After determining whether to structure a capital raise under Rule 506(b) or 506(c) of Regulation D, issuers of private funds or syndications must next consider which exemption to use under the Investment Company Act. The Investment Company Act requires “investment companies” to register with the Securities and Exchange Commission. Registration results in additional regulatory requirements that most smaller, private companies aim to avoid by qualifying for an exemption. This article explores the three most common exemptions: Section 3(c)(1), Section 3(c)(5)(c), and Section 3(c)(7).
Section 3(c)(1) Exemption: Limited Number of Investors
Section 3(c)(1) of the Investment Company Act exempts issuers who limit the number of investors to 100 or less. For venture capital funds, issuers may accept up to 250 investors so long as they meet the definition of a qualifying venture capital fund. When determining the number of investors, the issuer must look at the number of beneficial owners and also count each investor in any fund of funds. Small, private funds and syndications not involved in real estate, commonly use this exemption.
Key Considerations:
- Investor Limitation: 100 or fewer beneficial owners (250 for venture capital funds).
- Benefits: The 3(c)(1) exemption does not restrict the type of investor or types of investments.
- Disadvantages: The investor limitation can be restrictive for some issuers.
Section 3(c)(5)(c) Exemption: Real Estate Funds
Section 3(c)(5)(c) of the Investment Company Act exempts issuers who are investing primarily in real estate. To qualify, at least 55% of the portfolio must be allocated to real estate (including mortgages or liens on real estate), 25% must be allocated to real estate-related interests, and 20% may be in assets of the sponsor’s choice. Funds and syndications with a focus on real estate commonly use this exemption.
Key Considerations:
- Investment Limitation: 80% of portfolio investments must be in real estate and real estate-related assets (with 55% in real estate and 25% in real estate-related interests).
- Benefits: The 3(c)(5)(c) exemption does not have any restrictions on investor types or the number of investors.
- Disadvantages: Sponsors not investing primarily in real estate are not able to use this exemption and ongoing monitoring of portfolio allocation is required.
Section 3(c)(7) Exemption: Qualified Purchasers
For funds targeting larger and more sophisticated investors, 3(c)(7) offers an additional exemption. To qualify, only “qualified purchasers” may be accepted as investors in the fund. “Qualified Purchasers” are more sophisticated than accredited investors, and most often refer individuals who own $5 million+ in investments or any person or entity that owns and invests at least $25 million on a discretionary basis, either for their own account or for other qualified purchasers. Larger funds with high net-worth investors commonly rely upon the 3(c)(7) exemption.
Key Considerations:
- Investor Qualification: All investors must be qualified purchasers. Investors considered “accredited” or merely “sophisticated” are not eligible to invest in the company.
- Benefits: The 3(c)(7) exemption does not restrict the number of investors, types of investments, or amount of capital raised.
- Disadvantages: Only very sophisticated investors with significant assets may invest in the company, thus limiting the potential investor pool.
Selecting the right exemption depends on the fund’s target investors, investment strategy, size, and goals. Understanding each of the above Investment Company Act exemptions is critical to private securities offerings. Failure to comply with all of the requirements and limitations of each exemption may result in potentially severe consequences or penalties.
For any questions or assistance with structuring your offering, please don’t hesitate to reach out!