Compiled by Mike Godfrey in New York

Introduction

The term venture capital is usually taken to refer to investment in smaller, younger or riskier companies, but it overlaps with the expression 'private equity', which refers to investment in unquoted companies. The two terms are more or less synonymous in many countries, including much of continental Europe, but in the US, and to some extent in the UK, venture capital carries with it more of an implication of risk.

In this series we will use the term 'venture capital' to include 'private equity' since we will be more concerned with the tax regime under which investment takes place than with the niceties of classifying target companies.

Venture capital investment is eagerly sought after by almost all countries. Stock exchanges, banks and the bond markets provide sources of capital for larger companies, but the encouragement of financing mechanisms for smaller companies has been a constant theme for governments, particularly since the leading-edge sectors in high technology which are seen as so important by government are often populated by smaller, newer companies who have traditionally found it difficult to raise capital.

In their attempts to encourage the development of venture capital investment, governments have often provided generous tax incentives, to overcome the reluctance of investors faced with high-risk situations and the lack of protection for minority shareholders which is a characteristic of most corporate legal regimes.

The encouragement given to venture capital by governments, and the emergence of considerable numbers of 'high net worth individuals', has seen the emergence of a class of smaller venture capital investors known as 'angels'. Venture capital angels often commit individual amounts of between £10,000 and £100,000 to a single investment. There are those who will invest larger amounts either individually or in a syndicate. This may be done either directly through personal contacts or through a business angel network, which may be able to help set up a syndicate. Often there is a key individual, an "archangel", who brings the syndicate together by referring the deal to relatives, friends and business associates.

Angels invest in almost all industry sectors and at all stages of business development, although predominantly in start-up/early stage and expansion stage companies. Most have a preference for investing in companies located within about 100 miles from where they live or work. However, business angels registered with business angel networks operating on a national rather than a local basis may be more willing to make longer-distance investments.

Any investment in a developing company is likely to have some of the characteristics of a tax shelter, ie that the cost of borrowed capital (to invest) is a deductible expense in most countries providing the structure is right, and that returns (and payment of the tax on them) are deferred until an investment is realised. But it is when incentive tax breaks are added that venture capital investment becomes more than just one investment route among others. In this series, we will take a passing glance at the general tax regime for investment in a country, but we will concentrate mainly on the tax-privileged venture capital investment regimes in each case.

The US is the second country to be studied in the series; as the home of the venture capital industry, it is not surprising to find that the US has witnessed the greatest proliferation of venture capital investment techniques to be found anywhere.

NB: All investment is risky, and none more so than venture capital investment. The information given in this feature is purely for general information; it is crucial that any investment should take full account of the circumstances of the investor, and the characteristics of the investment regime concerned. Therefore, any investor should take appropriate professional advice and should not rely upon the contents of this feature.

Tax Shelters In The US

Although a venture capital investment in the US has the same tax shelter characteristics as elsewhere, that's to say, it allows some of the expenses of investment to be deducted against income, while taxing the eventual returns from investment on a favourable basis, the expression 'tax shelter' in the US commonly implies a more or less elaborate scheme whose goal is primarily to minimise taxation, with return on investment having only secondary importance. Before turning to examine venture capital in the US, therefore, we will briefly outline the current state of play as regards tax shelters in general.

In America as nowhere else, tax advisers, businesses and the tax authorities play the 'tax shelter' game with rare dedication. From time to time, the IRS launches an all out attack on tax shelters, and the shelter industry retreats - but it is soon back again, applying all its wits to the creation of ever more intricate ways of minimising tax bills.

Acceptable tax shelters make use of permitted loopholes or tax breaks which are there to encourage certain types of economic behaviour. The vast majority of tax shelters are in full compliance with the tax laws, but some cross the border-line into being what the Government terms "abusive tax shelters". These are cases where the revenue loss to the government produces little or no tax benefit to society.

The Tax Reform Act of 1986 represented the last major attack by Government on tax shelters; in 2000 it tried again during the 106th Congress, but was unsuccessful.

