Joseph W. Bartlett
In today’s environment, a number of prospective venture capital fund sponsors have, given the extraordinary length of time and due diligence imposed by skittish investors these days on blind pools, switched their model from a standard private equity or venture capital fund to what is currently called a “pledge” fund.
The interested investors are shown investment opportunities by the managers and are allowed to elect to participate, or not, on a deal-by-deal basis. Ted Forstmann, as I recall it, started in business with a pledge fund; and, given today’s climate, some quite talented and experienced individuals are electing that route. The fund is a Limited Liability Company, code named special purpose vehicle (“SPV”), designed to house the shares (“Shares”) of stock in a selected private company in the U.S. (“Newco”), the Shares to be purchased by investors rounded up by the sponsors functioning as the Managing Member of the SPV and the owners of its affiliate, the management company (the “Management Company”) functioning in the conventional format.
The core idea is that each investment is owned of record by a single SPV. The Chaperone locates Newco as Newco embarks on the hunt for capital, absorbs the terms Newco is offering including the desired pre-money valuation, negotiates successfully and then freezes the deal in place for, let’s say, 60 days in accordance with a no shop, no solicit clause (plus, of course, an NDA).
The Chaperone then rounds up from its contact list investors agreeing to subscribe to the amounts necessary, on a collective basis, to purchase the Shares and to pay certain expenses. One or more of the investors often agrees to act (informally) as the lead investor (the “Lead”) and, in that capacity, negotiates (with the Chaperone’s assistance as an adviser and typically as an investor as well) the terms of the deal, including engaging counsel to help close.
Neither the Chaperone nor the SPV has custody of the securities which are farmed out to a broker or service provider and, of course, neither holds itself out as a broker or receives a conventional success fee. The SPV is the owner of record. The Chaperone calls for contributions to the SPV to purchase the Shares and pay third party expenses, including a stated number for SPV organizational costs, out of the collective pockets of the investors (not including in this context the Chaperone in its capacity as an investor), an annual management fee out of the same pockets and a 20% carried interest to the Chaperone when Newco, with the Chaperone’s help and guidance, successfully closes on an exit event.
The structure of the typical pledge fund mimics that of a conventional venture or private equity fund. The investors contribute cash to the SPV and the SPV then buys the Shares as the record holder … for the benefit of the Chaperone, through the carried interest, and the investors through their percentage interests based on their capital contributions. Administrative expenses for the duration of the term … i.e., until the closing on the exit event … are reimbursed from the annual (or quarterly) management fee charged to the Fund and in turn to the investors. The investors (again ex- the Chaperone) also pay, on call, certain operating expenses the Management Fee does not cover, including costs of the acquisition of Newco’s Shares, provided that an Advisory Committee, appointed by the Chaperone but populated by the investor heavyweights, keeps an eye on expenses, fees and conflicts of interest … in other words, the Chaperone’s report card. An Advisory Committee’s charter is set out in Appendix B. As and when the Shares yield a profit … a capital gain presumably … upon an exit event, the carried interest is the Chaperone’s principal reward; as per the reasoning of the AngelList and FundersClub No-Action Letters, the Managing Member’s “profit” (its take home pay) is accordingly, aligned with those of the investors. The Management Fee is for out-of-pocket expenses, period!
The good news is that, assuming this structure gets the job done from the point of view of both the Chaperone and the investors, it serves two functions by navigating between the classic rock and hard place.
On the one hand, it avoids, courtesy of the No-Action Letters, the necessity for the Chaperone/Managing Member in order to make money for sourcing a good deal to register as a broker dealer and to join FINRA and, on the other hand, to run the risks which are inherent in the current broker dealer avoidance strategy… stretching the success fee over a long term “consulting” arrangement. In the latter case, the risk, of course, is that the arrangement is too cute by half … the consulting services are not real and the arrangement is vulnerable accordingly.
An important piece of the puzzle is whether the Chaperone, as the Managing Member (or the SPV itself) has to register as an investment adviser. The piece by my colleague, Jonathan Golub, is required reading on this issue “Registration, exemption and Compliance Requirements for Private Fund Managers.” https://blog.vcexperts.com/2016/04/05/registration-exemption-and-compliance-requirements-for-private-fund-managers/ Please read carefully the good news for a chaperone of an SPV based in New York State, the chaperone being Managing Member of five or fewer SPVs.
