Drawing on more than a decade of legal experience assisting entrepreneurs and investment funds, I have observed many instances in which Venture Capital Operating Companies (VCOCs) play a pivotal role. VCOCs can help private investment vehicles avoid significant compliance burdens under the Employee Retirement Income Security Act of 1974 (ERISA). Understanding how VCOC status works, including the criteria for qualifying and the strategic considerations involved, is critical for entrepreneurs, fund managers, and investors alike. This article outlines the key points of VCOC status, the ERISA framework behind it, and best practices for structuring these funds.
1. Why VCOC Status Matters for Entrepreneurs and Funds
Many private investment funds use capital from benefit plans or other entities governed by ERISA. Because ERISA imposes strict fiduciary rules and prohibited transaction regulations, fund managers may seek to avoid having their funds characterized as holding “plan assets.” When a fund holds plan assets, it must comply with extensive ERISA obligations, which can restrict investment strategies and complicate operational procedures.
One way to avoid being deemed to hold plan assets is for a fund to qualify as a Venture Capital Operating Company (VCOC). Meeting the VCOC requirements can streamline compliance and reduce the risk of fiduciary liability for the general partner, manager, and investors. The “look-through” concept of ERISA treats certain entities as transparent, meaning that if no exception applies, the assets inside a fund can be treated as plan assets—subjecting the fund’s activities to the extensive obligations of ERISA. If a fund is a VCOC, the plan’s investment is not looked through to the fund’s underlying assets, thus avoiding many ERISA restrictions.
2. ERISA’s Look-Through Rule and The Role of Operating Companies
Under ERISA, if an employee benefit plan invests in an entity by acquiring an equity interest, the law may treat the plan’s investment as an investment in the underlying assets of that entity—unless an exemption applies. Common exemptions include:
- Securities offered to the public.
- Securities issued by a registered investment company.
- Less than 25% of the value of each class of equity interests held by benefit plan investors.
- Entities classified as operating companies, which include VCOCs and Real Estate Operating Companies (REOCs).
For the private fund context, VCOC status remains a popular choice when a substantial percentage of the fund’s capital derives from ERISA-governed plans. By structuring a fund to meet VCOC requirements, managers effectively limit ERISA’s reach to the fund itself, avoiding the managerial complexities that would come if the fund were deemed to hold plan assets.
3. Understanding the VCOC Tests
A fund is considered a VCOC if it meets two essential tests:
- The 50% Test.
- The Actual Exercise Test.
Both tests hinge on how the fund invests its capital (particularly in operating companies) and whether it obtains and exercises direct contractual management rights in those portfolio companies. Qualifying initially is only one part of the equation; the fund must also maintain compliance year after year to avoid losing its VCOC status.
3.1 The 50% Test
To satisfy the 50% test, at least half of the fund’s assets (valued at cost, excluding short-term investments held pending distribution or long-term commitment) must be invested in “venture capital investments” or “derivative investments.” This threshold is measured on designated valuation dates:
- Initial Valuation Date: The day the fund makes its first long-term investment.
- Annual Valuation Date: A single day in each subsequent year (within a pre-established 90-day window) on which the fund reevaluates its holdings.
If the fund fails the 50% test on the initial valuation date or on any subsequent annual valuation date, it cannot retroactively fix the issue and re-qualify as a VCOC. The stakes are high: if you miss the 50% threshold one year, the opportunity to maintain VCOC status disappears.
3.1.1 Venture Capital Investments
A “venture capital investment” is an investment in an operating company in which the fund has acquired direct contractual management rights. The operating company itself must be engaged in producing or selling goods and services rather than merely investing in capital assets, metals, or other funds.
Crucially, there is no minimum ownership percentage or dollar threshold to qualify—what matters is securing robust management rights. This can include everything from board representation to specific consultation privileges. Equity investments are common, but certain debt investments can also qualify if accompanied by equivalent management rights.
3.1.2 Derivative Investments
Sometimes a fund’s initial venture capital investment changes status due to an IPO or a corporate reorganization. The concept of “derivative investments” captures these cases, allowing the fund to count the original investment as part of its 50% threshold for a specified time after a portfolio company’s public offering, reorganization, or merger.
Generally, an investment remains a valid derivative investment until the later of:
- Ten years from the date of the original venture capital investment.
- Thirty months from the date it converted to a derivative investment.
3.2 The Actual Exercise Test
Meeting the 50% Test only addresses how much of the fund’s capital is deployed in qualifying operating companies. Equally important is the Actual Exercise Test: in the ordinary course of business, the fund must actually exercise the management rights it obtains from at least one of its operating companies.