Many US tax shelters are business ventures in which accounting losses far exceed the accounting income. These losses are used to offset the taxpayer's income from other sources. Usually, a tax shelter also provides large deductions in its early years although the taxpayer may not have invested significant amounts of capital up front. For example, a taxpayer might purchase a rental property with a low down payment and offset his rental income with deductions for interest, taxes, and the maximum allowable depreciation.

There are many methods by which taxpayers shelter their losses, but these three characteristics are usually found in tax shelters, either separately or in combination:

• taxes are deferred to later years;
• ordinary gains (100 percent taxable) are converted to capital gains (only 40 or 50 percent taxable); or
• capital losses (often only partly deductible), are converted to ordinary losses (100 percent deductible).

Deferral also occurs when excessive deductions are taken in the early years of a tax shelter, a practice the IRS calls "front end loading." Examples of illegal front end loading practices are:

• deducting capital items by classifying them as advisory fees, management fees, or interest;
• deducting prepaid interest;
• not including prepaid income;
• deducting excessive depreciation, amortization, or depletion by using the wrong method, too short a useful life and/or too large a basis.

Although the counter-tax-shelter bill lost in the last Congress won't return in exactly the same form, there's no doubt that the administration will want to achieve approximately the same goals through legislation in the new Congress, and the IRS has already adopted rules along the lines of parts of the bill, so it is useful to review briefly what the bill would have done:

• The 'substantial understatement' penalty imposed on abusive corporate tax shelter items (as redefined) generally would be increased to 40% (from 20%), with no reasonable cause exception;
• The Treasury Department would be able to disallow deductions, credits, exclusions, or other allowances obtained in an abusive corporate tax shelter;
• Deductions for fees and tax advice expenses related to abusive corporate tax shelters would be denied, and a 25% excise tax would be imposed on fees received in connection with promoting or rendering tax advice related to abusive shelters;
• The corporate purchaser of an abusive corporate tax shelter would pay an excise tax of 25% of the maximum payment to be made under a tax benefit "protection arrangement."
  

The proposed legislation included a useful list of specific types of tax shelter, with proposed remedies - but of course at this moment the remedies do not apply:

• Forward stock sales. A corporate issuer of stock sold through a forward sale contract would be required to recognize as interest the time-value element of the forward contract. The proposal would be effective for forward contracts entered into on or after the date of first committee action;
  
  
• Built-in losses. The proposal targets the "importation" of foreign losses and other tax attributes incurred outside the U.S. taxing jurisdiction that are used to offset income or gain otherwise subject to U.S. tax. The proposal would eliminate such attributes and require that the tax basis be marked to market in certain circumstances.
  
  
• S corporation ESOPs. The proposal would 1) require an ESOP to pay tax on S corporation income (including capital gains) as the income is earned and 2) allow the ESOP a deduction for distributions of such income to plan beneficiaries.
  
  
• Serial liquidations. The proposal would impose withholding tax on any distribution made to a foreign corporation in complete liquidation of a U.S. holding company if the holding company was in existence for less than five years; the proposal also would apply with respect to serial terminations of U.S. branches.
  
  
• Basis shifting transactions. To prevent taxpayers from attempting to offset capital gains by generating artificial capital losses through basis-shift transactions involving foreign shareholders, the proposal would treat the portion of a dividend that is not subject to current U.S. tax as a nontaxed portion.
  
  
• Lessors of tax-exempt property. The proposal would deny a lessor the ability to recognize a net loss from a leasing transaction involving tax-exempt use property during the lease term.
  
  
• Mismatching of deductions and income. Deductions for amounts accrued but unpaid to related controlled foreign corporations, passive foreign investment companies, or foreign personal holding companies generally would be allowable only to the extent the amounts accrued by the payor are, for U.S. purposes, reflected in the income of the direct or indirect U.S. owners of the related foreign person. An exception would be provided for certain short-term transactions entered into in the ordinary course of business.
  
  
• Control test. The proposal would conform the control requirement for tax-free incorporations, distributions, and reorganizations with the ownership test used for determining affiliation.
  