A final word on this subject (for now anyway). An excellent piece on this subject, authored by Phyllis Schwartz at Schulte Roth, is featured with her permission on VC Experts www.vcexperts.com and I strongly recommend interested parties read the entire summary. Herewith some excerpts as an example of her expertise and in aid of adding useful items to this article. Phyllis is a colleague of mine from time to time on the New York City Bar Association Committee on Private Investment Funds and I am proud to feature some of her accomplishments  taken from the Schulte publication in which her material appears.
Phyllis Schwartz, Sample Observations
A. The structure of a pledge fund has many similarities to that of committed funds, with the principal exception regarding the right of Investors to opt into Thus, Investors in pledge funds have committed capital to cover fund expenses and fees. A pledge fund may consist of one or several Investors.
- The duty to offer investment opportunities is usually three years, a much shorter period than the typical five-year Investment period of a committed There is less convention on the hold periods for pledge fund investments, but five year hold periods would not be atypical.
- If an investor does not participate in a minimum number of deals, usually that investor loses its right to participate in future
- The timing and information provided to investors is critical to being able to operate pledge There are technical legal and practical considerations at play:
(a) Since they have to make an investment decision, investors should have simultaneous (or as close as possible) and equal access to For instance, there should be agreed upon formats for deal memoranda and for answering questions the sponsor receives from one investor (i.e., address one on-one or in an open forum for all investors); and
(b) Like desired co-investors, investors who are able to process information quickly should be targeted for pledge
- Management fees are paid on invested capital, and can be 2 percent, but there is a wide range of fee
- When a manager has more leverage, it will be able to charge a “commitment fee” for the obligation to show deals to its
- Like private equity funds, transaction fees paid to managers will trigger offsets to management fees.
- A carried Interest is usually charged to investors on a deal by deal basis, and 20 percent is the starting In certain cases, a manager may earn more than 20 percent depending on the performance targets of investments (like joint ventures).
- Clawbacks have become customary in pledge Even though investors can decide whether to invest in a deal, the presumption is that they will, and therefore, investors are generally able to require clawbacks and netting of losses against gains.
- Recalls of distributions will be more limited ln pledge funds and will only relate to losses arising from the actual deal creating the
- Expenses must be managed carefully, since management fees are not Notably, deal related expenses are carefully agreed to in advance (unlike committed funds). For instance, a pledge fund investment agreement will address broken deal expenses, and once an investor gives initial approval of its interest. In participating in a deal, that investor is usually required to cover broken deal expenses.
- The sponsor must think about how it will attract and reward operating partners in a pledge fund
- There is no stigma to running a pledge fund.
- Pledge funds facilitate the ability of emerging managers to enter the private equity They also bridge periods between committed funds, and they facilitate ongoing investments by managers who do not necessarily plan to raise any future trends.
- Pledge funds can result in the same operational burdens on managers as committed funds, such as reporting obligations and
- Pledge funds offer broad They can be used to start up a business to bridge investment management businesses and to wind down investment management businesses. Creative approaches to economic terms are more likely to be accepted by Investors in exchange for the right of investors to opt into deals.
 Phyllis is recognized by The Best Lawyers in America, Expert Guide to the World’s Leading Women in Business Law (Investment Funds). Expert Guide to the World’s Leading Investment Fund’s Lawyers. A member of the Private Investment Fund Forum, and frequently shares her insights on effective fund formation strategies at industry conferences and seminars. She recently addressed waterfall models of distribution, management fees and expenses, and investor terms and conditions in private equity fund raising. Phyllis is also co-author of Private Equity Funds: Formation and Operation (Practising Law Institute), the leading treatise on the subject, and she contributed a chapter on “Advisers to Private Funds – Practical Compliance Considerations” to Mutual Funds and Exchange Traded Funds Registration, Volume 2 (Practising Law Institute 2013).
The Dodd-Frank Wall Street Reform and Consumer Protection Act, which became law in 2010, complicated the registration and compliance landscape for investment advisers, including those that manage private funds (referred to in this material as “private fund managers”).  The question for New York-based investment advisers managing private funds is whether they have to register with the Securities and Exchange Commission (the “SEC”), the State of New York, or multiple states. As discussed below, New York-based fund managers are treated differently under the law from fund managers domiciled in other states. This material focuses on how New York-based private fund managers should navigate the registration requirements of federal and state law.
