Internet incubators: how to invest in the new economy without becoming an investment company

The explosive growth of Internet and other “new economy” companies has led many firms–venture capital firms as well as old-line industrial and financial services companies–to explore ways of participating in that growth by forming what are popularly called “incubators.” Incubators are typically organizations that foster startup companies by providing them with a package of the basic services they need to help them grow into viable businesses. These services may include management advice, access to capital, legal, and accounting services, technical support, office space, help in preparing business plans, and general “adult supervision.”

Incubators are not new. The first was formed in 1959 in Batavia, New York, in a vacant farm equipment factory.(1) With the rise of the Internet, however, the number of incubators has increased dramatically. Prominent Internet-focused incubators include CMGI, Internet Capital Group, idealab!, and Softbank.

What accounts for the popularity of this business development model? For one thing, it recognizes that many excellent new business ideas are generated by people–often fairly young people–who lack the business experience necessary to execute them. Second, the incubated businesses can benefit from the synergies possible from their relationships with other similar businesses under the incubator’s aegis. (Incubators and their investee companies are sometimes called “keiretsu,” the Japanese term for a network of interrelated companies, when they are structured to take advantage of these synergies.(2)) Finally

Frequently incubators find themselves bumping up against what is arguably the most burdensome and intrusive of the U.S. federal securities laws: the Investment Company Act of 1940 (ICA).(3) The ICA regulates “investment companies,” which include companies engaged primarily in the business of investing in securities.(4) Incubators may look like investment companies because, in exchange for providing their nurturing services, they often take substantial equity stakes in the newly hatched businesses. When these new companies go public, they can attract dizzying valuations, causing the stakes retained by the incubator to represent significant percentages of the incubator’s total assets. In addition, many incubators focus on the early stages of developing companies, and plan to sell their interests once the incubated companies are well enough developed to go public. A company that acquires minority interests in small businesses, waits for them to grow, and then sells those interests, starts to look more than a little bit like an investment company. Indeed, the Securities and Exchange Commission (SEC) staff is said not to like the term “incubator” because it connotes an intention to bring along companies from inception to IPO–and then to dispose of stock in those companies.

This Article discusses possible methods of organizing and operating an incubation business in a way that avoids becoming an “investment company” subject to regulation under the ICA. None of the alternatives is free from constraints and detriments

WHAT IS AN INVESTMENT COMPANY?

There are two basic circumstances under which an incubator would be deemed to be an investment company subject to ICA regulation. Under ICA section 3(a)(1), an issuer of securities is an “investment company” if it “is or holds itself out as being engaged primarily

“Investment securities” include all securities other than (i) government securities, (ii) securities of employees’ securities companies,(7) and (iii) securities issued by majority-owned subsidiaries that are not investment companies(8) and are not relying on the exemptions applicable to companies whose securities are owned by 100 or fewer persons(9) or are owned solely by “qualified purchasers.”(10)

The method for valuing the issuer’s assets for purposes of ICA section 3 is as follows: (i) for market-quoted securities owned at the end of the last fiscal quarter, the market value at the end of the quarter

Here is an example of how an incubator can run into trouble under the ICA: an incubator acquires separate 20% equity stakes in a series of Internet-related companies in partial payment for incubation services. Let’s say the incubator has total assets of $75 million, $5 million of which is represented by the incubator’s 20% stake in MyIPO.com, one of the incubated companies. MyIPO.com goes public, diluting the incubator’s interest to 10%, but giving MyIPO.com a market capitalization of $500 million. The incubator ends up having total assets of $120 million, because its interest in MyIPO.com has increased in value from $5 million to $50 million. As a result, because it owns investment securities in MyIPO.com now worth more than 40% of the incubator’s total assets, the incubator technically is an investment company subject to the registration and other requirements of the ICA, unless an exemption or other relief is available.

ICA Rule 3a-2 provides temporary relief for “transient investment companies.”(12) Under that rule, for up to one year, an issuer is deemed not to be engaged in the business of investing, reinvesting, owning, holding, or trading in securities, provided it has a bona fide intent to be engaged primarily, as soon as practicable (and in any event within the one-year period), in a business other than that of investing, reinvesting, owning, holding, or trading in securities.(13) No issuer can rely on this rule more often than once during any three-year period.(14) Rule 3a-2 has typically been used by traditional companies that have raised capital with the expectation of becoming, or investing in, operating businesses, but it has also been used by some incubators.

