Why the Venture Capital Operating Company Exemption Matters (and how a Management Rights Letter helps)

September 1, 2022 | By Kevin Vela

The Employee Retirement Income Security Act of 1974 (“ERISA”) is a federal law that regulates the investment and management of assets of employee benefit plans, such as 401(k) plans and pension plans. ERISA imposes strict “fiduciary” requirements for persons who manage and invest assets governed by ERISA (“Plan Assets”). If a venture capital fund (a “VC Fund”) raises capital from investors subject to ERISA (like pension funds, which are common investors for larger VC funds), the VC Fund will be considered a “fiduciary” and VC Fund assets will qualify as Plan Assets.

This will impose a high level of scrutiny and certain obligations on the fund unless the VC Fund can find an exemption. Obviously, VC Funds want to avoid this higher level of scrutiny when possible and thus an exemption is critical. One of the key ERISA exemptions available to VC Funds is the Venture Capital Operating Company (“VCOC”) exemption. The purpose of this blog is to explain that exemption.

Generally, an entity is a VCOC if:

on each measuring date, at least 50% of its assets are invested in venture capital investments or derivative investments and the entity has “management rights” (the “50% Test”); AND
during the evaluation period, the entity actually exercises management rights (the “Management Test”).[1]

The 50% Test is straightforward. What this requires is that 50% of a VCOC’s investments be in qualifying investments— either venture capital investments or derivative investments—on the measuring dates.

As to the Management Test, a VCOC is considered to have management rights when it has direct contractual rights with an operating company “to substantially participate in, or substantially influence the management of, the operating company”.[2] The exercise of management rights must be done on an ongoing basis, beginning on the date of the first investment. It is important to note that the Management Test assesses the actual control exercised not the potential control given contractually.

The Department of Labor has provided guidance on specific contractual rights that establish management rights for purposes of determining whether an entity qualifies as a VCOC. A few examples of which are as follows:

The right to appoint one or more directors to the board of the operating company;[3]
The right to consult or approve operating budgets or capital budgets;
The right to consult or approve of the purchase or sale of major corporate assets;
The right to appoint a person to serve as the corporate officer of the operating company;[4]
The right to regularly informally consult with and advise the management team of the portfolio company;[5] and
The right to examine the books and records of a nonpublic operating company.[6]

The form NVCA Management Rights letter addresses these concerns by giving contractual management rights to investors based on the Department of Labor’s guidance above. The rights fall under two main categories: access to financials and control through corporate decision-making. Other rights that may aid a VC Fund in meeting the threshold of the Management Test to qualify under the VCOC exemption are:

The right to receive quarterly and annual financial statements of the portfolio company, including the annual auditor’s report; and
The right to receive copies of all documents, reports, financial data, and other information that the VC Fund may reasonably request.

A VC Fund that aims to qualify as a VCOC should be aware of the following potential issues:

First Qualifying Investment: VC Funds cannot qualify as a VCOC prior to making its first qualifying investment with the appropriate amount of management rights. Moreover, if a VC Fund makes a non-qualifying investment prior to a qualified investment, it can never qualify as a VCOC.
Shared Management Rights: Contractual management rights shared with other investors will not count as management rights.
SPACs or SPVs: Management rights held by the holding company of the operating company are not considered management rights.

In conclusion, if a VC fund plans to take money from an employee benefit fund and does not want to be subject to ERISA, it is imperative to always obtain a management rights letter that provides opportunities to exercise control and actually exercise those rights during the annual valuation period. Doing so and keeping with the 50% rule will help to ensure VCOC status, and steer clear of ERISA imposed duties.

[1] 29 CFR 2510.3-101(d)(1).

[2] 29 C.F.R. § 2510.3-101(d)(3)(ii).

Posted in: Funding & Capital Raising