  
• Tracking stock. The proposal would give Treasury authority to treat "tracking stock" as nonstock (e.g., debt or a notional principal contract) or as stock of another entity as appropriate to prevent tax avoidance.
  
  
• Transfers of intangibles. The transfer of an interest in intangible property constituting less than all of the substantial rights of the transferor in the property would be treated as a tax-free transfer, but the transferor would be required to allocate the basis of the intangible between the retained rights and the transferred rights based on their respective fair market values. Consistent reporting would be required.
  
  
• Downstream mergers. Where a target corporation holds less than 80% of the stock of an acquiring corporation, and the target combines with the acquiring corporation in a reorganization in which the acquiring corporation is the survivor, the target would have to recognize gain, but not loss, as if it distributed the acquiring corporation stock that it held immediately prior to the reorganization.
  
  
• Current accrual of market discount. A taxpayer that uses an accrual method of accounting would be required to include market discount income as it accrues, effective for debt instruments acquired on or after the date of enactment.
  
  
• Partnership constructive ownership transactions. The proposal would treat long-term capital gain recognized from a "constructive ownership" derivative transaction as ordinary income to the extent the long-term capital gain recognized from the transaction exceeds the long-term capital gain that could have been recognized had the taxpayer invested in the partnership interest directly.
  
  
• Debt-financed portfolio stock. The proposal would tighten current-law rules requiring a corporation to reduce its dividends-received deduction with respect to dividends paid on debt-financed portfolio stock.
  
  
• Straddle rules. The proposal would 1) clarify that net interest expense and carrying charges arising from structured financial products containing a leg of a straddle must be capitalized and 2) repeal the current-law exception for certain straddles of actively traded stock.
  
  
• Effectively connected income. The proposal would expand the categories of foreign-source income that could constitute effectively connected income under IRC section 864(c)(4)(B)(ii) to include income that may be sourced by analogy to interest (interest equivalents) or dividends (dividend equivalents). Interest equivalents would include letter-of-credit fees, guarantee fees, and loan commitment fees.
  
  
• Overall foreign losses. For the purposes of IRC section 904(f), property subject to the recapture rules upon disposition under IRC section 904(f)(3) would include stock in a controlled foreign corporation.

The tax-shelter industry on Wall Street moved into top gear after the proposals were anounced, pushing through large numbers of schemes before the doors shut; but in the event the Bill languished. It's likely that the administration went overboard with its bill, trying to clear away too many encrustations in one sweep, and over-estimating its ability to push complex bills through the dying days of a Congress. It might have been more successful with a shorter, less ambitious bill.

The US Venture Capital Sector

Venture capital in the US can be divided into 'professional' and 'angel' finance. 'Professional' venture capital is typically provided through venture capital funds, while 'angel' venture capital is more usually invested direct by one or a small number of private individuals.

Generally, venture capital investors can be said to invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors. Venture capital is an important source of equity for start-up companies.

Venture capitalists generally invest in equity, and actively participate in the strategic development of their target companies. Nornally they have a long-term perspective.

Recently, some investors have been referring to venture investing and buyout investing as "private equity investing." This term can be confusing because some in the investment industry use the term "private equity" to refer only to buyout fund investing. Institutional investors commonly allocate 2% to 3% of their institutional portfolio for investment in alternative assets such as private equity or venture capital. Increasingly, the two terms overlap.

Professionally managed venture capital firms in the US are generally private partnerships or closely-held corporations funded by private and public pension funds, endowment funds, foundations, corporations, wealthy individuals, foreign investors, or venture capitalists themselves.

Professional venture capitalists mitigate the risk of venture investing by developing a portfolio of young companies in a single venture fund. Many times they will co-invest with other professional venture capital firms. In addition, many venture partnerships manage multiple funds simultaneously.

The phrase 'Angel Investor' originally referred to investors in Broadway plays, but by now the term encompasses a wide spectrum of individual investors in business and cultural activities.

