VC Funds Warehousing Investments: Traps for the Unwary
By Dan DeWolf, Talia Primor, Marine Bouaziz
One of the challenges facing venture capital firms is how to handle investments in portfolio companies prior to the initial close (“Initial Close”) of a new fund (“New Fund”). Typically, the investment advisor (“VC Advisor”), or a person wholly owned or controlled by the VC Advisor, will make such investment, “warehouse” it, and then transfer such investment to the New Fund promptly after the Initial Close. This strategy has been very effective for many fund managers as it enables them to commence the creation of a diversified portfolio of interesting companies for its future limited partners prior to the time of the Initial Close. While this is an effective strategy for fund raising purposes, VC Advisors should be aware of some of the pitfalls with warehousing investments.
Who can make these warehoused investments?
The Securities and Exchange Commission (“SEC”) has provided guidance as to who can make these warehoused investments.[1] Following this guidance is critically important so that the warehoused investments are not considered “non-qualifying investments” and thereby negatively impacting the ability of the VC Advisor to remain an Exempt Reporting Advisor.[2] Under the SEC guidance, a VC Advisor can warehouse investments in portfolio companies provided that (i) such investment is initially acquired by the VC Advisor (or a person wholly owned and controlled by the VC Advisor) directly from the qualifying portfolio company solely for the purpose of acquiring the investment for a venture capital fund that is actively in the process of raising capital, and (ii) the terms of the warehoused investment are fully disclosed to prospective investors prior to their committing to invest in the New Fund. Failure to follow this two-pronged test will adversely affect the regulatory requirements applicable to, and any available exemption from SEC-registration for, the VC Advisor.
Warehousing: A Major Hurdle to QSBS Eligibility
The Qualified Small Business Stock (“QSBS”) rules under Section 1202 of the U.S. Internal Revenue Code can offer substantial tax breaks to investors owning QSBS of a portfolio company through a venture capital fund. Each investor in a fund (an “Investor”) can potentially exclude up to 100% of the gain the Investor receives from the disposition of QSBS held by a fund up to the greater of $ 10 million or 10x its respective basis. However, navigating the requirements to achieve QSBS status can be complex, and one common pitfall, often overlooked by VC Advisors, is warehousing. QSBS is stock in a U.S. C corporation with gross assets of $50 million or less before and immediately after the stock is issued, and which is engaged in a “qualified trade or business”[3]. Section 1202 allows funds to purchase QSBS and then distribute the QSBS in kind or the cash proceeds associated with the disposition of such QSBS to their Investors who can then take advantage of the Section 1202 gain exclusion. However, there are a number of requirements for stock to qualify as QSBS, and one of these requirements cannot be met if the fund warehouses the investment.
One of the requirements for stock to qualify as QSBS is that the fund that disposes of the stock must have received the stock as a primary issuance (i.e., directly from the C corporation issuing it). However, when a VC Advisor warehouses an investment, it disrupts the primary issuance requirement by creating an intermediary step. Even if all the other requirements for stock to qualify as QSBS are met, because the New Fund will not receive the stock directly from the C corporation as a primary issuance, but from the person that initially made the investment (i.e., the investment advisor, general partner, or other affiliate) as a secondary sale, the stock will be disqualified from being QSBS eligible.
Thus, while warehousing investments may provide fundraising benefits to a New Fund, it will significantly limit the tax benefits attributable to QSBS and it is incumbent on each VC Advisor to be mindful of this trap.
[1] The full version of the SEC's Guidance Update is located on the SEC's website at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-13.pdf.
[2]Id.
[3] A list of businesses that are not qualified trade or business can be found in Section 1202(e)(3) of the U.S. Internal Revenue Code. This list includes, but is not limited to, businesses in personal services, financial services, farming, oil, gas and mining, hospitality, and real estate.