A 3(c)(1) fund is a pooled investment vehicle that is excluded from the definition of investment company in the Investment Company Act because it has no more than 100 beneficial owners (or, in the case of a qualifying venture capital fund, 250 beneficial owners) and otherwise meets criteria outlined in Section 3(c)(1) of the Investment Company Act.
A 3(c)(7) fund is a pooled investment vehicle that is excluded from the definition of investment company in the Investment Company Act because it is limited to investors that are qualified purchasers and otherwise meets criteria outlined in Section 3(c)(7) of the Investment Company Act.
An investor that meets certain standards outlined in Rule 501(a) of Regulation D qualifies as an accredited investor. For example, individuals may qualify by having (1) annual income exceeding either $200K (singly) or $300K (with spouse or spousal equivalent) in each of the two most recent years; (2) more than $1 million in net worth, excluding the primary residence (singly or with spouse or spousal equivalent); or (3) certain financial professional credentials. Qualifying as an accredited investor determines whether an investor can invest in businesses conducting common types of exempt offerings.
Angel investors are generally high-net-worth individuals who invest their own money directly in emerging businesses, typically in early funding rounds. Most angel investors are accredited investors as defined in Rule 501(a) of Regulation D, and many are current or former entrepreneurs themselves.
Assets Under Management (AUM)
AUM is the total value of assets for which an investment adviser provides certain kinds of investment advice. While methods of calculating AUM can vary, Form ADV provides details on how investment advisers are required to calculate regulatory assets under management.
An audit is an examination by an independent accountant of a company’s financial statements. Among other things, audits are intended to help provide investors with additional assurance—beyond management's own assertions—of a company’s financial position at a given moment in time.
Blue Sky Laws
State securities laws are often referred to as “Blue Sky” laws and govern the offer and sale of securities within a state. These laws cover many of the same activities that the SEC regulates, such as the offer or sale of securities and those who sell them, but apply only to offers and sales or persons who offer and sell securities within each state. In some instances, federal securities laws preempt the ability of the states to regulate the offer and sale of securities; however, some state laws—including antifraud laws—still apply.
Business Development Company (BDC)
A BDC is a type of pooled investment vehicle that is often described as a hybrid between a traditional investment company and an operating company. BDCs generally invest in debt or equity of small and medium-sized private companies and some small public companies, which are typically in their early stages of development or are distressed and unable to obtain bank loans or raise money from other investors. BDCs may also help manage the companies in which they invest.
A capitalization (or cap) table names the holders of a company’s equity securities (such as common stock, preferred stock, and convertible notes and warrants) and includes other related information (such as class of securities, number of shares or units held, purchase price and date of purchase or disposition).
Common stock is a type of security that represents an ownership interest—or equity—in a company. Holders of common stock have rights that typically include the right to vote to elect members to a company’s board of directors and to vote on certain corporate actions (such as takeover bids), and may have rights to dividend payments based on the company’s profits.
While common stockholders may have authority to exercise some control over the company through voting, they are typically last in the liquidation preference. For example, if the company is sold, common stockholders usually have rights to the company’s assets only after debtholders and preferred stockholders have been paid in full.
A convertible note, which is a type of security, is a loan made by an investor to a company that can be converted into a different security. Convertible notes are often used during seed rounds because of challenges valuing a company early in its life cycle. Typically, the note will automatically convert from debt into preferred stock of the company upon the closing of the next funding round or other agreed upon conditions.
Debt, which includes a loan, is an amount owed to an individual or entity for borrowed money to be repaid on an agreed upon maturity date, typically with interest. Depending on the type of debt, it may be repaid or converted into equity.
Dilution occurs when a company issues new shares of stock, leaving the existing stockholders with a smaller percentage ownership interest in the company.
Disclosure is information about a company’s results of operations, financial condition, and business that it makes available to investors in order to help them make informed investment decisions about the company.
Diversification is an investment strategy to reduce the impact of any single loss by allocating investments across multiple asset classes, categories, or companies. Investors in early-stage companies often use portfolio diversification, whether through pooled investment vehicles or as an individual angel investor.