Key Analysis: Regulatory Assets Under Management
The size of an investment adviser (in terms of its “regulatory assets under management” or “RAUM”) determines whether and where it is required to register if no exemption applies.  A shorthand method of calculating a private fund manager’s RAUM is the aggregate gross assets of all of the funds that it manages. Specific instructions for calculating RAUM are included in the federal Form ADV. So long as a private fund manager’s RAUM across all of its funds is below $25 million, then it is prohibited from registering with the SEC as an investment adviser at the federal level and is subject to potential state regulation and oversight.  In contrast, Rule 203A-1 under the Advisers Act provides that an investment adviser is eligible to register with the SEC if it has at least $100 million in RAUM.
The Advisers Act also recognizes a third category of investment adviser, called “mid-sized advisers.”  Mid-sized advisers are advisers having RAUM between $25 million and $100 million that are required to register with the SEC if either of the following applies: (1) the adviser is not required to be registered as an investment adviser in the state in which it maintains its principal office and place of business, or (2) if registered with a state, the adviser would not be subject to examination as an investment adviser by that state’s securities commissioner (emphasis added).  The SEC has recognized that New York is a state in which advisers are not subject to examination.  Thus, a New York-based investment adviser with assets under management of at least $25 million must register with the SEC, unless an exemption applies. To summarize the federal registration regime, if an investment adviser’s RAUM is
- between $0 and $25 million, the adviser must register with the relevant state regulatory authority or authorities, unless exempt at the state level, and is not permitted to register with the SEC;
- between $25 million and $100 million, the adviser must register with the relevant state regulatory authority or authorities (i.e., it is not permitted to register with the SEC), UNLESS it is domiciled in New York or Wyoming, in which case that adviser may register with the SEC or avail itself of an exemption from registration; and
- more than $100 million, the adviser may register with the SEC (and at $110 million, must register with the SEC), unless an exemption applies.
Note that this analysis assumes that a private fund adviser is solely advising private funds and has no other types of clients. The analysis changes if the adviser, in addition to or instead of managing private funds, advises clients through separately managed accounts. The impact of separately managed accounts on this analysis is beyond the scope of this material.
So what happens if a New York-based private fund manager has less than $25 million in RAUM? In many cases, private fund managers based in New York would remain exempt from registration in their own state. Section 359-eee of the New York General Business Law (the “NYGBL”) specifically excludes from the definition of “investment adviser” any person who has sold, during the preceding twelve months, investment advisory services to fewer than six (6) persons residing in the State of New York (other than financial institutions and institutional buyers, as defined by other regulations). Further, Section 11.4(c) of the New York Codes, Rules and Regulations (the “NYCRR”) provides that all investment advisers with more than five (5) clients in the State of New York must apply to register as an investment adviser in New York. There is no practical difference between “persons” under the NYGBL and “clients” under the NYCRR. Under NYCRR Section 11.12, a “client” means a natural person or an entity (such as a corporation, limited partnership, limited liability company, or trust). This means that a fund or managed account is a “client” under New York law. In other words, New York law does not require a fund manager to “look through” the fund and count the individual investors for purposes of determining how many New York resident clients it has.
Below is an easy-reference chart summarizing this discussion.
|New York-Based Fund Managers – Federal versus State Registration|
|RAUM||Permitted to register with the SEC?||Required to register in New York?|
|$0 – $24.9 million||No.||Yes, if the manager has 6+ New York clients.
Note 1: Other states may have rules requiring registration if the manager or its clients reside in those states.
Note 2: If the manager has fewer than 6 New York clients and RAUM is in this range, no registration required in New York or federally.
|Over $25 million||Yes, and the manager has the option to register with the SEC or rely on an exemption, if available.||No. Federal registration rules apply.|
Note that legal practitioners typically form funds as Delaware partnerships or limited liability companies. Delaware entities would not count as a New York client, even if all of the investors in the fund reside in New York. As a result, a New York fund manager advising multiple Delaware funds with aggregate assets across all funds of less than $25 million is still likely to be exempt from registration in New York and federally. Conversely, as shown in the chart above, if the fund manager’s aggregate RAUM across all funds exceeds $25 million, it will have to either register as an investment adviser with the SEC or, if applicable, rely on a federal exemption.
Federal Registration Exemptions for Fund Managers
As discussed above, New York-based private fund managers that solely advise private funds are generally exempt from registration at the state and federal level if their RAUM is below $25 million and are generally subject to federal registration when their RAUM exceeds $100 million. However, there are two important registration exemptions for private fund managers. The first is Section 203(m) of the Advisers Act, which exempts from registration any adviser that solely advises private funds and manages, in the aggregate, less than $150 million in RAUM in the United States. This is often called the “private fund adviser exemption.” To determine the availability of this exemption from registration, such calculations must be made annually.
