Small venture funds fell through the cracks of new FinCEN filing exemptions
Many emerging VCs should prepare for conversations with large LPs, later first closes, and multiple filings.
The venture community has an impressive lobby in Washington that keeps the administrative burden manageable for VCs. But sometimes they forget about the little guys. That can make it harder in some cases to run a $10M fund than a $1B fund - this is one of those cases.
Before I jump in, please subscribe for more insights tailored for emerging VCs raising and managing Fund I:
TOC:
Background on FinCEN filing requirement
Beginning in 2024, all US business entities are required to report their “beneficial owners” to the federal Financial Crimes Enforcement Network (FinCEN). This new requirement is designed to give the government a view into who controls, and financially benefits from, shell companies and other entities that are commonly used for shady business.
This is an understandable (and probably long overdue) development, given that the US is often cited as the best international jurisdiction for hiding assets. But, for US corporations, LLCs and partnerships, it can feel quite invasive: every person who controls, or owns 25% or more of, an entity needs to provide a birth date, social security number or tax ID, photo of a government ID, and other sensitive PII. This includes foreign nationals who may not otherwise be interacting with the US government.
To give teeth to the disclosure requirements, the penalties for non-compliance are pretty intense. A $10,000 fine is triggered almost immediately, and that can come along with criminal prosecution and up to 5 years in prison (which I hope FinCEN reserves for truly bad actors).
The convenient venture capital fund exemption
To address concerns over the invasiveness of the reporting, FinCEN adopted 23 exemptions from this new requirement for entities that already have significant government oversight - including VCs and their funds. However, to qualify for these exemptions, the venture firm needs to file Form ADV “with the Securities Exchange Commission”.
How emerging VCs fall through the cracks
By drafting the exemption this way, FinCEN left out many small VCs. That’s because VCs with less than $25M AUM are regulated by the states in which those advisers have their principal place of business, and:
Many states - including New York, New Jersey, Florida, Arizona, Georgia, Illinois, Oregon and Utah - don’t require small investment advisers to file Form ADV at all; and
For states that do require emerging VCs to file Form ADV, the filing isn’t “with the Securities Exchange Commission”, even though the Form ADV is submitted through the same online portal used by SEC-regulated advisers.
What this mean in practice for emerging VCs
There can be meaningful implications for the small funds who are left out of the exemption. Here are the major ones:
Possibly awkward conversations with anchor/large LPs: If a single LP holds more than 25% of the capital commitments of your fund (even for a short time), then the fund needs to report that ownership to FinCEN. That involves notifying the large LP(s) that the fund will be filing with FinCEN, and asking for their sensitive PII or a FinCEN ID number (the LP can apply for a FinCEN ID by providing their sensitive PII directly to FinCEN).
Later/larger first close: If you’re eager to get cash into the fund, you may be tempted to hold an early first close with just a handful of LPs. This can often result in one or more LPs holding more than 25% of the capital commitments immediately after the first close, and triggering a FinCEN filing regarding those LPs. To avoid this filing (and the awkward conversations it requires with the LPs), you may want to consider holding off on a first close until it’s large enough to avoid creating 25%+ LPs.
Multiple FinCEN filings over the life of the fund: An entity needs to report its beneficial ownership to FinCEN when it’s formed, when its beneficial ownership changes, and when it ceases to be a reporting entity. A small fund will need to report to FinCEN at least once (at formation) - but it’s likely to experience at least one of the other two filing events as well (possibly multiple times). Almost all small funds will eventually become exempt from filing, and will need to file a final report at that point (see the next section).
How a small fund becomes eligible for the venture capital fund exemption
A small fund will no longer need to report to FinCEN when its manager (the emerging VC) begins to file Form ADV with the SEC. That happens when the VC’s “regulatory assets under management” - which includes uncalled capital commitments and the fair market value of portfolio investments - grow beyond $25M. This threshold can be crossed in many ways, including:
Fund I raises >$25M in capital commitments.
A markup of Fund I’s portfolio puts its fair market value >$25M.
Fund II is raised and the combined capital commitments and portfolio values are >$25M.
If you want to talk about this issue, or you have other questions about raising or managing a venture fund, reach out. My law firm, Lidow PC, is exclusively focused on working with emerging VCs.