It is estimated that angel investors in the US invest three to five times more money than venture capitalists and fund thirty to forty times more ventures, making them the primary source of outside capital for entrepreneurs. Generally an angel investor has a net worth of $1 million or more or a salary of $200,000 or more for the past two years. An Angel investor must be prepared to get involved with the business and should have his or her own management experience. Angel investors may either be wealthy people with management expertise or retired business men and women who seek the opportunity for first-hand business development.

Typically, angel investors choose small companies that are too speculative for bank loans and too young for venture capital. Often they are in the high-tech, health services, retailing and personal services industries, but are not limited to those industries. Start-up businesses may need financing to begin operations, develop a product or bring that product to market. Angels also prefer to invest in industries that they are personally familiar with.

Angel investors are at the opposite end of the spectrum from companies using shelters driven mainly or wholly for tax reasons, in that they may actually hope to make money out of their investment, and also see it as a positive involvement in business terms. Nonetheless, 'angels' need to minimise their tax bills as much as anyone else, and venture capital is at the end of the day a tax-efficient investment.

In the US, the National Venture Capital Association (NVCA) is a trade association that represents the venture capital industry. Its membership of more than 400 consists of venture capital firms and organizations who manage pools of risk equity capital designated to be invested in young, emerging companies.

While the archetypical venture capital investor looks for baby Microsofts, there is in fact a wide range of different types of vc investor. Venture capitalists can be generalists, investing in various industry sectors, or various geographic locations, or various stages of a company's life; alternatively, they may be specialists in one or two industry sectors, or may seek to invest in only a localized geographic area.

Not all venture capitalists invest in "start-ups." While venture firms will invest in companies that are in their initial start-up modes, venture capitalists will also invest in companies at various stages of the business life cycle. A venture capitalist may invest before there is a real product or company organized (so called "seed investing"), or may provide capital to start up a company in its first or second stages of development, known as "early stage investing." Also, the venture capitalist may provide needed financing to help a company grow beyond a critical mass to become more successful ("expansion stage financing").

Some funds focus on providing financing to help the company grow to a critical mass to attract public financing through a stock offering or to attract a merger or acquisition with another company. At the other end of the spectrum from start-ups, some venture funds specialize in the acquisition, turnaround or recapitalization of public and private companies that represent favorable investment opportunities.

While high technology investment makes up most of the venture investing in the U.S., and the venture industry gets a lot of attention for its high technology investments, venture capitalists also invest in companies such as construction, industrial products, business services, etc. There are several firms that have specialized in retail company investment and others that have a focus in investing only in "socially responsible" start-up endeavors.

Venture capitalists will help companies grow, but they eventually seek to exit the investment. Most venture capital investments mature in three to seven years, but an early stage investment may take seven to ten years to mature, while a later stage investment many only take a few years. The life cycle of the investment must match the liquidity profile and investment goals of the investing limited partnership.

From a tax perspective, the timing of investment and of disposal or exit is obviously a key aspect, and one which is not necessarily under the control of the investor. If investments are being made through a venture capital fund, timing is specifically not under the control of the investor, although in a classical closed-end fund there's nothing to discuss, because the rules were laid down at the beginning. The vagaries of the market are one reason for preferring direct, individual investment, although an investment in any given company is probably even more volatile than the market as a whole.

Corporate Organisation Of Venture Capital Firms In The US

There are several types of venture capital firms, but most mainstream firms or wealthy individual investors invest their capital through funds organized as limited partnerships in which the venture capital firm serves as the general partner.

A limited partnership is a partnership that requires only one partner to assume personal liability for the business's liabilities (the general partner). There may be more than one general partner. However, there may also be other partners (limited partners) who are passive investors and do not incur personal liability.

Formation of a limited partnership requires compliance with state law; otherwise most states will treat all partners as general partners for purposes of personal liability for the business's obligations.

A limited partnership encourages contributions from investors who might be reluctant to assume the personal liability associated with a general partnership. A limited partner is merely an investor; he or she supplies the capital but is not involved in the day-to-day management of the business. In fact, limited partners are prohibited from becoming actively involved in the on-going management of the business or they forfeit their limited liability. The business must have at least one general partner who is responsible for overseeing operations and for making daily management decisions.