Prospective investors typically evaluate an investment opportunity by conducting a due diligence review of legal and financial disclosures. Investors may solicit information using a standardized due diligence checklist, request access to relevant information, and host meetings with management to ask questions.
While “equity” can refer to multiple concepts in the world of investing, in the context of capital raising, “equity” typically refers to an ownership interest in a company. For example, common stock is a form of equity interest in a corporation and membership interest is a form of equity interest in a limited liability company.
Generally, a business may not offer or sell securities unless the offering has been registered with the SEC or falls within an exemption from registration. An exempt offering—sometimes referred to as a private offering—is commonly used to describe the offer and sale of securities that is exempt from registration under the Securities Act. Each exemption has specific requirements that a company must meet.
Navigating Your Options | Exempt Offerings | Building Blocks: Accredited Investor | Building Blocks: General Solicitation | Building Blocks: Types of Investors | Building Blocks: Securities Law Violations | Capital Trends: Mapping Investment in America | Amendments to the Exempt Offering Framework Video
Exempt Reporting Adviser
- (1) Private Fund Adviser Exemption – it is an adviser solely to private funds that have less than $150 million in assets under management in the United States.
- (2) Venture Capital Adviser Exemption – it is an adviser solely to venture capital funds.
While exempt reporting advisers are not registered with the SEC, they are still subject to specific reporting requirements and certain other Investment Advisers Act and federal rules, and they also may be subject to state filing or registration requirements.
Financial statements are written records that communicate information about a company’s business activities and financial position. They provide important insights to investors into where a company’s money came from, where it went, and where it is now.
There are four main types of financial statements:
- Balance sheets show at a fixed point in time (such as the end of the quarter or fiscal year) a company’s assets (what it owns that has value), its liabilities (what it owes to others), and its shareholders’ equity (what would be left for the shareholders if the company sold its assets and paid off all its liabilities).
- Income statements show how much money a company made and spent over a specific period of time (such as over the company’s fiscal year).
- Cash flow statements show the company’s inflows and outflows of cash over a period of time (such as over the company’s fiscal year).
- Statements of shareholders’ equity show changes in the interests of a company’s shareholders over time. This differs from a company’s capitalization table, which tends to show the ownership as of a set date.
The footnotes to the financial statements often provide additional context and information to what is presented in the different financial statements.
Form ADV is a standard form used by investment advisers to register with the SEC or state securities regulators or to report as an exempt reporting adviser. Form ADV contains information about an investment advisory firm and its operations, including business practices, conflicts of interest, and fees. The form consists of three parts, the first two of which are available to the public on the SEC’s Investment Adviser Public Disclosure (IAPD) website.
A funding round is when a company raises money from investors on the same or similar terms within a specific time period. Rounds are often referred to by stage, starting with a seed round, followed by Series A and successively lettered Series rounds. A company’s valuation generally increases with each successive funding round, and the purchase price per share increases accordingly.
Companies may raise different funding rounds using different exemptions from registration under the Securities Act, which may require an analysis of whether the rounds are truly distinct or should be treated as a single offering, which is called integration.
Fund of Funds
A fund of funds is a type of pooled investment vehicle that primarily invests in other funds, instead of directly investing in debt or equity securities of operating companies, often with the goal of achieving improved asset allocation, diversification, or other investment objectives.
A general partner is an individual or an entity—typically affiliated with a venture capital firm, private equity firm, or other investment firm—that raises money from limited partners for a private fund organized as a limited partnership and that both invests in and manages the fund. A fund that is organized in a different structure, such as a limited liability company, has a managing member or other manager under applicable state law and governing documents of the fund instead of a general partner.
A solicitation that conditions the market for an offering of securities is generally viewed as a general solicitation that is marketing the securities. Some exempt offerings prohibit the use of general solicitation to market the securities.
A hedge fund is a type of private fund that generally invests in a diverse range of securities and typically has more flexible investment strategies than mutual funds. Many hedge funds seek to profit by using leverage (borrowing to increase investment exposure as well as risk), short-selling, and other speculative investment practices.