WHAT’S SO BAD ABOUT BEING AN INVESTMENT COMPANY?

Companies that are required to register as investment companies with the SEC, but have not done so, face dire consequences. Unregistered investment companies are forbidden under section 7(a) of the ICA from engaging in any business in interstate commerce.(15) Contracts that violate the ICA may be unenforceable.(16) The SEC can obtain injunctions against violations of the ICA, can refer such violations to the Justice Department for possible criminal proceedings, and can seek the appointment of a receiver.(17) The SEC is also authorized to seek money penalties in civil proceedings.(18)

So why not simply register? The short answer is that registered investment companies are subject to stringent regulation under the ICA and the Investment Advisers Act of 1940 (IAA),(19) including restrictions on affiliate transactions,(20) capital structure (including limits on borrowing),(21) performance fees payable to an investment adviser,(22) and, for closed-end investment companies, the ability to issue shares at less than net asset value.(23) The restrictions on issuing shares at less than net asset value can be especially burdensome because they preclude the use of stock options. The ICA’s restrictions on affiliate transactions are very broad, and could seriously limit an incubator’s ability to realize synergies from its portfolio companies. Unless an SEC exemption is obtained, they would also preclude an affiliate of the incubator, such as one of its controlling shareholders, from co-investing with the incubator.(24) A company engaged in a non-investment business that starts an incubator as a sideline would likely find it extremely difficult, if not impossible, to function as a registered investment company.

Some fund management companies have formed venture capital-style funds that have registered as “business development companies” under ICA section 54(a). Business development companies are exempt from some provisions of the ICA, and are able to pay performance fees to their investment advisers, but must invest at least 70% of their assets in specified eligible investments and must make available “significant managerial assistance” with respect to those investments.(25) One such company is meVC Draper Fisher Jurvetson Fund I, Inc., a closed-end fund that describes itself as an information technology venture capital fund.(26) For many–and perhaps most–incubators, however, registration under the ICA is not a viable option. For example, idealab! included a risk factor in its IPO registration statement stating that “[r]egistration as an investment company would subject us to restrictions that are inconsistent with our fundamental business strategy of equity growth through creating, building and operating interactive communications companies.”(27)

POSSIBLE EXEMPTIONS FROM REGISTRATION

The simplest way to avoid registration under the ICA is to stay private–as most venture capital funds do–by remaining within the security ownership limits set forth in either ICA section 3(c)(1) or section 3(c)(7).(28)

SECTION 3 (c)(1): NOT MORE THAN 100 BENEFICIAL OWNERS

Under ICA section 3(c)(1), even if an incubator becomes a prima facie investment company because it falls within the definition in section 3(a), it nevertheless would not be considered an investment company if its outstanding securities are beneficially owned by 100 or fewer persons and it is not making and does not presently propose to make a public offering of its securities.(29) There is a special counting rule under section 3(c)(1) providing that beneficial ownership by a company is deemed beneficial ownership by one person, unless that company is itself an investment company (or would be one but for the exemptions under sections 3(c)(1) or 3(c)(7)), in which case one must “look through” the investing company and count each of its security holders.(30) In a series of no-action letters, the SEC staff has taken the position that an entity formed for the purpose of making an investment in a company must also be “looked through” and its security holders counted toward the 100-holder limit.(31)

An incubator cannot rely on section 3(c)(1) if it is (or proposes to be) publicly held. Therefore, this exemption does not provide a long-term solution to an incubator that considers a future public offering to be an important business goal. The appeal of an IPO is obvious: the public’s appetite for new economy, venture capital-style investments can mean that an incubator focusing on this area would enjoy a very high public market multiple.

Some companies intending to remain “private” have found that they have exceeded the 100-owner test as a result of issuing stock options to their employees who are not “knowledgeable employees” as defined in ICA Rule 3c-5.

SECTION 3(c)(7): ALL BENEFICIAL OWNERS ARE “QUALIFIED PURCHASERS”

Under ICA section 3(c)(7), a company is not an investment company if its outstanding securities are acquired exclusively by “qualified purchasers” and it is not making and does not propose to make a public offering of its securities.(32) Qualified purchasers include individuals owning at least $5 million in investments, and entities that for their own accounts or the accounts of other qualified purchasers own and invest on a discretionary basis at least $25 million in investments.(33) A “qualified institutional buyer” under Rule 144A, which under Rule 144A(1)(I) includes a registered investment adviser, would also be a “qualified purchaser,”(34) except in certain limited circumstances.

