VCOC

What is VCOC?

VCOC means venture capital operating company. It is a status under the US Department of Labor's plan-asset regulation that keeps a fund's underlying investments from being treated as the assets of the pension plans invested in it. Qualify, and the manager is not an ERISA fiduciary over portfolio companies. Fail, and it is.

Why the status exists at all

The NVCA's Management Rights Letter opens with the cleanest statement of the problem. The assets of a pension plan subject to ERISA must be held in trust, the persons managing those assets have significant fiduciary duties and cannot engage in certain prohibited transactions, and if an ERISA plan invests in a venture fund then, absent an exemption, all of the fund's assets, including its investments in portfolio companies, are treated as assets of that plan. The trust requirement applies, the managing partner becomes an ERISA fiduciary, and the prohibited-transaction rules apply throughout.

There are two common ways out. The first is to stay under the participation threshold. ERISA section 3(42) provides that the assets of an entity are not treated as plan assets if, immediately after the most recent acquisition of any equity interest, less than 25 percent of the total value of each class of equity interest is held by benefit plan investors, and that in making that calculation the value of any equity interest held by a person other than a benefit plan investor who has discretionary authority or control over the entity's assets, or who provides investment advice for a fee, or an affiliate of such a person, is disregarded. The regulation states the same test from the other direction: participation is significant if 25 percent or more of the value of any class of equity interests is held by benefit plan investors.

The second way out, and the one venture funds actually use, is VCOC status, because it does not depend on who the limited partners are.

The two-part test

Paragraph (d)(1) of the regulation sets a status that runs from an initial valuation date through the last day of the first annual valuation period, or for the 12-month period following the expiration of an annual valuation period for a fund that already had the status. Within that period two things must be true.

The asset test. On the initial valuation date, or at any time within the annual valuation period, at least 50 percent of the fund's assets, other than short-term investments pending long-term commitment or distribution to investors, valued at cost, must be invested in venture capital investments or in derivative investments.

The conduct test. During that same period the fund must, in the ordinary course of its business, actually exercise management rights of the kind the regulation describes with respect to one or more of the operating companies in which it invests. The NVCA notes put the operational version plainly: in addition to obtaining management rights, the fund is required to actually exercise its management rights with respect to one or more of its portfolio companies every year.

Three definitions carry the weight. A venture capital investment is an investment in an operating company, other than another venture capital operating company, as to which the investor has or obtains management rights. Management rights means contractual rights directly between the investor and an operating company to substantially participate in, or substantially influence the conduct of, the management of the operating company. And an annual valuation period is a preestablished annual period, not exceeding 90 days in duration, beginning no later than the anniversary of the fund's initial valuation date, which once established may not be changed except for good cause unrelated to the determination.

Derivative investments keep the numerator from collapsing when a portfolio company goes public. An investment is a derivative investment if the investor's management rights ceased in connection with a public offering of the operating company's securities, or if it was acquired in exchange for an existing venture capital investment in connection with a public offering or with a merger or reorganization made for independent business reasons unrelated to extinguishing management rights. The relief expires: an investment stops being a derivative investment on the later of 10 years from the acquisition of the original venture capital investment or 30 months from the date it became a derivative investment.

There is also a wind-down accommodation. A fund keeps VCOC status through a distribution period that begins on a date it establishes after it has distributed to investors the proceeds of at least 50 percent of the highest amount of its investments outstanding at any time since it commenced business, measured at cost, and that ends on the earlier of the date it makes a new portfolio investment or the expiration of 10 years from the beginning of that period.

Worked example, arithmetic shown

All figures are hypothetical.

Testing the 50 percent asset test. At a date inside its annual valuation period the fund's holdings at cost are:

• $120,000,000 across 14 portfolio companies, each of which signed a management rights letter. These are venture capital investments.
• $20,000,000 in a company that went public last year, where the fund's management rights ceased at the offering. This is a derivative investment.
• $30,000,000 in another fund's interest, with no contractual rights running to any operating company. Not qualifying.
• $30,000,000 in Treasury bills held pending long-term commitment. Excluded from the calculation entirely.

Step one, build the denominator by removing the excluded short-term investments: $120,000,000 + $20,000,000 + $30,000,000 = $170,000,000.

Step two, build the numerator from venture capital investments plus derivative investments: $120,000,000 + $20,000,000 = $140,000,000.