Second, Section 203(l) of the Advisers Act provides a registration exemption specifically for venture capital fund managers, which is commonly referred to as the “venture capital exemption.” The venture capital exemption is based on a set of eligibility criteria that are set forth in the Advisers Act and are based on rules adopted by the SEC in July 2011. 
Importantly, fund managers relying on either the venture capital exemption or the private fund adviser exemption are nevertheless subject to certain provisions of the Advisers Act and continuous SEC reporting obligations, including a requirement to file and update portions of Form ADV Part 1 with the SEC. Since exempted venture capital fund managers and other exempted private fund managers have an obligation to report to the SEC, they are called Exempt Reporting Advisers or “ERAs.” Although exempt from registration, ERAs are still subject to and owe fiduciary duties to their clients. Prudent ERAs should adopt policies and procedures reasonably designed to prevent violations of the Advisers Act and to ensure they are meeting their fiduciary obligations.
Obligations for Registered Investment Advisers
If a private fund manager’s RAUM exceeds $100 million and it is unable to rely on a federal exemption from registration, it may be required to register as an investment adviser with the SEC. In this case, a private fund manager will have to submit parts 1 and 2 of the Form ADV to the SEC. The Form ADV is a federal filing that is publicly and freely accessible online. The Form ADV requires the registrant to provide a description of its business, its clients, ownership, fees, and a lengthy narrative discussion of various issues that the SEC has deemed to be material to it and to investors.
In addition, registered investment advisers – whether they are registered with the SEC or at the state level – are required to have a set of written compliance policies and procedures, including a code of ethics, and to appoint a chief compliance officer to oversee the firm’s compliance program. A federally registered investment adviser is subject to the Advisers Act and its rules as well as increased oversight by the SEC, primarily through its inspection and enforcement powers. A registered investment adviser is responsible for implementing policies and procedures to ensure that it has a compliance program that is reasonably designed to prevent violations of the Advisers Act. These include policies designed to address, for example:
- conflicts of interest and anything that might contravene the adviser’s fiduciary duties toward its clients
- recordkeeping requirements (such as preparation of required records and their maintenance, document retention practices, and tracking of communications to current and prospective investors)
- reporting requirements like Form ADV updates
- portfolio management policies (including allocations of investment opportunities among clients and consistency with client objectives)
- supervision and hiring of employees; discipline; chain of reporting, process to rectify employee and trading errors; and whistleblowing policies
- trading matters, such as soft dollars and best execution (which would not be applicable to a venture fund)
- custody of client assets
- privacy and protection of client confidential information
- social media policies
- marketing and other communications to current and prospective investors
- ethics (personal and proprietary trading (and monitoring thereof), gifts and entertainment reporting, insider trading prohibitions, political contribution restrictions)
Special note regarding payment of performance fees. The Advisers Act prohibits a registered investment adviser from receiving performance-based compensation (i.e., performance fees/allocations/carried interest) from their clients in the U.S. unless they are “qualified clients.” A “qualified client” must meet asset and income tests that differ from the requirements imposed on accredited investors. Qualified clients are defined as:
- A natural person who has, at the time immediately after entering into an advisory relationship with an adviser, at least $1,000,000 under management with the investment adviser (i.e., if the person invests $1 million in a fund or SPV, they would be a qualified client);
- A natural person or a company that has a net worth of at least $2,000,000 at the time the contract is entered into;
- A Qualified Purchaser (as defined in the Investment Company Act of 1940, as amended); or
- Certain affiliates and employees of the adviser.
Note that the prohibition on the receipt of performance fees does not apply to unregistered/exempt investment advisers. Thus, as long as a private fund manager is unregistered or exempt from registration, it can receive carried interest from each fund or SPV. If a New York-based private fund manager has any intent to register after achieving the $25 million RAUM threshold, then it makes sense to prequalify all investors in its funds as “qualified clients” in addition to qualifying them as “accredited investors”.
Jonathan Golub, email@example.com, April 2016
 For purposes of this material, the term “private fund” encompasses hedge funds, private equity funds, and venture capital funds whose beneficial ownership interests are sold to investors in a manner not involving a general solicitation. For legal purposes, private fund managers are considered “investment advisers” potentially subject to federal registration with the Securities and Exchange Commission or registration in one or more states.
 RAUM is gross assets in “securities portfolios” and private funds for which the adviser provides continuous and regulatory supervisory or management services. The federal Form ADV’s instructions provide the RAUM calculation method.