Companies relying on section 3(c)(7) are not subject to the 100-owner limit of section 3(c)(1), although the incubator would need to stay below 500 holders to avoid having to register as a reporting company under the Securities Exchange Act of 1934.(35) Nevertheless, the section 3(c)(7) exemption is not likely to be useful to an incubator that wants to issue equity options to employees, some of whom are unlikely to be qualified purchasers or “knowledgeable employees.” Moreover, the section 3(c)(7) exemption, like the section 3(c)(1) exemption, would be unavailable once the incubator proposed to make a public offering.

RULE 3a-1: UNDER 45% OF ASSETS AND INCOME DERIVED FROM NON-INVESTMENT BUSINESS

ICA Rule 3a-1 provides that even if the value of a company’s investment securities exceeds 40% of the value of its total assets, the company will not be considered an investment company if it satisfies the following tests:

* no more than 45% of the value of its total assets (excluding government securities and cash) and no more than 45 % of its net income after taxes (for the last four fiscal quarters combined) come from securities other than (i) government securities, (ii) securities issued by employees’ securities companies, (iii) securities issued by majority-owned subsidiaries that are not investment companies (and that are not relying on the exclusions in ICA sections 3(b)(3) or 3(c)(1)(36)), and (iv) securities issued by non-investment companies controlled primarily by the incubator through which the incubator engages in a non-securities business

* it is not and does not hold itself out as being engaged primarily, and does not propose to engage primarily, in the business of investing, reinvesting, or trading in securities

* it is not a “special situation investment company”.(37)

A “majority-owned” subsidiary is a company 50% or more of the voting securities (i.e., securities that vote for the election of directors) of which are held by the incubator.(38) In some cases, it may be possible to structure an incubator investment so that it is a “majority-owned” subsidiary even in the absence of actual control over the day-to-day business.

A company is “controlled primarily” by the incubator if (i) the incubator controls the company (“control” is defined in ICA section 2(a)(9) to mean the power to exercise a controlling influence over the management or policies of a company, and is presumed to exist where a person beneficially owns more than 25% of the company’s voting securities(39) and (ii) the incubator has more control than anyone else.(40)

“Special situation investment companies,” according to the SEC, “are companies which secure control of other companies primarily for the purpose of making a profit in the sale of the controlled company’s securities.”(41) The SEC has compared special situation investment companies with holding companies:

In contrast, a holding company generally secures control of other companies

primarily for the purpose of engaging in the other companies’ line of

business. For a holding company to be excluded by section 3(b)(1) or

3(b)(2) from the Act’s definition of investment company it must both

control the companies it claims to do business through and actively

exercise that control, i.e., it must engage in the non-investment company

business “through” the controlled or subsidiary companies.(42)

There is no bright-line distinction between a special situation investment company, and a conglomerate that actively buys and sells businesses. Nevertheless, the issue will be important to a company seeking to rely on Rule 3a-1 or to obtain an order under section 3(b)(2), described below.

Although Rule 3a-1 allows for ownership of a greater percentage of investment securities than does section 3(a)(1)(C), the 45 % income test may become difficult to satisfy if the incubator realizes a large gain from the sale of one of its strategic investments. That’s what happened to idealab!, discussed below, preventing it from relying on Rule 3a-1.

SECTION 3(b)(1): PRIMARILY ENGAGED IN OTHER BUSINESSES, DIRECTLY OR THROUGH WHOLLY OWNED SUBSIDIARIES

ICA section 3(b)(1) provides that an issuer is not an investment company if it is primarily engaged, either directly or through wholly owned subsidiaries, in a business other than that of investing, reinvesting, owning, holding, or trading in securities.(43) This exemption is unlikely to be available to most incubators, however, in light of its requirement that the issuer engage in the non-securities businesses directly or through subsidiaries that are wholly owned.