Practically, this means the fund should devote “substantial resources” to involvement in at least one portfolio company’s management. It is not enough to simply hold the contractual right; the fund must demonstrate active participation—such as having a representative sit on the company’s board, consulting on significant strategic decisions, or receiving detailed updates beyond standard corporate communications.
This test must be satisfied:
- From the date of the fund’s initial valuation through the end of the first annual valuation period.
- During each 12-month period following the end of each annual valuation period.
4. Advantages of VCOC Status
When structured correctly, a fund’s VCOC status can grant it freedom from many ERISA rules. Here are a few advantages:
- Greater Investment Flexibility: Without VCOC status, a fund deemed to hold plan assets must adhere to ERISA’s fiduciary and prohibited transaction requirements. VCOC status sidesteps those issues, enabling the fund to execute deals more quickly and flexibly.
- Reduced Managerial Burden: Because ERISA imposes complex obligations on fiduciaries, a fund that fails to qualify as a VCOC may find itself embroiled in constant compliance checks and potential liability.
- Wider Investor Base: Institutional investors subject to ERISA are more willing to invest if they are assured their investment will not create compliance headaches. Attaining VCOC status can therefore attract a broader pool of investors.
5. Structuring and Tiering Issues
Occasionally, funds create subsidiary structures for holding certain investments. While layering can be advantageous for tax or liability reasons, it also raises special considerations for VCOC compliance.
5.1 Wholly Owned Subsidiaries
A fund can still treat a particular investment in an operating company as a qualifying venture capital investment if it invests through one or more subsidiaries, provided each subsidiary is wholly owned by the fund (or the fund’s other wholly owned subsidiaries) at all times. In other words, the fund must own 100% of the capital and profits interests in that subsidiary.
Note that in some jurisdictions, local laws may complicate or limit the ways a company can grant management rights to a non-direct shareholder. This can present practical hurdles to ensuring that management rights flow directly to the VCOC fund (and not merely to the subsidiary), which remains critical to meeting the VCOC requirements.
5.2 Investing Through Other Structures
If a fund purchases a participation interest in a bank loan or invests in convertible securities through an intermediary that technically holds the note, it may fail to meet the “direct” investment requirement needed for a venture capital investment. For instance, a participation in a bank loan typically makes the bank—rather than the operating company—your direct counterparty. Without direct management rights from the operating company itself, the arrangement generally does not qualify as a venture capital investment under the VCOC rules.
6. Timing of First Investments and ERISA Capital
A newly formed fund cannot be a VCOC before it makes its first long-term investment (the date that triggers the initial valuation). This means any ERISA money contributed to the fund prior to that point could be deemed subject to ERISA, creating potential liability and prohibited transactions. Several strategies can mitigate this risk:
- Just-in-Time Funding: Call capital from ERISA investors to arrive precisely on—or just before—the closing of the fund’s first portfolio investment.
- Escrow Arrangements: Require that ERISA investor contributions go into a restricted escrow account until the fund’s first long-term investment closes.
- Credit Facilities: Draw down on a credit line or loan for the fund’s early investments, then call ERISA capital after the first long-term deal is sealed.
- Use of Non-ERISA Capital First: Rely on non-ERISA investors to fund the initial deals. ERISA investors come in later, potentially paying an interest or make-up amount.
- Warehousing: The general partner or an affiliate may purchase an investment and “warehouse” it before transferring it to the fund at cost or fair market value, without any markup, on or after the date that qualifies as the fund’s first investment.
7. Ongoing Management Fees, Expenses, and Subsidiary Capitalization
Before the fund’s initial valuation date, certain ERISA investors may refuse to pay management fees or expenses if that payment triggers “plan asset” status prematurely. In some cases, ERISA investors pay fees directly to the general partner rather than contributing them to the fund.
Additionally, when setting up wholly owned subsidiaries to deploy capital, a VCOC fund should avoid capitalizing these entities too far in advance of the first investment. Overcapitalizing a subsidiary that exists before the fund’s VCOC status is set may inadvertently subject those assets to ERISA. Where local law demands a minimum capitalization, the fund should typically stay within that legal minimum.
8. VCOCs in Wind-Down: The Distribution Period
Funds have a finite lifespan, and eventually they move into a wind-down or “harvesting” phase. The regulations allow a VCOC to maintain its status during a “distribution period,” even if it no longer meets the 50% test or the Actual Exercise Test. The distribution period can begin once the fund distributes proceeds of at least 50% of the highest amount of its investments (other than short-term investments) outstanding at any point in the fund’s life.
