Intro
Sometimes, all we want to do is bring together great capital sources—pension funds, endowments, and other ERISA-covered plans included—and invest in the next big thing. But if you’re managing a fund and these plan investors come on board, you can bump into some hefty ERISA regulations. One workaround? Become a Venture Capital Operating Company (VCOC). This post breaks down why that status matters, how to qualify, and the nitty-gritty of structuring a VCOC so you can keep the wheels turning smoothly.
Why Bother with VCOC Status?
If you’ve got significant backing from U.S. private-sector employee benefit plans (or other ERISA-governed entities), you risk your fund being labeled as holding “plan assets.” That classification can bring strict fiduciary standards, prohibited transaction rules, and complicated reporting requirements—frankly, a headache you’d rather avoid.
Most plan investors want to steer clear of plan asset status. Qualifying as a VCOC is a tried-and-true way to keep them comfortable while letting you focus on building your portfolio rather than wading through endless compliance.
How to Qualify as a VCOC
To earn (and keep) VCOC status, a fund must clear two major hurdles:
- The 50% Test
- The Actual Exercise Test
The 50% Test
At least 50% of the fund’s assets (at cost, ignoring short-term investments) need to be in venture capital investments or derivative investments.
Venture Capital Investments
“Venture capital investment” typically means you’re acquiring an equity or debt stake in an operating company along with direct contractual management rights. It’s not enough to just have some basic info rights or a friendly observer seat. You need a genuine say in the company’s direction—like appointing a director or having a real voice in major decisions.
Derivative Investments
In short, these are former venture capital investments that changed form—maybe the portfolio company went public and your management rights dissolved, or you swapped your stake in a merger or reorganization. They keep their status as qualifying investments for a set period (the longer of 10 years from the original investment or 30 months after the investment became “derivative”).
Valuation Timing
You must meet the 50% requirement:
- On the day you make your first non-short-term investment (known as the initial valuation date).
- Once every year, on a date the fund picks for its annual valuation.
If you blow it on either occasion, you lose VCOC status and can’t just magically re-qualify. However, once you’re in “distribution mode” (more on that later), you can relax a bit on this test.
Operating Company, Defined
Basically, your portfolio company must be a “real” business—selling goods or services, not just passively holding stuff like real estate or securities. This is determined by the facts and circumstances of what the company actually does day-to-day.
Direct Contractual Management Rights
Your fund must hold these rights directly. Think appointing a board member, consulting on big strategic moves, or having consistent access to financials and operational data so you can actively guide the company’s direction. If you have multiple affiliated funds investing, each one needs its own set (or a crystal-clear allocation) of these rights.
The Actual Exercise Test
Even if you have management rights on paper, you need to use them in a “substantial” way for at least one portfolio company. This must happen:
- Between your initial valuation date and the end of your first annual valuation period.
- Every 12 months after that.
Structuring Tips (and Potential Pitfalls)
Investing Through Subsidiaries
The simplest path is to invest directly in the operating company. But if you do it through a subsidiary, make sure it’s wholly owned (100% of capital and profits) by the fund, or that you only carve out a tiny sliver to keep necessary tax classifications intact. If you’re not fully committed to that arrangement, you might risk losing the look-through benefit.
Participation Interests in Bank Debt
Buying a participation interest from a bank loan isn’t a direct investment in the operating company itself—it’s a deal with the bank. So it usually won’t count toward your 50% test as a “venture capital investment.”
The First Investment Dilemma
Before you cross that initial valuation date threshold, you can’t call yourself a VCOC. But if you’re drawing ERISA money before you’ve formally qualified, you might accidentally trigger plan asset status early.
Here are some popular moves to avoid that situation:
- Calling capital “just in time” right before a deal closes.
- Using escrow arrangements (following DOL guidelines) to hold ERISA cash until you’re ready.
- Relying on a credit facility, then drawing capital once you’ve made your first investment.
- Tapping non-ERISA investors first for your initial deal.
- Having the general partner warehouse the investment and then transferring it to the fund once it’s set up as a VCOC.
Also, watch out for management fees or operational expenses that might lock you into ERISA oversight earlier than intended. Keep the structure clean so you don’t inadvertently step into plan asset territory.
When You’re Wrapping Things Up: The Distribution Period
After a VCOC has handed out at least half of its investments (by value) to its own investors, it enters the “distribution period.” While in this stage, you no longer have to keep meeting the 50% and Actual Exercise tests—good news if your portfolio’s winding down.
But be careful:
- If you make a fresh investment in a brand-new company (not already in your portfolio at the start of the distribution period), your clock resets, and you’re back to meeting those tests again.
- The distribution period also ends if 10 years go by from the start of that phase.
Even if you’re adding more money to an existing portfolio company, be sure it doesn’t accidentally count as a whole new investment. It’s a fine line worth some extra diligence.
What ERISA Investors Usually Want
Because of their own compliance obligations, investors subject to ERISA often ask for:
- VCOC Opinion or Certificate: A legal statement or attestation confirming the fund’s plan to qualify as a VCOC at the first investment.
- Annual Certification: Proof every year that you’re still a VCOC (sometimes they even request a formal opinion from your lawyers).
- Excuse Provisions: A mechanism to step aside from deals that could cause regulatory trouble.
- Withdrawal Rights: The power to bail out if the fund loses VCOC status.
- Amendment Protections: Assurance that key ERISA-related terms in your fund docs won’t change without their say-so.
Final Thoughts
If your fund draws in substantial ERISA money, pinning down VCOC status is a smart way to keep operations flowing without the full weight of ERISA. Nailing the 50% and Actual Exercise tests—and building in direct management rights—can keep you out of plan asset status. Meanwhile, staying on top of investor requests (like annual certifications or withdrawal provisions) keeps everyone happy.
Ultimately, juggling ERISA compliance is just part of the job if you want to tap that capital. With some proactive planning and the right structures in place, you can ensure your fund grows and thrives while avoiding unnecessary regulatory landmines.
Resources:
- Why the Venture Capital Operating Company Exemption Matters and How a Management Rights Letter Helps
This article explains the importance of VCOC status under ERISA and the role of management rights letters in securing that status.
https://velawood.com/why-the-venture-capital-operating-company-exemption-matters-and-how-a-management-rights-letter-helps/ - Operating as a VCOC and the Management Rights Letter
A comprehensive guide on the requirements and implications of operating as a VCOC, including the significance of management rights letters.
https://www.morganlewis.com/-/media/files/special-topics/vcpefdeskbook/fundoperation/vcpefdeskbook_operatingasavcoc.pdf - Advisory Opinion 2002-01A | U.S. Department of Labor
Official guidance from the U.S. Department of Labor on the criteria for qualifying as a VCOC under ERISA regulations.
https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/advisory-opinions/2002-01a - What is a Management Rights Letter? | Wyrick Robbins Emerging Growth
An overview of management rights letters and their importance in establishing VCOC status for venture capital funds.
https://ventures.wyrick.com/blog/what-is-a-management-rights-letter - Navigating the Plan Asset Rules: ERISA Plan Investment in Private Equity Funds
An article discussing the plan asset rules under ERISA and how private equity funds can navigate these regulations, including the use of VCOC status.
https://frostbrowntodd.com/navigating-the-plan-asset-rules-erisa-plan-investment-in-private-equity-funds-fiduciary-focus-series/
These resources offer valuable insights into the significance of VCOC status and practical guidance on achieving and maintaining it within the framework of ERISA regulations.
