california investments

							          California Regulation of Investment Advisers:
          Recent Changes Affecting Venture Capital Firms




                                                           June 2002

2138169
Highlights

•   Rule 260.204.9 – New exemption from California
    certification requirement for investment advisers (the “CA
    Exemption”)
     – Effective March 27, 2002

•   Available to general partners/managing members (“GPs”)
    of venture capital and other private equity funds (“Funds”)
    that satisfy either of two tests:
     – Qualified assets under management of $25 million or more
     – Management rights in portfolio companies
Highlights (cont.)

•   “Assets Test” is problematic
     – Even a transitory failure to have sufficient qualified
       assets under management could result in loss of the
       CA Exemption




                    Recommended Action:
    Obtain management rights in portfolio companies,
                regardless of Fund size
Highlights (cont.)

•   Additional Benefit:
     – Management rights can help a Fund to qualify as a “venture
       capital operating company” under ERISA
Investment Adviser Regulation in California

•   California investment advisers must be certified by the California
    Department of Corporations, except
      – When registered with the U.S. Securities and Exchange
        Commission (“SEC”) under the Investment Advisers Act of 1940
        (the “Federal Advisers Act”), or
      – When qualified for a California exemption
•   Investment adviser (“IA”) – An individual or entity that
      – for compensation
      – engages in the business of advising others
      – with regard to investing in, purchasing or selling securities
•   GPs typically are IAs
Benefits of CA Exemption

•   GPs could face penalties if not certified or exempt
           Administrative action (e.g., cease and desist orders)
           Possible fines or criminal prosecution

•   The requirements of SEC registration or California
    certification can be intrusive and burdensome
           Disclosure of personal information
           Ongoing compliance obligations
Qualifying for CA Exemption

•   GP must satisfy either one of two tests
     – Assets Test
           Focus on the GP’s qualified assets under management
     – Management Rights Test
           Focus on whether the GP or its affiliated persons have
           “Management Rights” in at least 50% of each Fund’s
           portfolio companies

•   Each test has four elements, three of which are common to
    both
 Elements of the Two Tests

             Assets Test                      Management Rights Test
IA must not hold itself out generally to   Same
the public as an investment adviser

Fewer than 15 “Clients”                    Same

Exempt from registration under the         Same
Federal Advisers Act



Qualified assets under management of       IA provides investment advice only to
$25 million or more                        “Venture Capital Companies”
Common Element: “Holding Out” to the Public

•   The CA Exemption does not define the phrase “hold itself out”
     – Under SEC interpretation of a similar phrase in the Federal Advisers
       Act
           Holding out includes:
              – Use of the term “investment adviser” or a similar description of advisory
                services in materials circulated to the public
                      Business cards or stationery
                      Web sites
                      Advertisements or interviews
              – Letting it be known generally by word of mouth or otherwise that the GP is
                available to provide investment advice or will accept new Clients
           Holding out does not include:
              – The private marketing of a new Fund via a PPM or similar materials
Common Element: Fewer than 15 Clients

•   “Client” has the same meaning as under the Federal
    Advisers Act
     – Generally, a Fund is a single Client
     – However, a single Fund may count as more than one Client if
           The Fund is managed to serve the investment objectives of one or
           more separate investors (“LPs”), rather than the Fund as a whole
              – Each LP may count as a separate Client
     – LPs with special rights not shared by all LPs in the Fund may count
       as separate Clients
           Common sources of special rights:
              – Side letters
              – Co-investment arrangements
     – Funds managed by affiliated GP entities are counted as Clients of
       each GP entity
Common Element: Federal Exemption

•   The IA must be exempt from registration with the SEC
    under the “private adviser exemption” of the Federal
    Advisers Act
     – Fewer than 15 investment advisory Clients during the
       preceding 12-month period
     – No “holding out” to the public as an investment adviser
     – Not an investment adviser to:
           Registered investment companies
           Business development companies
Separate Element: Assets Under Management

•   The IA and its Affiliated Persons must have at least $25
    million of Qualified Assets under management
     – Management – Provision of continuous and regular
       supervisory or management services
           Serving as GP of a Fund typically would qualify as
           management of the Fund’s assets
     – Affiliated Persons – Other persons that control, are controlled
       by, or are under common control with the IA
           Typically, all GP entities controlled by a common group of
           individual fund mangers are Affiliated Persons
Assets Under Management (cont.)