Sale of ownership interests in a limited partnership may be treated as a sale of securities, and state and federal securities laws must be consulted.

The most common type of venture capital firm is an private, independent venture that has no affiliations with any other financial institution. Venture capital firms may also be affiliates or subsidiaries of a commercial bank, investment bank or insurance company and make investments on behalf of outside investors or the parent firm's clients. Still other firms may be subsidiaries of non-financial, industrial corporations making investments on behalf of the parent itself. These latter firms are typically called "direct investors" or "corporate venture investors."

Other organizations may include government affiliated investment programs that help start up companies either through state, local or federal programs. One common vehicle is the Small Business Investment Company or SBIC program administered by the Small Business Administration, in which a venture capital firm may augment its own funds with federal funds and leverage its investment in qualified investee companies.

While the predominant form of organization is the limited partnership, in recent years the tax code has allowed the formation of either Limited Liability Partnerships, ("LLPs"), or Limited Liability Companies ("LLCs"), as alternative forms of organization. However, the limited partnership is still the predominant organizational form. The advantages and disadvantages of each has to do with liability, taxation issues and management responsibility.

The venture capital firm will organize its partnership as a pooled fund; that is, a fund made up of the general partner and the investors or limited partners. These funds are typically organized as fixed life partnerships, usually having a life of ten years. Each fund is capitalized by commitments of capital from the limited partners. The venture fund will have from a few to almost 100 limited partners depending on the target size of the fund. Once the partnership has reached its target size, the partnership is closed to further investment from new investors or even existing investors so the fund has a fixed capital pool from which to make its investments.

Making investments in portfolio companies requires the venture firm to start "calling" its limited partners' commitments. The firm will collect or "call" the needed investment capital from the limited partner in a series of tranches commonly known as "capital calls". These capital calls from the limited partners to the venture fund are sometimes called "takedowns" or "paid-in capital." Some years ago, the venture firm would "call" this capital down in three equal installments over a three year period. More recently, venture firms have synchronized their funding cycles and call their capital on an as-needed basis for investment.

Although the classical, fixed-term limited partnership fund has emerged as the dominant form for venture capital investment, it is illiquid during the term of the partnership. Difficulties of valuation have probably been the main reason preventing the emergence of a secondary market in partnership shares, although just recently the sheer size of the venture capital sector, plus perhaps the woes of the high technology industry, have been factors tending to encourage the development of secondary liquidity. Investors locked into partnerships with many basket-case investments may want to rescue what little they can from the mess.

Some types of "secondary" partnership have emerged that specialize in purchasing the portfolios of investments of existing venture capital firms. These secondary partnerships, expecting a large return but taking high risks, invest in what they consider to be undervalued companies.

As in the mutual fund sector, the choice of investment targets is often delegated to specialist advisors or management agencies. In some cases, the investor will provide liquidity to an advisor, or 'gatekeeper', which pools the assets of its various clients and invest these proceeds as a limited partner into a venture or buyout fund currently raising capital. Alternatively, an investor may invest in a "fund of funds," which is a partnership organized to invest in other partnerships, thus providing the limited partner investor with added diversification and the ability to invest smaller amounts into a variety of funds.

Exiting A Venture Capital Investment

Exit strategies vary considerably according to the structure of investment, from the lone 'angel' investor at one extreme to publicly-quoted venture capital funds of funds at the other, but exit routes consist of an IPO (initial public offering), trade sale of shareholdings, merger or acquisition.

IPO

During the go-go years of the TMT boom in the 1990s, the initial public offering was the most popular and visible exit route for most venture capital investee companies. Investors, whether venture capital funds or individuals, are 'insiders' during a flotation and their shareholdings are subject to disposal limitations for after the IPO. Once the stock is freely tradable, usually after about two years, investors can choose whether to liquidate the investment and roll it over into another investment, or to hold the shares hoping for further appreciation. Funds or individuals making the latter choice in 1999 or 2000 have had reason to regret their decision in many cases due to precipitate falls in high-tech company valuations. Over the last twenty-five years, almost 3000 companies financed by venture funds have gone public in the US.