An investment adviser is an individual or firm that is engaged in the business of providing investment advice to others or issuing reports or analyses about securities for compensation. Investment advisers may include money managers, investment consultants, financial planners, general partners of private funds, and others who are compensated for providing advice about securities. Investment advisers are required to register with the SEC or applicable state securities regulators as a registered investment adviser unless they are exempt from applicable registration requirements (for example, as an exempt reporting adviser).
Investment Advisers Act of 1940
The Investment Advisers Act regulates investment advisers. With certain exceptions, the Investment Advisers Act requires that firms compensated for advising others about securities investments register with the SEC and comply with regulations designed to protect investors. In addition, certain provisions of the Investment Advisers Act, such as anti-fraud prohibitions, also apply to investment advisers that are not registered with the SEC.
Generally, an investment company is a pooled investment vehicle that issues its own securities and is primarily engaged in the business of investing in other securities.
An investment company invests the money it receives from investors on a collective basis, and each investor shares in the profits and losses in proportion to the investor’s interest in the investment company. Investment companies can be categorized into three main types: open-end funds (for example, mutual funds), closed-end funds, and unit investment trusts.
However, not all companies that issue securities and are primarily engaged in the business of investing in securities are considered investment companies as defined in the Investment Company Act. For example, some may be considered private funds that are not registered or regulated as investment companies under the federal securities laws. laws.
Investment Company Act of 1940
The Investment Company Act—often referred to as the before ‘40 Act—regulates investment companies. The Investment Company Act focuses on public disclosure about pooled investment vehicles and their investment objectives, as well as on investment company structure and operations. Investment companies subject to the Investment Company Act must disclose various information, including their financial condition and investment policies to investors when stock is initially sold and, subsequently, on a regular basis.
An institutional investor is an entity that invests capital. Examples of institutional investors generally include banks, mutual funds, hedge funds, pension funds, insurance companies, some investment advisers, and university endowments.
A limited partner is an investor who commits capital to a private fund. Unlike a general partner, a limited partner’s participation in the fund’s investment activities is restricted, and its personal liability for fund debt is limited to the amount of money that the limited partner contributed or committed to contribute. The relationship of a limited partner with the fund and the general partner is governed by a Limited Partnership Agreement. For a fund that is organized as a limited liability company, the investor is referred to as a member under applicable state law and governing documents of the fund.
Securities of private companies are generally illiquid assets because there are typically fewer buyers and sellers, and resale restrictions pursuant to Securities Act Rule 144 may apply to securities acquired in an exempt offering.
A liquidation preference is a right that an investor may have to be paid before other investors upon a liquidation event, such as the sale of the company. Preferred stockholders typically receive a liquidation preference over common stockholders. Liquidation preferences are often expressed as a multiple of the initial investment, such as 1X or 2X, plus accrued but unpaid dividends. Liquidation preference may vary by class of stock and may be negotiated during each funding round.
Management fees are fees generally paid out of fund assets to its adviser in exchange for managing the fund. For example, a private equity fund manager typically charges a fee based on a percentage of capital invested in the fund or committed to the fund, in addition to a performance fee.
For example, a private equity fund manager typically uses a fee structure that includes a yearly management fee based on committed capital or invested capital (for example, 1%, 2%, etc.) and a performance fee based on the profits made above a certain benchmark (for example, 10%, 20%, etc.). The latter is often referred to as “carried interest.” These arrangements are often referred to by these percentages (for example, a 2% management fee and 20% performance fee is referred to as “2 and 20”).
The maturity date is when a borrower must make the final payment on a loan or other debt to the lender.
A membership interest is a security that represents an ownership interest—or equity—in a limited liability company (LLC), represented on a company’s cap table either by percentages or by units. Ownership and governance of LLCs typically uses different terminology than corporations, such as members instead of shareholders, operating agreement instead of bylaws, and membership interests or units instead of shares or stock. An LLC may assign different levels of voting and economic rights to members by issuing different classes of membership interest.
Performance fees are compensation provided to an adviser based on the performance of a client’s portfolio.
A common way to calculate such fees is based on a percentage of investment profits. For example, carried interest is a type of performance fee, in the form of a portion of profits from an investment or investments, paid to private fund managers in venture capital and private equity firms. See management fees definition above for examples of private equity fund fees.
