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In February 2024, the SEC proposed an amendment to the qualifying venture capital fund parameters. The change would lift the $10 million ceiling on qualifying venture capital funds to $12 million. This proposal was expected: the law requires the SEC to revisit the dollar cap on qualifying venture funds at least once every five years, to index it for inflation.
While a 20% increase to the fund AUM limit is a move in the right direction, the expected $12 million cap remains too restrictive to be an effective mechanism for facilitating capital formation among new and emerging managers. Congress should pass legislation to increase the size and investor limits to enhance the utility of the qualifying venture capital fund exemption.
Issue
Congress created the “qualifying venture capital fund” exemption to Section 3(c)(1) of the Investment Company Act to make capital formation easier for emerging venture capital fund managers by increasing the number of permitted investors in venture capital funds under a certain size. In practice, the current parameters limit the utility of this provision.
To better support innovation and job creation in the venture capital sector, Congress can intervene to modernize the criteria for qualifying venture capital funds to account for existing market conditions.
How it works: Under Section 3(c)(1) of the Investment Company Act of 1940, a private fund may remain exempt from registering with the SEC as an investment company if it has no more than 100 investors.
Qualifying venture capital funds, however, may have up to 250 beneficial owners and still claim exemption under 3(c)(1), provided that they manage no more than $10 million in assets and meet the definition of a venture capital fund. This cap will likely rise to $12 million in 2024.
Why it matters: The higher limit of beneficial owners was intended to help emerging managers assemble competitive funds by collecting smaller contributions from a greater number of accredited investors. However, failure to meaningfully adjust the dollar threshold for qualifying venture capital funds has rendered their special status obsolete, and has stymied Congress’s intent to diversify beneficial ownership of venture capital assets.
Background
The vast majority of emerging venture capital funds seek exemption from registration under Section 3(c)(1). Congress added the definition of a “qualifying venture capital fund” to Section 3(c)(1) as part of the bipartisan Economic Growth, Regulatory Relief, and Consumer Protection Act (S. 2155). The objective was to make capital formation easier for emerging venture capital managers, but data shows the criteria for qualification were never right-sized for the market. Over time, they have become even more outdated.
The case for modernization
A $10 million ceiling for qualifying venture capital funds was never ideal and fast became obsolete. Raising the limit to $12 to index for inflation will not go far enough to modernize the provision.
Rising costs
Economic growth, technological sophistication, inflation, and other factors have contributed to a rise in the cost of doing business in venture capital. Put simply, entrepreneurs are raising more money at each stage of company development than they were just five years ago.
Carta data shows that throughout much of 2017 and 2018, the median seed-stage round hovered around $2 million. But since Q1 2021, the median seed-stage round has been at least $3 million—a 50% rise over less than a half decade. Meanwhile, the $10 million ceiling on qualifying venture capital funds hasn’t budged—and the current proposal to raise the ceiling only increases it by 20%. This means the provision will likely be even less useful in the coming five years than it was in the past.
Reduced ability to compete for deals
Why does this matter? Seed investors typically need to invest in 30-35 companies for their funds to be viable. Investors at the earliest stages need to take far more “shots on goal” than funds investing at the later stages, when companies already have product-market fit and viable business models. A 50% rise in the cost of seed-stage investment means that funds capped at $10 million (or even $12 million) are less able to keep up with rising costs. This can make them less attractive to investors and less competitive in the market.
Funds are foregoing qualifying status
The purpose of the special provisions for qualifying venture capital funds was to help more emerging managers raise funds that would be competitive in the market, and to allow more small-check inventors to gain exposure to the venture asset class. The caps on beneficial owners and fund size make qualifying venture capital funds, as currently defined, incapable of achieving these goals.
Not only does the $10 million or $12 million no longer support the number of portfolio companies it did just five years ago, but investors are also being left out: Recognizing the limitations of the fund size cap, funds are foregoing qualified status and raising larger funds from up to 100 larger investors, under the conventional 3(c)(1) limit. Less than half of the first-time funds launched on Carta since from 2016-2021 managed $10 million or less. And only 2% of first-time funds formed on Carta in 2021 had more than 100 LPs, which suggests that vanishingly few fund managers pursue exemption as a qualifying venture capital fund.
Potential changes
Congress has the ability to amend the criteria for qualifying venture capital funds. The SEC’s Small Business Capital Formation Advisory Committee has already recommended that the agency raise caps on both fund size and beneficial ownership.
Bottom line
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The AUM cap and 250 beneficial owner limit for qualifying venture capital funds are both too low for the qualifying venture capital fund exemption to serve its intended purposes. Raising these thresholds will help foster innovation in the venture capital sector, particularly for emerging funds and founders.
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