Mergers and Acquisitions

Mergers and acquisitions represent the most common type of successful exit for venture investments. In the case of a merger or acquisition, the venture firm or investor will receive stock or cash from the acquiring company. Less often than with an IPO, shares acquired in this way may be subject to 'lock-up' limitations for a period of time.

Valuations

It's a characteristic of the venture capital investment sector that investee companies will go through several rounds of financing as they grow towards the magic moment of an exit. Each round of financing requires that the existing and incoming investors should agree on a valuation of the investee company. During the glory days of the 1990s bull market, valuation was not difficult - just think of a number and double it!

Things are very different now, not least because of the various types of 'umbrella' or 'claw-back' mechanism typically included in venture capital shareholders' agreements. There are various ways in which venture capital investors seek to limit the risks they are taking, and one of the more usual is to have a clause limiting the returns of other shareholders if exit takes place at a low valuation - thus the venture capital company may receive back its investment in cash before the sale proceeds are divided among the shareholders. It gets paid out twice, therefore. Such clauses are perceived as unfair by entrepreneurs when they operate at low valuations - but they are easy to skip over when you are desperate for funding!

The volatility of stock markets, the existence of lock-up agreements, and the protection clauses in shareholders' agreements taken together mean that valuing venture capital funds is much more of an art than a science. This doesn't matter so much in a closed-end fund with illiquid investments, where valuation may be irrelevant until the fund closes, but it matters a lot from a tax perspective to any investor whose investments are disposed of during the life of a fund or who is party to a takeover.

The US Tax Regime For Venture Capital

Unlike many other countries that seek to foster venture capital investment, the US provides no federal tax breaks as such - that's to say, no deductions are allowed of initial capital expenditure against current income. However there are such deductions at the state level in many cases - whether this matters depends on income tax levels in a particular state. They vary from 1% to 12%.

Still, the overall tax regime for venture capital investment in the US is reasonably benign, which is why the absence of specific federal tax breaks has not impeded the growth of a gigantic venture capital sector.

Important features of the US federal tax system for investment are that interest expense involved in investment is deductible against investment returns and to some extent against regular income, capital losses are offsetable against gains, and losses on passive investments (less than 10% of a company, and including investments held through a limited partnership) are deductible against investment income (income within the passive 'basket').

Capital gains are included within income in the US and are subject to income tax; however, the maximum rate of tax on gains from investments held for more than 12 months is 20%, and this is reduced to 18% if the hold is for more than 5 years. If a qualifying small-business asset is held for more than five years, there is a 50% exclusion of capital gains on disposal.

The corporate forms used for venture capital investment are almost always 'pass-through', ie the limited partnership or similar is fiscally transparent, so that its gains or losses are attributed to investors without intervening taxation. Evidently, this does not apply to publicly-listed venture capital funds which take the form of mutual funds (often, funds of funds), and are taxable in their own right.

As examples of state-level schemes favouring venture capital investment we will take Virginia, which passed a fairly typical law resembling that in other states where there is a substantial high-tech community.

In Virginia, the 1998 so-called 'angel investor' law gives people who invest in small high-tech, biotech and manufacturing firms a state income tax credit for 50 percent of their investments. The investment must be for cash and neither the investor, the investor's family nor the investor's affiliates can receive any type of compensation from the business for one year. The maximum credit is $50,000 and, although the investment must be held for five years, the investor can apply for a tax credit immediately. The credit is available for individuals and estates only - businesses cannot receive the credit.

Eligible businesses receiving the investments must have annual gross revenues under $5 million, must operate principally in Virginia and cannot be in the fields of or related to banking, finance, construction and consulting.

The hitch is that the state set aside only $5 million to be used for the credits, so investors may not receive a full 50 percent credit depending on how many apply. The tax department will add the investments from the year and divvy up the credits equally among investors.

Some states allow the deduction against business income tax as well as giving it to individuals.