For example, a private equity fund manager typically uses fee structure that includes a yearly management fee based on assets under management (e.g., 1%, 2%, etc.) and a performance fee based on the profits made above a certain benchmark (e.g., 10%, 20%, etc.). The latter is often referred to as “carried interest.” These arrangements are often referred to by these percentages (e.g., a 2% management fee and 20% performance fee is referred to as “2 and 20”).
Registered investment advisers should reference Section 205(a) of the Investment Advisers Act and the rules thereunder for additional information on performance fee arrangements.
Pooled Investment Vehicle
A pooled investment vehicle is an entity—often referred to as a fund—that an adviser creates to pool money from multiple investors. Each investor makes an investment in the fund by purchasing an interest in the fund entity, and the adviser uses that money to make investments on behalf of the fund. Investors generally share in the profits and losses in proportion to their interest in the fund.
Funds can vary significantly in terms of size, holding periods, and types of underlying investments. A few common types of funds include: mutual funds, exchange-traded funds, hedge funds, private equity funds and venture capital funds.
A portfolio company is an operating company that has received an investment from a fund. A portfolio company generally represents one of several investments for a fund (for example, a venture capital fund or a private equity fund).
Preferred stock is a type of security that represents an ownership interest—or equity—in a company with preferential rights over common stockholders, such as:
- (1) Liquidation preference;
- (2) Anti-dilution protection, such as pro-rata rights to invest in future funding rounds or minimum conversion price terms;
- (3) Rights to dividends; and
- (4) Limited voting rights, such as electing designated directors or approving major transactions.
Private Equity Fund
A private equity fund is a type of private fund that is managed by a private equity firm, which may be required to register with the SEC as an investment adviser. Private equity funds pursue a variety of investment strategies (for example, buyout, growth equity, and venture capital). A typical investment strategy undertaken by private equity fund is to take a controlling interest in a portfolio company and engage actively in the management and direction of the business in order to increase its value. Some private equity funds may also specialize in making minority investments in fast-growing businesses or startups.
A private fund is a pooled investment vehicle that is excluded from the definition of investment company by Section 3(c)(1) or 3(c)(7) of the Investment Company Act—commonly referred to as a 3(c)(1) Fund or a 3(c)(7) Fund. The term private fund is often associated with private equity funds, venture capital funds, and hedge funds.
Private funds and their advisers are subject to other federal securities laws. For example, when private funds raise money from investors through exempt offerings, they are subject to state and federal securities laws. In addition, persons who manage private funds may be required to register as an investment adviser with the SEC or applicable state securities regulators unless they are exempt from applicable registration requirements (for example, as an exempt reporting adviser).
A term commonly used to refer to certain types of exempt offerings.
A qualified purchaser is an investor that meets certain financial and sophistication standards, as defined in the Investment Company Act and its rules. For example, an individual may be a qualified purchaser if the investor owns $5 million or more in investments, and an entity may qualify if it owns and invests on a discretionary basis at least $25 million in investments.
An investment adviser to venture capital funds may qualify as an exempt reporting adviser that is not required to register with the SEC if the fund invests at least 80% of its assets in qualifying investments under Rule 203(I)-1 under the Investment Advisers Act, which generally means direct equity investments in private companies. Notably, pure debt instruments, secondary shares, public issuances, fund of fund investments, and some digital assets are generally not considered qualifying investments.
Qualifying Venture Capital Fund
A qualifying venture capital fund is a type of private fund that is excluded from the definition of investment company under Section 3(c)(1) of the Investment Company Act because it meets the following criteria:
- (1) no more than 250 beneficial owners;
- (2) no more than $10 million in aggregate capital contributions and uncalled capital commitments; and
- (3) qualifies as a venture capital fund.
Registered Investment Adviser
A registered investment adviser is an investment adviser that is registered with either its state securities regulator or the SEC. An adviser is typically subject to the laws of the state where the adviser maintains its principal office or place of business until it has at least $100 million of assets under management, under which amount an adviser is generally prohibited from registering with the SEC.
