When a venture capital fund takes in investors who are subject to ERISA, the fund may also become subject to the numerous and onerous ERISA regulations without an exemption. Such regulations would make operating the fund untenable. For example, the fund may be prohibited from paying carried interest to the fund managers.
There are two exemptions through which a venture capital fund can avoid being subject to ERISA:
1. 25% Test Exemption: Less than 25 percent of each class of equity interests of the venture capital fund is held by investors who are subject to ERISA.
2. Venture Capital Operating Company (VCOC) Exemption: At least 50% of the venture capital fund’s assets are invested in operating companies in which the fund has contractual management rights.
In order to secure the VCOC Exemption, it has become customary for venture capital funds to ask each of its portfolio companies to sign a management rights letter providing the fund with such management rights.
It is important to note that a fund relying on the VCOC exemption should ensure that its first portfolio investment includes contractual management rights in order to satisfy the exemption requirement, and that it does not take LP money subject to ERISA before that first investment is made; otherwise, the fund be disqualified from being eligible for the exemption.
In addition, if the fund managers or their affiliates “warehouse” portfolio investments for transfer to the fund, it is important that the transfer documents provide that management rights with regard to such investments be transferred to the fund to ensure that the venture capital fund has the necessary contractual management rights to satisfy the exemption.
As ERISA regulations are complex, fund managers should seek the advice of the relevant professionals to ensure compliance if they will be receiving investor funds subject to ERISA.