Policy Issues Affecting The Venture Capital Sector

There are a number of ongoing issues which are relevant for venture capitalists in the US.

Accounting Standards

The Financial Accounting Standards Board (FASB), an independent regulatory body overseen by the Securities and Exchange Commission (SEC), has wanted for some years to eliminate pooling accounting for business combinations. In Europe, the equivalent technique, known as merger accounting, has been banned, and the International Accounting Standards Committee (IASC), an advisory body made up of representatives from FASB and other foreign accounting standards boards, is against it.

Under pooling, the balance sheets of the two companies are combined, and no change in asset value is recognized. Under purchase accounting, a business combination is treated as the purchase of one company by another. The value of the purchased company is then treated as an asset and the value is restated to reflect the price paid to its shareholders. Purchase accounting poses serious difficulties for tech sector growth companies because of the costs involved. This is mainly because under current purchase accounting rules, goodwill (the difference between the purchase price and the value of all identifiable assets of the purchased company) must be allocated to intangible assets amortized over a period of time. These amortization expenses often can cause a company that would otherwise report profits to instead report losses.

A solution to the problem being cavassed recently would require the amortisation of goodwill under purchase accounting, only if a triggering event indicating that the goodwill has been impaired takes place.

Stock Options

The IASC has issued paper calling for rules to require companies to expense the stock options they offer to directors and employees. FASB made a similar proposal several years ago but ultimately dropped it in the face of fierce industry and congressional opposition. Business has long maintained that stock options are not to be viewed as compensation and thus should not be expensed. The FASB has indicated that it does not intend to revisit this issue, but there remains a long-term concern about the IASC's agenda.

ERISA

The ERISA reform in 1979 which modified the 'prudent man' rule, limiting the right of pension funds to invest in anything but the most conservative investment vehicles, led to a substantial flow of funds into venture capital companies. However, House Committee hearings last year concluded that the rules remain too restrictive, and there is a good chance of further reforms to ERISA in the new Congress which would be beneficial for the venture capital sector.

Hart-Scott-Rodino Reform

The Hart-Scott-Rodino Antitrust Improvements Act of 1976 (HSR) prohibits consummation of certain acquisitions of assets or voting securities until the parties file notification forms with the Department of Justice and Federal Trade Commission and the applicable waiting period has expired.

The HSR rules have long been seen as a serious impediment to concentration in the venture capital sector - filing fees alone are $45,000, never mind attendant legal costs. Many in Congress agreed that the fees are essentially a tax on industry.

The HSR Act was significantly amended, effective February 1, 2001, with a key improvement being an increase in the threshold for transaction filings to $50 million (from $15 million), a change that is expected to reduce the number of filings under the Act by approximately half. Other important changes include eliminating the size of person test for transactions valued at in excess of $200 million, setting the filing fee based on the value of assets or voting securities to be held resulting from the acquisition (up to a maximum filing fee of $280,000), and extending the waiting period following substantial compliance with a "Second Request" to 30 days for most transactions.

• The size of the transaction threshold also will no longer be met by acquiring 50% or more of the voting securities of an issuer with annual net sales or total assets of $25 million or more. Thus, if an acquisition does not result in an acquiring person holding an aggregate total amount of voting securities and assets of the acquired person in excess of $50 million, no filing will be required.
• Any transaction that results in an acquiring person holding an aggregate total amount of voting securities and assets of an acquired person in excess of $200 million will be reportable regardless of the size of the parties to the transaction.
• The new filing fees are based on the aggregate total amount of voting securities and assets of the acquired person to be held as a result of the acquisition (rather than the current $45,000 per reportable transaction) as follows:
  • The filing fee remains $45,000 if the aggregate amount of assets and voting securities to be held as a result of the acquisition is less than $100 million.
  • The filing fee will be $125,000 if the aggregate amount of assets and voting securities to be held as a result of the acquisition is from $100 million to less than $500 million.
  • The filing fee will be $280,000 if the aggregate amount of assets and voting securities to be held as a result of the acquisition is $500 million or more.