SECTION 3(c)(2)(a): UNDERWRITERS AND BROKER-DEALERS

ICA section 3(c)(2)(a) exempts: From the definition of “investment company,” “[a]ny person primarily engaged in the business of underwriting and distributing securities issued by other persons, selling securities to customers, acting as broker, and acting as market intermediary, or any one or more of such activities, whose gross income normally is derived principally from such business and related activities.”(44) A “market intermediary” is a person in the business of entering into transactions on both sides of the market for “financial contracts”–i.e., individually negotiated contracts commonly entered into by participants in the financial markets that are (i) in respect of securities, commodities, currencies, interest rates, or other measures of value or similar interests and (ii) entered into in response to a request from a counter party for a quotation, or are otherwise entered into and structured to accommodate the objectives of the counter party.(45)

Garage.com, which operates an online marketplace that seeks to match up entrepreneurs and venture capital funding sources (for which Garage.com receives placement agent fees that are often paid in the form of equity), indicates in its preliminary prospectus that it believes it can rely on the broker-dealer exemption, and that its counsel believes it is reasonable for the company to do so.(46) Garage.com notes, however, that the broker-dealer exemption has not “been subject to substantial regulatory or judicial interpretation,” and that it cannot assure that the SEC or a court would agree with its interpretation.(47)

SECTION 3(b)(2): SEC ORDER

Under ICA section 3(b)(2), an incubator could seek an SEC order declaring the incubator to be primarily engaged in a business other than that of investing, reinvesting, owning,, holding, or trading in securities, either directly, through majority owned subsidiaries, or through controlled companies conducting similar types of businesses. The filing in good faith of a section 3(b)(2) application exempts the applicant for 60 days from the provisions of the ICA.(48)

Internet Capital Group (ICG) obtained a section 3(b)(2) order before it went public.(49) Other section 3(b)(2) orders have been obtained by Microsoft Corporation, Global TeleSystems Group, ICOS Corporation, AirTouch Communications, Yahoo! Inc., and idealab!.(50)

Although a section 3(b)(2) order may be the only feasible way for a public incubator to avoid ICA registration, the orders do not come without cost. First, section 3(b)(2) orders take time to obtain–as long as six to twelve months. Second, there are no guarantees that, even after protracted negotiation with the SEC, an order will be granted. Third, these orders require the applicant to make representations that can substantially constrain its future activities. To obtain its order, ICG represented that at least 60% of its total assets would continue to be invested in companies that it controls.(51) idealab! made the same representation to obtain its order.(52) (“Control” would be determined using the test under ICA section 2(a)(9), described above.(53)) idealab! represented that it acquires interests in its network companies for the long term and that it does not contemplate selling interests in those companies in the ordinary course of business, although it expects that from time to time it might sell its interest in a company that no longer adds value to the overall network.(54) Another significant constraint is the requirement that a section 3(b)(2) applicant invest in companies engaged in “similar types of businesses.”(55)

It should be noted that a section 3(b)(2) order provides an exemption only from the 40% test of section 3(a)(1)(C), but not from the “primarily engaged” test of section 3(c)(1)(A). As a result, a company operating under a section 3(b)(2) order must be careful not to hold itself out as being in the investment business.

The question of whether a company is “primarily engaged” in a non-investment company business is a factual issue that the SEC analyzes using a five-factor test:

(1) the company’s historical development

(2) its public representations of policy

(3) the activities of its officers and directors

(4) the nature of is present assets

(5) the sources of its present income.(56)

The SEC has stated that the last two of these factors are the most important: the nature of its present assets (as evidenced by the percentage of the company’s assets represented by investment securities), and the sources of its present income (as evidenced by the percentage of the company’s income derived from investment securities).(57) The SEC has also indicated that “the activities of the [applicant’s] officers and directors are relevant for determining both control and whether the parent company is engaged in a non-investment company business `through’ another company.”(58)

Some of the section 3(b)(2) applications referred to above present better facts than others. For example, AirTouch was able to tell the SEC that of its 14,000 employees, only two spend any time on investment activities.(59) Similarly, Microsoft told the SEC that it was unaware of any public representations suggesting it was in any business other than the computer software business.(60) Companies like AirTouch and Microsoft just don’t seem like investment companies.

More difficult facts are presented in the applications by ICG and idealab!, both companies that are commonly referred to as incubators.

Internet Capital Group

ICG needed an exemption because more than 40%–indeed, 96% of its assets consisted of investment securities

idealab!

