Application of the Hart-Scott-Rodino
Act to Venture Fund Transactions

By Michele S. Harrington

Hogan & Hartson L.L.P.

August 30, 2000

This article discusses in general terms the circumstances under which investment funds might have to file a Hart-Scott-Rodino (“HSR”) notification report and observe a waiting period before making certain investments. By necessity this memorandum is very general and is not a substitute for consulting HSR counsel on a transaction-by-transaction basis. Part I describes the HSR Act and the three threshold tests for reportability. Part II describes certain exemptions that are commonly applicable to venture fund investments.

I. The HSR Act

The Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the “HSR Act” or "the Act”) applies to certain acquisitions of assets or voting securities [1]/ and requires that both the “acquiring person” and the “acquired person” file a premerger notification if the transaction satisfies each of the three tests set forth below (the commerce test, the size-of-person test, and the size-of-transaction test) and is not otherwise exempt. A $45,000 HSR filing fee must accompany the acquiring person’s HSR notification.[2] In addition, the parties cannot close on a reportable transaction until the 30-day HSR waiting period expires or is terminated.

For purposes of the Act, the acquired and acquiring persons are not only the parties to the transaction, but include each party’s ultimate parent entity (“UPE”) and all entities which its UPE controls directly or indirectly. 16 C.F.R. § 801.1(a)(1). The term “ultimate parent entity” means an entity which is not “controlled” by any other entity. 16 C.F.R. § 801.1(a)(3). Federal Trade Commission (“FTC”) regulations define “control” as holding 50% or more of the voting securities of a corporation or having the contractual right to designate 50% or more of its directors. Control of a partnership or limited liability company ("LLC") is defined as having the right to 50% or more of the profits of the partnership or LLC or the right, in the event of dissolution, to 50% or more of the assets of the partnership or LLC. 16 C.F.R. § 801.1(b). Thus, in order to determine the UPE of each party to the transaction, one looks “upstream” to determine what entity ultimately controls each party. One then looks “downstream” to all entities which that UPE controls, either directly or indirectly, to determine what entities are included within the “person” of which the UPE is a part. [3]/

The Three Threshold Tests [4]/

The Commerce Test. The HSR Act applies only if the acquiring or acquired person is engaged in “commerce.” As used in the Act, the term “commerce” means trade or commerce among the states, with foreign nations, or between the District of Columbia or any territory of the United States and any state, territory, or foreign nation. Generally the commerce test would be satisfied with respect to investments contemplated by investment funds.

The Size-of-Transaction Test. The “size-of-transaction” test is satisfied if an acquiring person would hold, as a result of the acquisition, either (A) 15% or more of the voting securities or assets of the acquired person, or (B) an aggregate amount of voting securities and assets of the acquired person that exceeds $15 million. To determine if the size-of-transaction test is satisfied, an acquiring person would have to aggregate the voting securities of the acquired issuer (including the voting securities of any other issuer under common control with the acquired issuer) it currently holds with the voting securities or assets it is acquiring in the present transaction. Thus in many cases, while an investment fund does not have to make a filing at the time of an initial investment, it may need to do so at the time of a "follow-on" investment.

The Size-of-Person Test. The “size-of-person” test essentially requires that (i) one person have annual net sales or total assets of at least $10 million and (ii) the other person have annual net sales or total assets of at least $100 million. Annual net sales are as stated in the most recent regularly prepared annual statement of income and expense, and total assets are as stated in the most recent regularly prepared balance sheet. 16 C.F.R. § 801.11. [5]/ Under the Act, the annual net sales and total assets of all entities under common control are aggregated with those of the UPE to determine whether the size-of-person test is satisfied. 16 C.F.R. § 801.11. In situations where a $100 million person is acquiring assets or voting securities from a person not engaged in manufacturing, [6]/ the size-of-person test would not be satisfied if the acquired person had annual net sales less than $100 million and total assets of less than $10 million. 15 U.S.C. § 18A(a)(2)(B).

If any one of the three threshold tests is not satisfied with respect to an investment contemplated by an investment fund, no HSR notification would be required with respect to that investment.

1. Measuring the Value of Voting Securities

In a voting securities transaction, the value of the securities in question depends on whether those securities are publicly traded. If the securities to be acquired are publicly traded, their value is the greater of “market price” or acquisition price. “Market price” is the lowest closing quotation for the securities within 45 or fewer days preceding consummation of the transaction (but not earlier than the day prior to execution of the contract or agreement). 16 C.F.R. § 801.10(c). If the securities to be acquired are not publicly traded, the price the parties have set is conclusive as to the value of the securities. If the parties have not set a price, or the price is contingent on future events, the acquiring person has an obligation to make a good faith evaluation of the securities’ fair market value. [7]/

When an acquiring person already holds voting securities of an issuer and plans to acquire additional voting securities of that issuer (or an entity under common control with that issuer), the acquiring person must aggregate the value of the voting securities it will acquire (as determined pursuant to the preceding paragraph) with the value of the voting securities it already holds to determine if the size-of-transaction test is met. If it already holds publicly traded securities, the value of such securities is the “market price” (see above). If the securities already held are not publicly traded, the value is the fair market value as determined by the acquiring person. 16 C.F.R. § 801.13.

