technique


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Background: ERISA Fiduciaries

Most General Partners are not qualified ERISA fiduciaries

• Compliance costs are high

• Self-dealing and prohibited transaction rules can interfere with normal venture fund operations

• Many forms of carried interest are not permitted


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Background: Significant Participation Test

Many funds satisfy the Significant Participation Test

• ERISA Investors and other types of retirement plans (together, “Benefit Plan Investors”) must hold less than 25% of the value of each class of Fund interests

• Test is applied after each acquisition of an interest

– “Acquisition” is defined so broadly that the test can be appliedalmost continuously


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It can be difficult to satisfy the Significant Participation Test even if less than 25% of Fund capital is committed by Benefit Plan InvestorsExamples:

• Defaults by non-Benefit Plan Investors can increase the relative ownership of Benefit Plan Investors

– Non-Benefit Plan Investors (e.g., individuals and corporations) default more frequently than Benefit Plan Investors

• Non-Benefit Plan Investors may wish to transfer their interests to Benefit Plan Investors

– Benefit Plan Investors represent a large portion of secondary market purchasers


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• “Side Letters” or similar arrangements that grant special rightsto one or more investors may split the Fund into multiple classes, each of which must consist of less than 25% Benefit Plan Investors

– Restructuring efforts might cause a Fund to be divided into multiple classes of interests

– Large investors may negotiate for special rights in exchange for supporting General Partner’s restructuring plan and/or continuation of the Fund


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Background: VCOC Requirements

In general, a Fund will be a VCOC if:

• At least 50% of its portfolio investments (valued at cost)

• are in operating companies

• with respect to which the Fund holds “Management Rights”

These requirements must be satisfied:

• At the Fund’s first portfolio investment, and

• At least once during each “Annual Valuation Period”


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Management Rights

• Consist of rights to “substantially participate in, or substantially influence the conduct of” the management of an operating company

• Must be direct contractual rights to the Fund

– Informal rights resulting from large stock ownership don’t qualify

– Contractual rights held by a “sister fund” co-investing in the same company don’t qualify

• Often obtained through a standard “Management Rights Agreement”


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Traditionally, attorneys have advised that a Fund cannot become a VCOC if it failed to qualify:

• As of its first portfolio investment, or

• During any subsequent Annual Valuation Period

The VCOC Restructuring provides a limited exception to this general rule


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VCOC Restructuring

Summary of Steps• Existing Fund (“EF”) creates subsidiary Fund (“SF”)

• SF makes an initial portfolio investment with respect to which it obtains Management Rights and thereby qualifies as a VCOC

• SF enters into separate Management Rights Agreements with portfolio companies of EF

• EF merges into SF, with SF as the surviving entity

• SF changes its name to EF


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VCOC Restructuring

Existing Structure: Stage One

EF, L.P.

GP, L.L.C. Investors

Notes:

EF holds various portfolio company securities, but does not qualify as a VCOC

Portfolio Securities


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VCOC Restructuring

Pre-Merger: Stage Two

EF, L.P.


SF, L.P.

$Portfolio

Securities

Notes:

EF is the sole limited partner of SF and holds 100% of economic interest

GP manages SF, but holds no economic interest

EF contributes cash to SF in order to facilitate Stage Three


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VCOC Restructuring

Pre-Merger: Stage Three

EF, L.P.


SF, L.P.

Notes:

SF uses cash to make its initial portfolio investment in Op Co and simultaneously obtains Management Rights

As a result, SF qualifies as a VCOC

Op Co, Inc.

$

Management Rights



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VCOC Restructuring

Pre-Merger: Stage Four

EF, L.P.


SF, L.P.

Notes:

SF obtains Management Rights from existing portfolio companies of EF

Op Co, Inc.

Management Rights



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VCOC Restructuring

Merger: Stage Five

EF, L.P.


SF, L.P.

Notes:

EF merges into SF

SF is the surviving entity

Op Co, Inc.



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VCOC Restructuring

Post-Merger: Stage Six

SF, L.P.


Notes:

GP and Investors hold exactly same rights in SF that they held in EF

SF has sufficient Management Rights in entire portfolio to continue to qualify as a VCOC


(Including Op Co)

Management Rights


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VCOC Restructuring

Post-Merger: Final Stage

EF, L.P.


Notes:

SF has changed its name to EF

Restructuring is complete


(Including Op Co)

Management Rights


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Issues to Consider

The US Department of Labor has not issued specific guidance on this structure

• VCOC status of surviving entity would be based solely on opinion of counsel

Consider obtaining opinion of an ERISA boutique firm to supplement advice from primary Fund counsel


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Issues to Consider

Because there is no substantive change in the rights and duties of the General Partner and Investors, the VCOC Restructuring should not be considered a new issuance of securities

• However, the law is not entirely clear

• WSGR discussions with SEC are ongoing

• Unless and until direct guidance obtained from SEC, consider re-validating all Investors as “accredited” and/or “qualified”

– Restructuring could be precluded if Investors cannot be re-validated or redeemed


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Issues to Consider

Costs are not trivial

• Investor consents required

• Management Rights must be obtained

• Contracts and agreements must be reviewed to ensure that merger will not violate covenants and restrictions

– Approvals may be required from some contractual counterparties


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Issues to Consider

Obtaining Management Rights can provide benefits beyond ERISA compliance

• May permit exemption from California investment adviser registration

• See WSGR presentation “California Regulation of Investment Advisers: Recent Changes Affecting Venture Capital Firms” (June 2002)


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Conclusions

Relying upon the Significant Participation Test can be risky and interfere with Fund transfers, etc.

If you’ve relied on the Significant Participation Test, but may not be able to qualify in the future, consider VCOC Restructuring

When forming new Funds, qualify as a VCOC whenever practicable


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For More Information

See WSGR memorandum “ERISA Rules Applicable to Venture Capital Funds”


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This presentation is intended only as a general discussion and should not be regarded as legal

advice. For more information, please contact your Fund Services Group attorney.

Wilson Sonsini Goodrich & RosatiFund Services Group650 Page Mill Road

Palo Alto, California 94304Tel: 650-493-9300

www.wsgr.com

qualifying as a vcoc after a fund’s initial investment

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