The experience of idealab! graphically illustrates the difficulties inherent in trying to plot a course through the SEC’s exemptions from investment company status, idealab! began by relying on section 3(c)(1), but exceeded the 100-owner limit as a result of issuing employee stock options.(67) When it sold part of its stake in eToys in an IPO, idealab! reduced its eToys stake to below 25%, creating a presumption under section 2(a)(9) that idealab! no longer controlled eToys.(68) At the same time, the IPO created a very high market capitalization for eToys, causing the value of idealab!’s interest in eToys to dwarf the value of idealab!’s interest in controlled companies. idealab! tried to deal with the problem by selling some more stock in eToys and investing the proceeds in controlled companies, but idealab! was prevented from being able to rely on Rule 3a-1 because the income from the sale caused idealab! to exceed the 45% income limit, idealab! then relied for a year on the Rule 3a-2 exemption for transient investment companies, filed a section 3(b)(2) application, and began relying on the 60-day exemption provided to section 3(b)(2) applicants.(69) The SEC agreed to extend this exemption while the SEC considered the application.(70)

According to idealab!’s application, the primary focus of idealab! is to control and operate Internet companies that it has conceived of, although in some instances it has acquired non-controlling interests in companies that were considered “strategically important to the overall network” because they were in similar lines of business to idealab!’s controlled companies.(71) The application states that it is not part of idealab!’s strategy to generate income by selling interests in its companies, although it has done so with respect to six companies.(72) idealab! has interests in three companies that make investments in Internet companies, and acts as co-manager of five venture capital funds. The application states that the subsidiaries that co-manage the venture capital funds are not themselves investment companies, because they are engaged in the fund management business and not in the business of investing, reinvesting, owning, holding, or trading in securities.(73)

Even if it satisfied the SEC’s five-factor test, idealab! still would not have been eligible to receive a section 3(b)(2) order if it were a special situation investment company. idealab! stated that just because a holding company sometimes sells securities of a controlled company does not make it a special situation investment company, “particularly if the securities were held for a relatively long time or if there were legitimate business reasons for selling.”(74) idealab! cited Entrepreneurial Assistance Group, Inc.,(75) in which the SEC staff gave no-action relief to an issuer that intended to buy majority interests in operating companies and committed to hold them for at least two years.(76) idealab! noted that it had acquired controlling stakes in twenty-six companies and over a period of almost four years had sold interests in only three.(77) It also pointed to the lack of diversity in its portfolio and the fact that it does not have a policy of shifting investments to different industries.(78) idealab! said it intended to retain its interests in its controlled companies for the long term “unless there are significant reasons for selling, such as an unsuccessful business model or the emergence of an appropriate merger partner.”(79) There is an obvious tension between trying to demonstrate that a company is not a special situation investment company while at the same time trying to preserve its flexibility to sell when it makes sense to do so. The SEC granted an exemption to idealab! in October 2000, over eight months after idealab! filed its initial application.(80)

Do’s and Don’t’s to Increase the Chances of Getting an Order

Obtaining a section 3(b)(2) order takes a good deal of advance planning. To maximize its chances of success, the farsighted section 3(b)(2) applicant will have been careful to structure itself–and refer to itself–as much as possible as an operating company, and not as an investment vehicle. Its offering materials will not refer to “exit strategies,” which connote an intention to dispose of holdings. It will make sure that most or all of its investments are above the 25% threshold that creates a presumption of control, and will have negotiated anti-dilution protections to make sure those investments remain above 25 % after future financing rounds. (Portfolio companies may not like this kind of anti-dilution protection.) Moreover, it will actually exercise control over its greater-than-25 % subsidiaries. It will have sold as few of its holdings as possible. Its employees will be primarily operations experts, not investment analysts. It will be governed by a board of directors or management committee, not an investment committee. And it will not have called itself an “incubator.”(81)

CONCLUSION

Unless an incubator is willing to commit to remaining private, it will typically need to make a fundamental choice about how to make investments. It must either manage its investing activities so that it can remain below the 40% investment securities limit of section 3(a)(1)(C) or the 45% income and asset tests of Rule 3a-1, or else it must make investments in similar businesses that logically fit together under the incubator’s operational control, and seek section 3(b)(2) relief from the SEC. It may be difficult, however, to switch to the second strategy after having pursued the first.

It should be borne in mind that this area is continuing to evolve. The SEC has been receiving increasing numbers of section 3(b)(2) applications. On the one hand, guidelines are being fashioned through the exemptive order process. On the other hand, a political tug-of-war is developing between entrepreneurs and the registered investment company community. For example, the Investment Company Institute recently expressed concern about unregistered investment companies competing with registered technology funds.(82) It will be interesting to see whether the SEC issues general interpretive advice in this area, in light of the fact that the highly fact-intensive nature of section 3(b)(2) analysis is likely to make it hard for the SEC to develop meaningful principles of general applicability.

