When operating under the Section 3(c)(7) exemption from the Investment Company Act, the issue then becomes how a private investment fund can provide an equity ownership to key employees. Its unlikely that your key employees will have the $5 million in investments needed to qualify as an investor. (Each investor in a 3(c)(7) private investment fund must be Qualified Purchaser.)
The SEC established Rule 3C-5 to allow "knowledgeable employees" to invest in their company's private fund without having to be a qualified purchaser. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act. You will still need to determine if the employee's acquisition of the interest is exempt from the registration requirements of the Securities Act. Most likely that will mean that the knowledgeable employee will need to be an accredited investor. Meeting that $200,000 per year / $300,000 per year if married income (and a reasonable expectation of that income continuing) threshold may be the biggest impediment to offering equity interests further down the company ladder.
The first category of "knowledgeable employees" is the management of the covered company, which covers these positions:
Executive Officer is defined in Rule 3C-5 as:
The second group of knowledgeable employees are those who participate in the investment activities. Those employees need to meet these requirements:
The 12 month limit is not limited to 12 months at the employee's current company. The SEC concluded that it is not necessary to require that an employee work for the particular fund or management affiliate for the entire 12-month period as long as the employee has the requisite experience to appreciate the risks of investing in the fund and performed substantially similar functions or duties for another company during that 12 month period.
Whether an employee actively "participates in the investment activities" of a private fund will be a factual determination made on a case-by-case basis. In a 1999 No Action letter sent to the ABA the SEC said the following would NOT be knowledge employees:
The SEC also said that research analysts who investigate the potential investments for the fund may not be knowledgeable employees unless they research all potential portfolio investments and provide recommendations to the portfolio manager.
For additional commentary on developments in compliance and ethics, visit Compliance Building, a blog hosted by Doug Cornelius.