Ask a MoFo: Startup Regulatory Frameworks

The following article is part of our "Ask a MoFo" series, where we address some of the frequently asked questions our MoFo startup team is asked during the course of business. These questions span the entirety of the startup lifecycle – from questions relating to incorporation, to tips for a successful exit. We encourage you to submit questions you would like to see answered as part of this series to ECVCevents@mofo.com.

As a founder of a startup, you may consider an equity financing opportunity with a venture capital firm (a VC), but it is important to understand some of the regulatory frameworks that apply to VCs and how they might impact the structure of your financing.

Regulatory Framework

There are two regulatory considerations you should keep in mind when negotiating with VCs: (i) VCs operate under Section 203(l) of the Advisers Act of 1940, as amended, and file as venture capital exempt reporting advisers with the SEC (the “Advisers Act Exemption”), and (ii) VCs rely on the venture capital operating company exemption (“VCOC Exemption”) under the Employee Retirement Income Security Act of 1974. The Advisers Act Exemption and VCOC Exemption have various requirements, but the key ones for founders to understand are the 80% rule and management rights requirement.

80% Rule

To comply with the Advisers Act Exemption, VCs must utilize 80% of their capital commitments toward qualifying portfolio investments. Qualifying portfolio investments include: (i) equity offerings, which are typically in the form of preferred stock, warrants, securities convertible into common stock, and limited partnership interests (i.e., not pure debt), (ii) acquiring investments directly, rather than through a third party (for example, by investing in what is known as a fund of funds that in turn makes direct investments), and (iii) investing in non-publicly traded companies (and not being contractually required to participate in acquiring shares of a portfolio company once such company goes public).

Management Rights

In order to qualify for the VCOC Exemption, a VC must employ at least half of its assets toward portfolio companies that provide it with certain management rights. “Management rights” means that the VC will have contractual rights to substantially participate in, or substantially influence the conduct of, the management of the portfolio company. Examples of these rights include the right to (i) appoint one or more directors to the portfolio company’s board, (ii) consult or approve operating budgets or capital budgets, (iii) consult or approve the sale of major corporate assets, (iv) appoint a person as the corporate officer of the portfolio company, (v) regularly informally consult with and advise the management team of the portfolio company, and (vi) examine the books and records of the portfolio company. Given this test, you should anticipate that all venture firms participating in a financing round in your Company will ask for a management rights letter (MRL), even if the relevant venture firms are also being granted a board seat. Fortunately, the National Venture Capital Association provides a standard form of MRL and so these agreements tend to not be substantially negotiated. (See https://nvca.org/recommends/nvca-2020-management-rights-letter-2/.)

One caveat is that if your Company is U.S.-based, and your VC investor is considered a non-U.S. actor or has non-U.S. owners, you should make sure to work with legal counsel to determine how the MRL (and other deal terms) interact with regulatory regimes such as the Committee on Foreign Investment in the U.S. (or CFIUS).

Conclusion

Overall, VCs can provide your Company with capital and business expertise to facilitate growth, with an eye towards a successful exit. Those upsides, however, come with some restrictions, including that the VCs may (i) prefer equity investments (or convertible securities), and (ii) request certain contractual rights related to the management of your company, typically in the form of an MRL. We nevertheless advise consulting legal counsel to ensure that those rights are no more than necessary and that CFIUS or other regulatory regimes aren’t otherwise implicated.