(1.) Frederick Burger, Business Incubators: How Successful Are They?, AREA DEV., .Jan. 1999, at 76.

(2.) PETER F. DRUCKER, MANAGEMENT CHALLENGES FOR THE 21ST CENTURY 30-33, 90-91, 114 (1999).

(3.) 15 U.S.C. [subsections] 80a-1 to 80a-64 (1994 & Supp. IV 1998).

(4.) 15 U.S.C. [sections] 80a-3(a)(3).

(5.) ICA [sections] 3(a)(1), 15 U.S.C. [sections] 80a-3(a)(1) (1994). This is a “classic” investment company.

(6.) ICA [sections] 3(a)(3), 15 U.S.C. [sections] 80a-3(a)(3). This is sometimes referred to as an “inadvertent” investment company.

(7.) ICA [sections] 3(a)(3), 15 U.S.G. [sections] 80a-3(a)(3).

(8.) ICA [sections] 3(a)(3), 15 U.S.C. [sections] 80a-3(a)(3).

(9.) ICA [sections] 3(c)(1), 15 U.S.C. [sections] 80a-3(c)(1).

(10.) ICA [sections] 3(c)(7), 15 U.S.C. sections 80a-3(c)(7) (Supp. IV 1998).

(11.) ICA [sections] 2(a)(41)(A), 15 U.S.C. [sections] 80a-2(41)(A) (1994).

(12.) 17 C.F.R. [sections] 270.3a-2 (2000).

(13.) Id. [sections] 270.3a-2(a).

(14.) Id. [sections] 270.3a-2(c).

(15.) ICA [sections] 7(a)(4), 15 U.S.C. [sections] 80a-7(a)(4).

(16.) ICA [sections] 46(b), 15 U.S.C. [sections] 80a-46(b).

(17). ICA [sections] 41(d), 15 U.S.C. [sections] 80a-41(d).

(18.) ICA [sections] 41(e), 15 U.S.C. [sections] 80a-41(e).

(19.) 15 U.S.C. [subsections] 80b-1 to 80b-21 (1994).

(20.) See ICA [sections] 17(a), (d), 15 U.S.C. [sections] 80a-17(a), (d).

(21.) ICA [sections] 18, 15 U.S.C. [sections] 80a-18 (1994 & Supp. IV 1998).

(22.) See IAA [sections] 5(a)(1), 15 U.S.C. [sections] 80b-5(a)(1) (1994).

(23.) See ICA [sections] 23(b), 15 U.S.C. [sections] 80a-(23)(b).

(24.) ICA [sections] 17(d), 15 U.S.C. [sections] 80a-17(d).

(25.) ICA [sections] 2(a)(48)(B), 15 U.S.C. [sections] 80a-2(a)(48)(B) (1994). The definition of “significant managerial assistance” is contained in section 2(a)(47) of the ICA. 15 U.S.C. [sections] 80a-2(a)(47).

(26.) meVC, meVC DFF Fund I(visited Sept. 27, 2000) available at <http://www.meVC.com/ FundI/ fundfacts.asp>.

(27.) idealab!, Registration Statement on Form S-I filed with the SEC (Apr. 20, 2000), available at <http://www. sec.gov / Archives/edgar/data/1045647/000109238800000145.txt>.

(28.) ICA [sections] 3(c)(1), (7), 15 U.S.C. [sections] 80a-3(c)(1), (7) (1994 & Supp. IV 1998).

(29.) ICA [sections] 3(c)(1), 15 U.S.C. [sections] 80a-3(c)(1) (1994 & Supp. IV 1998). Under ICA Rule 3c-5, “knowledgeable employees” do not count toward the 100-owner limit. “Knowledgeable employees” include directors, executive officers, and employees (other than those performing solely clerical, secretarial, or administrative functions) who, in connection with their regular duties, participate in the incubator’s investment activities and have been doing so (for the incubator or another company) for at least 12 months. 17 C.F.R. [sections] 270.3c-5(4), (6) (2000).

(30). 17 C.F.R. [sections] 270.3c-1(b).

(31.) See, e.g., Cornish & Carey Commercial, Inc., SEC No-Action Letter, 1996 SEC No-Act. Lexis 625 (June 21, 1996)

(32.) ICA [sections] 3(c)(7), 15 U.S.C. [sections] 80a-3(c)(7). Under ICA Rule 3c-5, “knowledgeable employees” can also own securities of a section 3(c)(7) company. 17 C.F.R. [sections] 270.3c-5(b).