Step three, divide: $140,000,000 / $170,000,000 = 82.4 percent. The test requires at least 50 percent, so the fund passes on assets.

Step four, test the conduct prong separately. Passing on assets is not enough; the fund must have actually exercised management rights at one or more operating companies inside the period. A memo recording that a partner met with two portfolio companies' management on their annual operating plans, under the rights in their letters, is the evidence.

Now break it. Suppose the non-qualifying fund interest is $130,000,000 instead of $30,000,000 and there is no derivative investment. Denominator: $120,000,000 + $130,000,000 = $250,000,000. Numerator: $120,000,000. Result: $120,000,000 / $250,000,000 = 48.0 percent, which is below 50 percent, and the status fails for that period.

Testing the 25 percent participation threshold on the same fund. Assume one class of limited partner interests worth $200,000,000, of which benefit plan investors hold $60,000,000 and the manager itself holds $10,000,000.

• The manager has discretionary authority over the entity's assets and is not a benefit plan investor, so its $10,000,000 is disregarded.
• Measurement base: $200,000,000 minus $10,000,000 = $190,000,000.
• Participation: $60,000,000 / $190,000,000 = 31.6 percent.
• 31.6 percent is at or above 25 percent, so benefit plan investor participation is significant and the fund cannot rely on the threshold. It needs VCOC status.

Note what the disregard does: excluding the manager's interest raises the measured percentage rather than lowering it, because it comes out of the denominator.

How it shows up in documents

Four documents, in order of how often they are read.

The management rights letter is the operative one. The NVCA model is a letter on portfolio-company letterhead confirming that, effective as of the investor's purchase of preferred stock, the investor is entitled to contractual management rights in addition to any information and inspection rights given to all investors in the financing. Its bracketed rights include, where the investor is not on the board, the right to consult with and advise management on significant business issues including management's proposed annual operating plans, with management meeting the investor regularly at the company's facilities; the right to examine books and records and inspect facilities; and the right to receive copies of all notices, minutes, consents and other material provided to directors, with a carve-out where the board determines in good faith on advice of counsel that exclusion is reasonably necessary to preserve attorney-client privilege or protect highly confidential proprietary information.

The same letter carries a bracketed paragraph disclaiming any rights that would be triggering rights under Section 721 of the Defense Production Act, including control, board membership or observer rights, access to material nonpublic technical information, and involvement in substantive decision making about sensitive personal data, critical technologies or covered investment critical infrastructure. The NVCA's footnote says to include it where the investor is a foreign person, so a management rights letter does not accidentally create a CFIUS problem. The same footnotes warn that the more of the letter's rights you strip out, the less clear it is that the VCOC exemption is satisfied.

The letter's rights terminate when the investor and its affiliates hold no shares, on a firm commitment underwritten public offering, or on a merger or consolidation meeting the stated conditions, with confidentiality obligations surviving.

Alongside it: the limited partnership agreement, which usually contains a VCOC covenant and the definition of the annual valuation period; the fund's annual VCOC certificate or memo, which is the file that proves both prongs were met; and the ERISA representations in the subscription documents that let the manager measure benefit plan investor participation in the first place.

Common mistakes

• Signing management rights letters and never exercising the rights. The conduct prong is annual and independent of the asset test.
• Valuing the portfolio at fair value for the 50 percent test. The regulation says valued at cost.
• Including short-term investments in the denominator. They are excluded when held pending long-term commitment or distribution to investors.
• Assuming a board seat substitutes for a contractual right running from the company to the investor. Management rights are contractual rights directly between the investor and the operating company.
• Letting the annual valuation period drift. It is preestablished, no longer than 90 days, must begin no later than the anniversary of the initial valuation date, and cannot be changed except for good cause unrelated to the determination.
• Forgetting that the manager's own interest is disregarded in the 25 percent calculation, which pushes the measured percentage up.

How it relates to adjacent terms

VCOC is the venture-side twin of REOC, the real estate operating company exemption in paragraph (e) of the same regulation, which substitutes real estate that is managed or developed for operating-company investments. It is the reason information rights and board observer seats get negotiated as contractual entitlements rather than courtesies. And it is why an institutional LP's side letter may require the fund to maintain VCOC status for the life of the fund and to notify the LP if it lapses.