•   “Qualified Assets” include:
     – Securities
     – Unfunded capital commitments that are callable upon demand
           Open issue: What if a capital commitment is subject to reasonable
           limitations on call?
             – Example: Fund agreement states that no more than 40% of committed
               capital may be called within any 12-month period

•   Caution: Cash held by a Fund does not count as a
    Qualified Asset
     – Problems under this rule can be avoided by investing idle cash in
       securities such as government bonds and non-bank money market
       funds
Assets Under Management (cont.)

•   Caution: The assets under management requirement must
    be satisfied at all times
     – This can prevent qualification for the CA Exemption under
       the Assets Test when
           The IA’s first Fund has an initial closing of less than $25 million
           Fund assets decline during a wind-up period
           Other
Separate Element: Advice Only to Venture
Capital Companies (Management Rights Test)

•   A Fund is a “Venture Capital Company” if
     – At least once during each annual period following the Fund’s
       first closing
     – At least 50% of the Fund’s assets (valued at cost, excluding
       idle funds investments) are either:
           “Venture Capital Investments”; or
           “Derivative Investments”
Advice Only to Venture Capital Companies (cont.)

•   Venture Capital Investment – A security issued by an Operating
    Company as to which the GP, the Fund, or an Affiliated Person
    holds Management Rights
•   Operating Company – An entity that is primarily engaged in the
    production or sale of a product or service
     – Includes:
           Holding companies operating through majority-owned subsidiaries
           Companies conducting research or development toward eventual
           production or sale of a product or service
     – Excludes:
           Companies primarily engaged in the management or investment of
           capital
Advice Only to Venture Capital Companies (cont.)

•   Management Rights – Rights to:
     – Substantially participate in,
     – Substantially influence the conduct of, or
     – Provide or offer to provide significant guidance and counsel
       concerning
     – The management, operations or business objectives of an
       Operating Company
Advice Only to Venture Capital Companies (cont.)

•   Per the California Department of Corporations, Management
    Rights historically have included one or more of the following:
      – Veto or approval rights as to certain operational or structural matters
      – Inspection or information rights
      – Board membership or observer rights

•   These rights are similar to those that would qualify as
    management rights under the ERISA “venture capital operating
    company” (“VCOC”) rules
      – Under ERISA, each Fund seeking VCOC status must directly hold its own
        management rights
      – For purposes of the CA Exemption, Funds not seeking VCOC status can
        qualify as Venture Capital Companies via Management Rights held directly
        or by Affiliated Funds investing in the same portfolio companies
Advice Only to Venture Capital Companies (cont.)

•   Suggestion
     – Use Management Rights Agreements that satisfy the
       requirements of both ERISA and the CA Exemption
     – Each Fund within a family of parallel Funds that must qualify
       as a VCOC enters into Management Rights Agreements with
       portfolio companies
     – Other Funds within the family rely upon the VCOCs’
       Management Rights for purposes of the CA Exemption
     – If no Fund within the Family is required to qualify as a VCOC,
       select one Fund to enter into Management Rights
       Agreements
Advice Only to Venture Capital Companies (cont.)

•   Derivative Investments – Securities acquired by a Fund
     – In the ordinary course of its business
     – In exchange for an existing Venture Capital Investment:
           Pursuant to exercise or conversion rights,
           In connection with a public offering by the issuer, or
           Upon the merger or reorganization of the issuer
Advice Only to Venture Capital Companies (cont.)

•   Caution: To satisfy the Management Rights Test, every
    Client must be a Venture Capital Company
     – If a side letter or other special arrangement with an LP
       qualifies the LP as a Client, the Management Rights Test will
       not be satisfied unless the LP is itself a Venture Capital
       Company
           In general, a side letter will cause an LP to qualify as a Client
           only if the side letter causes the GP to provide the LP with
           investment advisory services; thus, many types of side letters
           will not be problematic under the Management Rights Test
Conclusions

•   For the past several years, California law has been unclear
    regarding certification requirements for venture capital and
    other private equity IAs
     – Regulators and IAs have been in something of a “holding
       pattern”

•   Now, all California-based IAs should take steps to ensure
    compliance
     – Obtain certification or qualify for an exemption
Conclusions (cont.)

•   If possible, satisfy the Management Rights Test
     – More reliable than the Assets Test over the long term
     – Serves as a back-stop even if the GP expects to satisfy the
       Assets Test
     – Compliments VCOC compliance efforts
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 & Rosati
                    Fund Services Group
                     650 Page Mill Road
                 Palo Alto, California 94304
                     Tel: 650-493-9300
                       www.wsgr.com