 See, section 203(A) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), which provides that no investment adviser that is “regulated or required to be regulated” as an investment adviser in the state in which it maintains its principal office and place of business can register as an investment adviser with the SEC unless the investment adviser has regulatory assets under management of at least $25 million.
 Advisers Act section 203(A)(a)(2).
 Id. See, also, SEC Release No. IA-3221, Rules Implementing Amendments to the Investment Advisers Act of 1940, July 19, 2011.
 See, SEC Division of Investment Management: Frequently Asked Questions Regarding Mid-Sized Advisers, at http://www.sec.gov/divisions/investment/midsizedadviserinfo.htm; see, also, SEC Office of Investor Education and Advocacy, Investor Bulletin: Transition of Mid-Sized Investment Advisers From Federal to State Registration, December 2011, at http://www.sec.gov/investor/alerts/transition-of-mid-sized-investment-advisers.pdf.
 In other words, New York fund managers may voluntarily register with the SEC if they meet minimum eligibility criteria for federal registration, even if an applicable registration exemption exists. There are various reasons why an adviser would want to register with the SEC. For example, SEC registration may help to attract capital from institutional investors and may allow an adviser to sidestep state-level requirements to license their advisory personnel.
 See “Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers,” Release No. IA-3222 (July 21, 2011). Advisers Act Rule 203(l)-1 defines a “venture capital fund” as a private fund that (i) holds no more than 20 percent of the fund’s bona fide capital commitments in non-qualifying investments (other than short-term holdings); (ii) does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15 percent of the private fund’s aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days (subject to limited exceptions); (iii) does not offer redemption or similar liquidity rights to investors except under extraordinary circumstances; (iv) represents itself to investors as being a venture capital fund; and (v) is not registered under the Investment Company Act and has not elected to be treated as a business development company under the Investment Company Act.
Advisory Committee Charter
The Advisory Committee (the “Committee”) is a Committee appointed by ABC Partners I, LLC, the Managing Member (the “Managing Member) of ABC SPV I, LLC (“the “Company’), the Committee consisting of the Members of the Company other than the Managing Member. Capitalized terms used but not defined herein shall have the meaning set forth in the Limited Liability Company Agreement of the Company (as may be amended from time to time, the “Agreement”).
The primary purpose of the Committee is to fulfill the advice and consent responsibilities set forth in the Limited Liability Company Agreement of the Company (the “LLC Agreement”), as well as those delegated to the Committee by the Members of the Company including but not limited to the Managing Member, including potential conflicts of interest between the Managing Member or any of its Affiliates, on the one hand, and the Company and the Managing Member on the other.
The Committee shall have full authority to (i) review any matter brought to its attention with full access to all books, records, facilities and personnel of the Company and its Managing Member; (ii) retain, terminate and determine funding for such independent legal financial or other advisors or consultants as the Committee deems necessary or appropriate for the Committee to fulfill its responsibilities; and (iii) request any officer or personnel of the Company or its Affiliates, the Company’s counsel and auditors to attend a meeting of the Committee or to meet with any members of or consultants to, the Committee.
The Company shall provide appropriate funding, as determined by the Committee and without further action by the Managing Member, for payment of (i) any advisors employed by the Committee; and (ii) ordinary administrative expenses of the Committee necessary or appropriate for carrying out its responsibilities.
This Committee shall be comprised of two or more Members of the Company who will be appointed by the Managing Member and shall serve until their successors are duly appointed and qualified. The Managing Member shall have the Authority at any time to remove, with or without cause, one or more members of the Committee. The Members of the Committee shall designate a Chair of the Committee by a majority vote of the Committee membership.
The Committee will meet on an as-needed basis to advise and consult with the Managing Member, and consent or not consent as to matters presented to it by the Managing Member and/or other Company Members including, but not limited to, any transaction or issue involving a possible conflict of interest. Specific duties of the Committee will include, without limitation, considering and voting on questions involving conflicts of interest arising in the course of the Company’s business as submitted to the Committee by the Managing Member or any Member of the Company, the objective of the Committee being to resolve any such conflicts in an equitable fashion in the interests of all participants and, in any event, the interests of the Company’s Members, and to offer guidance to the Members consistent with the advice and guidance concerning Advisory Committees in the Private Equity Principles of the Institutional of Limited Partners Association, Version 2.0, January 2011 and/or any subsequent version.
The Members of the Committee shall be indemnified as provided in the Limited Liability Company Agreement.