The following chart illustrates applicable laws based on an investment adviser’s assets under management:
|Investment Adviser (AUM)||Applicable Law|
|Small Adviser: < $25 million||State|
|Mid-Size Adviser: $25–$100 million||Generally State|
|Large Adviser: > $100 million||Federal|
A registered offering—often referred to as a public offering—is commonly used to describe an offer and sale of securities that has been registered under the Securities Act. Companies that would like to offer securities to the public through a registered offering must file a registration statement and may not sell the securities until the registration statement is effective.
Building Blocks: Offering Types | Building Blocks: Registered Offerings | Building Blocks: Liquidity Events | Building Blocks: Securities Laws Violations | Navigating Your Options | Registration under the Securities Act | Going Public | Capital Trends: Mapping Investment in America
A Regulation A offering is a type of exempt offering—sometimes referred to as a “mini IPO”—that permits a business to offer and sell up to $75 million of securities to the investing public through a process that is similar to, but less extensive than, a registered offering. Companies that have completed a Regulation A offering are subject to certain ongoing reporting requirements.
A Regulation Crowdfunding offering is a type of exempt offering that permits a business to offer and sell its securities to the investing public through crowdfunding. Crowdfunding generally refers to a financing method in which money is raised through an online platform, soliciting relatively small individual investments or contributions from a large number of people. Note that other types of crowdfunding, such as rewards-based and donation-based fundraising, that do not involve securities are not regulated by the SEC. Companies that have completed a Regulation Crowdfunding offering are subject to certain ongoing reporting requirements.
Regulation D is a series of rules that regulate certain types of exempt offerings. The following exemptions are set forth in Regulation D: Rules 504 (sometimes called “limited offerings”), 506(b) (sometimes called “private placements”), and 506(c) (sometimes called “general solicitation offerings”). Each rule has specific requirements that a company must meet.
Restricted stock units (RSUs) and restricted stock awards (RSAs) are issued by a company to its employees as compensation. RSUs and RSAs each have different tax consequences and the following attributes:
- (1) The shares of stock underlying an RSA are owned by the recipient on the date of the grant. The holder can sell or transfer the shares after certain vesting conditions are met.
- (2) An RSU is a right to receive shares of stock once certain vesting conditions are met. The recipient does not own any shares of stock on the date of the grant.
- (3) Vesting conditions may include the achievement of milestones, such as length of employment or performance metrics.
Rural Business Investment Company (RBIC)
An RBIC is a privately-owned investment fund that is licensed and regulated by the U.S. Department of Agriculture. RBICs use the money raised from investors to make debt and equity investments in qualifying small businesses located primarily in rural areas.
A secondary market is a market where existing securities are bought and sold in transactions between investors, rather than from the company.
Securities and Exchange Commission (SEC)
The U.S. Securities and Exchange Commission (SEC) is a federal government agency that was established to regulate and enforce the federal securities laws.
The SEC has a tripartite mission of:
- (1) protecting investors
- (2) maintaining fair, orderly and efficient markets
- (3) facilitating capital formation
Often referred to in capital formation transactions as equity, convertible debt, stock, shares, or membership interests, a “security” includes instruments such as stocks and bonds, as well as investment contracts. The federal securities laws broadly define what a security is and require all offers and sales of securities either to be registered under its provisions or to qualify for an exemption from registration.
Securities Act of 1933
The Securities Act—often referred to as the before '33 Act—generally (1) requires that investors receive financial and other information concerning securities being offered for public sale and (2) prohibits deceit, misrepresentations, and other fraud in the offer and sale of securities. More specifically, the Securities Act requires a company to file a registration statement containing information about itself, the securities it is offering, and the offering, unless the offering is an exempt offering.
Securities Exchange Act of 1934
The Exchange Act—often referred to as the before '34 Act—created the SEC and empowers it with broad authority over all aspects of the securities industry. This includes the power to register, regulate, and oversee brokerage firms, transfer agents, clearing agencies, and the nation's securities self-regulatory organizations (SROs).
The Exchange Act also prohibits certain types of conduct in the markets, including fraudulent activities and insider trading, and provides the SEC with disciplinary powers over regulated entities and persons associated with them. The Exchange Act also empowers the SEC to require periodic reporting of information by companies with publicly traded securities.
