TLDR:
- Venture capital firms often warehouse investments in portfolio companies before the initial close of a new fund to begin creating a diversified portfolio.
- SEC guidance outlines who can make these warehoused investments and the potential pitfalls, such as the impact on regulatory requirements and QSBS eligibility.
One of the challenges facing venture capital firms is how to handle investments in portfolio companies prior to the initial close (“Initial Close”) of a new fund (“New Fund”). Typically, the investment advisor (“VC Advisor”), or a person wholly owned or controlled by the VC Advisor, will make such investment, “warehouse” it, and then transfer such investment to the New Fund promptly after the Initial Close. This strategy has been very effective for many fund managers as it enables them to commence the creation of a diversified portfolio of interesting companies for its future limited partners prior to the time of the Initial Close.
While this is an effective strategy for fund raising purposes, VC Advisors should be aware of some of the pitfalls with warehousing investments. The Securities and Exchange Commission (“SEC”) has provided guidance on who can make these warehoused investments. Following this guidance is critically important to ensure that the warehoused investments are not considered “non-qualifying investments,” which could impact the VC Advisor’s ability to remain an Exempt Reporting Advisor.
Furthermore, warehousing investments can be a major hurdle to achieving Qualified Small Business Stock (“QSBS”) status under Section 1202 of the U.S. Internal Revenue Code. VC Advisors must navigate complex requirements to achieve QSBS status and avoid common pitfalls such as warehousing, which disrupts the primary issuance requirement for stock to qualify as QSBS.
Overall, while warehousing investments may provide fundraising benefits to a New Fund, it is important for VC Advisors to be mindful of the regulatory and tax implications associated with this practice to ensure compliance and maximize benefits for investors.
