National Venture Capital Association
January 15, 2003
Jonathan G. Katz
Re: File No. S7-47-02, Certain Research and Development Companies
Dear Mr. Katz:
The National Venture Capital Association ("NVCA")1 is commenting on the Commission's proposed rule for Certain Research and Development Companies, File No. S7-47-02. Venture capital funds invest heavily in biotechnology providing risk capital to companies with heavy capital demands and long time horizons to investment return. On behalf of our membership, we want to commend the Commission for this rulemaking to provide increased flexibility to biotechnology research and development ("R&D") companies in determining whether they qualify as investment companies under the Investment Company Act of 1940 ("ICA").
NVCA strongly supports the Biotechnology Industry Organization's ("BIO") petition and the intent of the Commission's Proposed Rule 3a-8 under the ICA. From the perspective of investors in biotechnology R&D companies, the Commission's proposed rule would make important and much needed refinements to current guidance regarding exemption from investment company status under the ICA.
As the Commission observed in its ICOS order2, an R&D company often exhibits characteristics that, using a strict application of the Tonopah3 primary business test, would deny it a 3(b) exemption from classification as an inadvertent investment company under Section 3(a)(3) of the ICA. A typical R&D company requires a great deal of capital in order to research and develop products that often are not brought to market for several years. Much of its assets typically consist of intellectual capital and technologies that are not included as capitalized assets on its balance sheet, making it difficult for them to be properly considered-as they in fairness should be-in a comparison of assets and income under Tonapah.
The Commission's willingness in ICOS to consider a bona fide biotechnology R&D company's use, in addition to the composition, of its assets and income in deciding whether to grant a 3(b) exemption from investment company status was an important advancement in updating Tonopah to reflect the economic realities of biotechnology R&D companies. However, the biotechnology industry has undergone significant changes in the decade since ICOS was issued.
More and more biotechnology R&D companies find it necessary to make investments that allow them to acquire the expertise and technology to remain competitive in bringing innovative products to market. In many instances, these vital "strategic investments" are non-controlling, and cannot be considered secure investments made for the purpose of capital preservation. This poses a significant problem for the typical biotechnology company seeking to qualify for 3(b) exemption under ICOS. The order requires, among other things, that substantially all of a company's non-controlling securities present limited credit risk and be invested in a manner consistent with the preservation of its assets until needed to finance operations.
As a result of this conflict, many biotechnology firms are presented with a Hobson's choice of altering or foregoing important strategic investments in order to qualify for exemption. This has the effect of dampening their efforts to share costs or risks, conduct joint research, obtain financing, and enjoy a host of other collaborative benefits - activities that biotechnology investors like venture capitalists encourage.
An additional problem has emerged in recent years regarding the "reduction of principal" prong of ICOS. The Commission stated in ICOS that, in order to satisfy this exemption criterion, a bona fide R&D company would be expected to spend more on R&D than it earns in gross investment income. The Commission recognized only a limited exception to this expectation, stating that a company may occasionally spend less on R&D than its investment income, but that it should not be a consistent pattern. This requirement poses increasing difficulties for biotechnology companies, particularly the fledgling companies in which venture capitalists often have interests. As the Commission noted in ICOS, R&D companies require large amounts of capital to develop products, and they seek to raise that capital whenever market conditions are favorable. This reality, combined with expenses that are spread over the course of many years as a company develops a product and brings it to market, can cause young biotechnology companies' investment income to exceed their R&D expenses on more than just an occasional basis.
The NVCA believes that the Commission's proposed rule, coupled with the proposed revisions submitted to the Commission by BIO in its comment letter dated January 9, 2003, effectively addresses venture capitalists' intellectual property valuation, strategic investment, and reduction of principal concerns outlined, supra. The rule would provide a better picture of the economic reality of biotechnology R&D companies, and also would provide bona fide R&D companies with the necessary additional flexibility, beyond that provided in ICOS, to develop and bring innovative products to market. In doing so, it would work to the benefit of biotechnology companies, investors, and consumers alike.
Should the Commission desire further information or comments from NVCA, please feel free to contact me or NVCA's regulatory counsel, Brian Borders.