Venture capital funds have traditionally been available only to institutions and wealthy individuals through private placements.  Fund managers were traditionally limited in designing fund structures for investors who did not meet the definition of a “qualified purchaser” (generally, individuals with assets of less than $2.1 million) or funds that have more than 100 investors. These requirements are discussed in greater detail on our private ICO and crypto funds page.

Business Development Companies (BDCs) are a form of a closed-end, publicly-traded fund that is registered with the Securities and Exchange Commission (SEC) under to the Investment Company Act of 1940 (the Company Act). BDCs assist with the facilitation of raising capital for financially troubled, small and developing companies who have in the past lacked access to the public capital markets. As such, they may be used as a publicly traded vehicle for investing in a portfolio of securities tokens issued by “eligible portfolio companies” (defined below).

BDCs may be thought of as publicly traded venture capital funds. They are typically structured as closed end funds: they issue shares to the public, and then invest the proceeds in venture capital investments in a portfolio of private companies.  Their shares trade in the public markets and rise and fall like any other stock.  This is in contrast to an open-end fund (i.e., a mutual fund), where new shares are continually available for purchase from the fund, and may be sold back to the fund, at the current net asset value per share of the fund.

BDCs are required to provide “significant managerial assistance” to the businesses that they invest in, including operational and management assistance. This means that BDCs are not the “passive” investment vehicles. Instead BDCs make their investments through equity capital or long-term debt with the aim of generating current income or capital appreciation. In the last few years, a variety of the private-equity managers have launched the BDCs as a way to access pubic capital.  Examples include BDCs from Apollo, Ares and BlackRock.

Can a BDC invest in ICO Tokens?

For the time being, no.  In January 2018, the SEC’s Director of the Division of Investment Management issued a “Staff Letter: Engaging on Fund Innovation and Cryptocurrency-related Holdings” to investment company market associations analyzing a number of unsolved questions relating to the registration of investment companies that invest in cryptocurrencies and tokens.  The letter concluded:

Until the questions identified above can be addressed satisfactorily, we do not believe that it is appropriate for fund sponsors to initiate registration of funds that intend to invest substantially in cryptocurrency and related products, and we have asked sponsors that have registration statements filed for such products to withdraw them.

The staff letter is discussed in greater detail on our blog post.

When these industry issues have been addressed and the SEC clears investment companies for registration, ICO BDCs should be come a reality.

BDC Benefits

BDCs have several advantages when compared to other types of investment funds:

  • Unlike private venture capital funds, BDCs offer liquidity to the investors because their shares trade in the public markets.
  • Unlike private venture capital funds, BDC investors need not be limited to to “qualified purchasers” and the investors don’t have to meet the net worth and income requirements applicable to private funds.
  • BDCs give their fund managers accessibility to permanent capital which is not subject to shareholder redemption as is common in private fund structures.
  • Unlike the other types of registered investment companies, BDC managers can charge performance fees, similar to managers of private venture capital funds.

BDC Limitations

BDCs have some limitations and restrictions, including of the following:

  • BDCs are forced to maintain low leverage and the total amount of debt is not permitted to exceed their total equity. This restriction does not apply to private venture capital funds.
  • BDCs are restricted in their ability to enter into transactions with affiliates.
  • BDCs are required to implement procedures and policies that will prevent any violations of the Federal securities laws. This involves the appointing of a chief compliance officer that will administer these procedures and policies.
  • A single BDC investment may not account for over 25% of the total holdings of the BDC. In addition, 70% of all the assets have to be invested in a limited amount of categories, as discussed below.
  • BDCs are required to distribute a minimum of 90% of the taxable earnings every quarter.

Permitted Investments

Section 55 of the Investment Company Act requires every BDC to invest a minimum of 70% of its total assets into the following:

  • Privately issued securities that are purchased from the issuers which are “eligible portfolio companies”;
  • Securities of the “eligible portfolio companies” controlled by the BDC, in which an affiliated individual of the BDC must be the director;
  • Privately issued securities of the companies that are subjected to reorganization, bankruptcy proceedings, insolvency or any other similar proceeding as well as those that are not able to meet the required obligations without any material assistance;
  • Government securities, cash items, cash or the high-quality debt-securities that are about to mature in one year or less; and
  • Office equipment and furniture, interests in either real-estate or other non-investment assets that are similar that are incidental to the operations of the BDC.

An “eligible portfolio company” is defined as any issuer that (a) is organized and has its principal place of business in the United States, (b) is not an investment company other than a small business investment company wholly owned by the BDC, and (c) does not have any class of publicly-traded securities with respect to which a broker may extend credit.

Tax Treatment

In most instances, BDCs are organized as a regulated investment companies (RICs) under Subchapter M of the Internal Revenue Code, and thus are able to avoid taxation at the company level on that portion of income and capital gains distributed to shareholders. Distributions to shareholders will be taxable either as capital gains or ordinary income in a similar manner as are distributions from the mutual funds. To qualify for RIC treatment, in general at least 90% of the BDC’s income must consist of interest, dividends, gains from sales of securities and similar types of income and gains and the BDC must distribute to its stockholders for each taxable year at least 90% of its investment company taxable income (consisting generally of net investment income from interest and dividends and net short-term capital gains). A BDC must also satisfy certain requirements with respect to its portfolio diversification.

How to Form a BDC

In order to become a BDC, the company is required to file a Form N-6 with the SEC. This is followed by the requirement of filing the notice on the Form N-54A which indicates that it has chosen to be an entity that will be regulated in the form of a BDC.

The process of electing to become regulated as a BDC, the company is required to register its equity securities under Section 12 of the Securities Exchange Act of 1934. These registrations necessitate that the BDC must periodically file Forms 10-K, 10-Q and 8-K along with proxy statements like any other public company. The BDC is also required to register the offer and sale of its shares under the Securities Act of 1933, as well as filing a Form N-2 registration statement that includes a detailed prospectus and other information, including audited financial statements.

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Lawyers for ICO's, ICO funds and BDC's, and Cryptocurrency Exchanges