This phase ends on the earlier of:
- The date the fund makes a “new portfolio investment” that is not a follow-on in an existing venture capital investment.
- Ten years from the start of the distribution period.
A “new portfolio investment” means any fresh capital investment into a new company or an existing company that was never a qualifying venture capital investment. If a VCOC enters the distribution period and later injects money into a struggling portfolio company that did not previously qualify as a venture capital investment, it risks inadvertently losing VCOC status. This can create a trap for the unwary, so many funds carefully coordinate their distribution period to avoid unexpected capital calls in disqualified investments.
9. Typical Requests from ERISA Investors in VCOC Funds
Because ERISA investors want to ensure compliance and limit liability, they frequently ask for specialized contractual protections in the fund’s partnership agreement or side letters. Common requests include:
9.1 VCOC Opinion
Some ERISA investors require a formal legal opinion stating that upon the fund’s first investment, it will or should qualify as a VCOC. In other cases, a certificate from the fund’s general partner may suffice. Often, this request dovetails with timing issues: ERISA investors may refuse to fund until the date of the first qualifying investment, ensuring they are never at risk of inadvertently subjecting themselves (or the fund) to ERISA’s plan asset rules.
9.2 Annual Certificate
An annual certificate from the general partner confirming that the fund continues to meet VCOC requirements is also common. The certificate is typically delivered to ERISA investors within a specified timeframe each year. Less commonly, investors might require an updated VCOC opinion from counsel annually—though that is a higher hurdle and more expensive process.
9.3 Capital Call Excuses and Special Withdrawal Rights
ERISA investors often negotiate “excuse rights” enabling them to skip a capital call if participating would violate legal restrictions or compliance obligations. These provisions protect them if the fund’s subsequent investments or structural changes jeopardize the fund’s VCOC status (or run afoul of other regulations).
Additionally, investors may ask for a right to withdraw (or force a redemption of their interests) if the fund fails to maintain VCOC status. This can be triggered by a definitive event—such as the fund missing the 50% threshold—allowing an ERISA investor to exit rather than continue in a now non-compliant fund.
9.4 Amendment Restrictions
Given the importance of VCOC safeguards, ERISA investors often negotiate that these protections may not be amended without their consent. This ensures that subsequent changes to the limited partnership agreement or operating agreement cannot dilute their rights.
10. Practical Tips for Entrepreneurs and Fund Managers
For entrepreneurs raising capital from VCOCs (or for managers operating a VCOC), a few strategic pointers can smooth the process:
- Proactively Negotiate Management Rights: If your company seeks capital from a VCOC, understand that the fund requires meaningful management rights. Negotiating a board seat or consultative rights in a timely and clear manner can expedite funding.
- Assess Corporate Structure Early: If you use multiple layers of subsidiaries, ensure each layer can grant or accommodate direct contractual rights in a way that satisfies VCOC requirements.
- Plan for Follow-On Investments: Once a fund is in its distribution period, any new portfolio investment can end that status if not a continuing venture capital deal. Communicate with investors to avoid surprises.
- Work with Experienced Counsel: Given the complexity of ERISA rules, dedicated legal guidance can help navigate potential traps and ensure that transactions are structured correctly from the start.
- Maintain Documentation: From original investments to subsequent follow-ons, keep thorough records of how management rights are exercised. This paper trail can prove critical if the fund’s VCOC status is later questioned.
11. Conclusion
VCOC status provides a strategic advantage to funds that aim to include ERISA plan investors without subjecting themselves to the full scope of ERISA regulations. For entrepreneurs, understanding this mechanism is valuable because it shapes the dynamics of who invests in your company, how deals are structured, and how much say the investor may have in operational decisions.
By carefully meeting the two core tests—the 50% test and the Actual Exercise Test—and remaining vigilant about ongoing compliance, a fund can preserve its VCOC status throughout its lifecycle. This delicate balance involves an awareness of how investments are deployed, how management rights are negotiated and used, and how follow-on investments or exit strategies may impact the fund’s standing in later years.
If you’re raising capital from ERISA-governed investors, consider how the desire for VCOC status affects deal negotiations, corporate governance structures, and your own reporting obligations. Properly handled, VCOC status can unlock capital while minimizing the administrative burden of ERISA rules—a win-win for both managers and investors in the entrepreneurial ecosystem.