2. Measuring the Percentage of Voting Securities

The size-of-transaction test turns in part on the percentage of the issuer’s outstanding (not fully diluted) voting securities that will be held by the acquiring person. In cases where the issuer has a charter or articles that permit classes of voting securities to vote as a class for directors, calculation of the outstanding voting securities must be made pursuant to a formula descried in 16 C.F.R. § 801.12. Under this section:

[T]he percentage shall be the sum of the separate ratios for each class of voting securities, expressed as a percentage. The ratio for each class of voting securities equals:

(i)(A) The number of votes for directors of the issuer which the holder of a class of voting securities is presently entitled to cast, and as a result of the acquisition, will become entitled to cast, divided by,

(B) The total number of votes for directors of the issuer which presently may be cast by that class, and which will be entitled to be cast by that class after the acquisition, multiplied by,

(ii)(A) The number of directors that class is entitled to elect, divided by (B) the total number of directors.

See 16 C.F.R. § 801.12(b).

For example, assume that an investment fund holds 500 shares of class A stock and no shares of class B stock of X. By virtue of its class A holdings, the fund has 500 of the 1000 votes which may be cast by class A to elect four of X's ten directors. Applying the formula, the fund holds 500/1000 x 4/10 or 20 percent of the voting securities of X. If, on the other hand, the fund holds 500 shares of X's class A stock and 60 shares of X's class B stock, the fund would hold 20 percent of the voting securities of X because of its holdings of class A stock. As a result of its class B holdings, the fund has 60 of the 100 votes which may be cast by class B stock to elect six of X's ten directors. Applying the formula, the fund calculates that it holds 60/100 x 6/10 or 36 percent of the voting securities of X because of its holdings of class B stock. Since the formula requires that a person that holds different classes of voting securities of the same issuer add together the separate percentages calculated for each class, the fund holds a total of 56 percent (20 percent plus 36 percent) of the voting securities of X.

II. Exemptions

While there are many exemptions to the filing requirements of the HSR Act, only the most common exemptions in venture capital transactions will be discussed below.

A. The Minimum Dollar Value Exemption

In circumstances where the 15% but not the $15 million portion of the size-of-transaction threshold test is satisfied, a “minimum dollar value” exemption could apply. In voting securities transactions, the exemption would apply if, as a result of the acquisition, the acquiring person would not hold voting securities which confer control (i.e. at least 50% of the voting securities) of an issuer which, together with all entities which it controls, has annual net sales or total assets of $25 million or more. 16 C.F.R. § 802.20(b).

B. Acquisitions Not Exceeding A Greater Notification Threshold

When a fund files a HSR notification to report its acquisition of voting securities it must indicate what threshold it expects to cross -- $15 million worth of assets and voting securities or 15%, 25%, or 50% of the outstanding voting securities of the acquired issuer. The fund would then have one year from the date of the expiration or termination of that HSR waiting period to cross the indicated threshold. 16 C.F.R. § 803.7. If the fund crosses that threshold within a year, the fund may acquire additional voting securities of the same issuer for five years after the expiration or termination of the initial HSR waiting period without filing again so long as the fund does not cross the next filing threshold. 16 C.F.R. § 802.21.

C. Passive Investor Exemption

If the fund acquires and holds 10% or less of the outstanding voting securities of an issuer, regardless of the value of such securities, and the fund intends to be a “passive investor,” the fund would not have to report its acquisition of such securities. 16 C.F.R. § 802.9. A fund would qualify as a passive investor only if the fund acquires the voting securities “solely for the purpose of investment.” Voting securities are held solely for the purpose of investment “if the person holding or acquiring such voting securities has no intention of participating in the formulation, determination, or direction of the basic business decisions of the issuer.” 16 C.F.R. § 801.1(i)(1). [8]/

D. Transactions Which Do Not Directly Or Indirectly Increase The Percentage Of Voting Securities Held

The Act also exempts from its filing requirements:

acquisitions of voting securities, if, as a result of such acquisition, the voting securities acquired do not increase, directly or indirectly, the acquiring person's per centum share of outstanding voting securities of the issuer.

15 U.S.C. § 18a(c)(10). When employing this exemption, it is important to calculate the percentage of outstanding voting securities pre- and post- the upcoming acquisition pursuant to the 16 C.F.R. § 801.12 formula, if applicable, described at pages 4-5, supra. Under this exemption, depending on the circumstances, even a substantial additional investment, if made pro rata with other investors, may not increase the percentage held by the fund and may thus not be reportable.

E. The Intraperson Transaction Exemption

The intraperson transaction exemption applies to:

acquisitions of voting securities of an issuer at least 50 per centum of the voting securities of which are owned by the acquiring person prior to such acquisition.

15 U.S.C. § 18a(c)(3). Further, 16 C.F.R. § 802.30 provides that:

[a]n acquisition (other than the formation of a joint venture . . . ) in which, by reason of holdings of voting securities, the acquiring and acquired persons are . . . the same person, shall be exempt from the requirements of the act.

16 C.F.R. § 802.30. (emphasis added) Essentially, this exemption would apply if the fund holds 50% or more of the outstanding voting securities of Issuer X and intends to acquire additional shares of Issuer X voting securities.

F. The Institutional Investor Exemption

Certain types of institutional investors (listed in 16 C.F.R. § 802.64) do not have to report certain acquisitions of voting securities if:

(1) Made directly by an institutional investor in the ordinary course of business and solely for the purpose of investment;

(2) As a result of the acquisition the acquiring person would not control the issuer; and

(3) As a result of the acquisition the acquiring person would hold either

(i) Fifteen percent or less of the outstanding voting securities of the issuer; or

(ii) Voting securities of the issuer valued at $25 million or less.

16 C.F.R. § 802.64. The types of institutional investors eligible for the institutional investor exemption include investment companies registered under the Investment Company Act of 1940 (the “ICA”) and Small Business Investment Companies regulated by the Small Business Administration. However, because most venture funds are structured so as not to be an “investment company” within the meaning of the ICA and are not licensed as Small Business Investment Companies, the institutional investor exemption is not likely to be available to them.