The seed round is typically a company’s first funding round, often raised from friends and family, angel investors, or early-stage funds in exchange for a convertible note. Capital at this stage may be used for product development and market research.
Series rounds may also be broken into early-stage (Series A and B) and late-stage (Series C+). While the use of proceeds varies, commonly:
- (1) Series A often supports a company with an initial customer base and proof of concept.
- (2) Series B often supports a company scaling production and expanding customer base.
- (3) Series C often supports companies optimizing operations in preparation of a future initial public offering.
Simple Agreement for Future Equity (SAFE)
A simple agreement for future equity (SAFE) is an agreement between a company and an investor in which the company promises to give the investor a future ownership interest in the company if certain triggering events occur, such as a future equity financing or an acquisition of the company. The owner of the SAFE does not have an ownership interest in the company unless the triggering event occurs and converts the instrument into equity. Like convertible notes, SAFEs are often used during seed rounds; however, unlike convertible notes, SAFEs generally do not include a valuation of the equity at the time of issuance, instead deferring that calculation until the triggering event occurs.
Small Business Investment Company (SBIC)
An SBIC is a privately-owned investment fund that is licensed and regulated by the Small Business Administration. SBICs use the money raised from investors to make equity and debt investments in qualifying small businesses.
State Securities Regulators
While the SEC regulates and enforces the federal securities laws, each state has its own securities regulator who regulates the offer and sale of securities and enforces states securities laws, often referred to as Blue Sky laws, within its state.
A stock is a security that represents an ownership interest—or equity—in a corporation. Equity holders of stock are often called “stockholders” or “shareholders.” Different classes of stock, such as common stock and preferred stock, have different voting and economic rights.
A stockholder’s ownership interest is often reflected as either a percentage of stock or a number of shares on the company’s capitalization table.
A stock option provides the holder with the right—but not the obligation—to “exercise” their option to purchase a certain number of shares of company stock at an agreed-upon price (a strike price) after a vesting period.
A company’s valuation, the worth of a company determined by an analyst or as agreed upon by the company and its investors, typically establishes how much the company and its investors value the company. The valuation establishes how much equity the investor will receive in exchange for its investment.
Valuations are often expressed as pre-money, before the funding round, and post-money, after the funding round. For example, assume an investor offers a company $250,000 based upon a $1 million valuation:
|Pre-Money Valuation||Post-Money Valuation|
If the $1 million valuation is pre-money, the company is worth more than if the $1 million valuation is post-money (i.e., includes the $250,000 in new money). This can have a significant impact on ownership percentages.
Venture Capital Fund
A venture capital fund is a type of private fund that is managed by a venture capital firm, which may be required to register with the SEC as an investment adviser. Venture funds typically invest in businesses in exchange for equity and some firms specialize in particular industries or in companies at a certain stage (for example, early, mature, or later stage).
- (1) represents to investors that it pursues a venture capital strategy;
- (2) generally limits redemption rights;
- (3) holds no more than 20% of the amount of the fund’s aggregate capital contributions and uncalled capital commitments in non-qualifying investments (often referred to as the 20% non-qualifying basket); and
- (4) limits the use of leverage.
Venture capital investments have a long time horizon and are generally locked in until a liquidity event (for example, acquisition or initial public offering) when the venture capital firm and its fund investors hope to realize profits from their investment. For example, venture capital funds are typically structured to last at least ten years and may operate longer as they work to exit all of their portfolio companies.
Building Blocks: Private Funds | Building Blocks: Types of Investors | Federal Securities Laws | Rules Implementing Dodd-Frank Act Amendments to the Investment Advisers Act: A Small Entity Compliance Guide | Press Release and Fact Sheet: Dodd-Frank Act Amendments to Investment Advisers Act
This glossary represents the views of the staff of the Office of Advocate for Small Business Capital Formation. It is not a rule, regulation, or statement of the Securities and Exchange Commission (the “Commission”). The Commission has neither approved nor disapproved its content. This glossary, like all staff statements, has no legal force or effect: it does not alter or amend applicable law, and it creates no new or additional obligations for any person.
Modified: June 27, 2022