(33.) ICA [sections] 2(a)(51)(A), 15 U.S.C. [sections] 80a-2(a)(51)(A).

(34). 17 C.F.R. [sections] 270.2(a)51-1(g)(1).

(35.) 15 U.S.C. [sections] 781(g)(1)(1994).

(36.) Rule 3a-1 was not amended at the time that section 3(c)(7) was added to the ICA. As a result, assets and income from majority-owned section 3(c)(7) companies appear not to count toward the 45% limits of Rule 3a-1. Whether this was intended is at best unclear, and the SEC may at some point amend Rule 3a-1 to address the point. Accordingly, for planning purposes, it would be safer to assume that section 3(c)(7) company assets and income will count toward the Rule 3a-I limits. See 15 U.S.C. [sections] 80a-3 (1994 & Supp. IV 1998)

(37.) 17 C.F.R. [sections] 270.3a-1 (2000).

(38.) ICA [sections] 2(a)(24), 15 U.S.C. [sections] 80a-2(a)(24) (1994).

(39.) ICA [sections] 2(a)(9), 15 U.S.C. [sections] 80a-2(a)(9).

(40.) Health Communications Services, Inc., SEC No-Action Letter, 1985 WL 54225 (Apr. 26, 1985).

(41.) Certain Prima Facie Investment Companies, Investment Company Act Release No. 10,937, 18 SEC DOCKET 948, 1979 WL 17387 (Nov. 13, 1979) [hereinafter Certain Investment Companies Release].

(42.) Id. n.19 (citations omitted). See also In re United Stores Corp., Investment Company Act Release No. 314, 10 S.E.C. 1145, 1942 WL 1450 (Feb. 12, 1942) (the primary business of a special situation investment company “is to acquire securities for investment with a view to increasing their value and later disposing of them at a profit.”).

(43.) ICA [sections] 3(b)(1), 15 U.S.C. [sections] 80a-3(b)(1) (1994). Whether an issue was “primarily engaged” in a given business would be analyzed using the five-factor test described infra at the text accompanying note 56.

(44.) ICA [sections] 3(c)(2)(A), 15 U.S.C. [sections] 80a-3(c)(2)(A) (1994 & Supp. IV 1998).

(45). ICA [sections] 3(c)(2)(B), 15 U.S.C. [sections] 80a-3(c)(2)(B).

(46.) Garage.com, Inc., Risk Factors in Form S-1 filed with the SEC (June 2, 2000).

(47.) Id.

(48.) ICA [sections] 3(b)(2), 15 U.S.C. [sections] 80a-3(b)(2) (1994).

(49.) In re Internet Capital Group, Inc., SEC 3(b)(2) Order, Investment Company Act Release No. 23,961, 70 SEC DOCKET 1004, 1999 WL 639532 (Aug. 23, 1999) [hereinafter ICG Order].

(50.) In re Microsoft Corp., SEC 3(b)(2) Order, Investment Company Act Release No. 16,467, 41 SEC DOCKET 472, 1988 WL 240432 (July 5, 1988)

(51.) Internet Capital Group, Inc., Notice of Application for 3(b)(2) Order, Investment Company Act Release No. 23,923, 70 SEC DOCKET 514, 1999 WL 548684 (July 28, 1999) [hereinafter ICG Application].

(52.) Bill Gross’ idealab!, Notice of Application for 3(b)(2) Order, Investment Company Act Release No. 24,642, 65 Fed. Reg. 57,211 (Sept. 15, 2000) [hereinafter idealab! Application].

(53.) Id. See also ICA [sections] (2)(a)(9), 15 U.S.C. [sections] 80a-(2)(a)(9) (1994).

(54.) idealab! Application, supra note 52.

(55.) ICA [sections] 3(b)(2), 15 U.S.C. [sections] 80a-3(b)(2).

(56.) In re Tonopah Mining Co. of Nevada, 26 SEC 426, 427 (July 21, 1947)

(57.) Tonopah Mining, 26 SEC at 427

(58.) Certain Investment Companies Release, supra note 41, n.23.

(59.) AirTouch Communications, Inc., Notice of Application for 3(b)(2) Order, Investment Company Act Release No. 24,271, 71 SEC DOCKET 1383, 2000 WL 115855 (Jan. 28, 2000).

(60.) Microsoft Corp., Notice of Application for 3(b)(2) Order, Investment Company Act Release No. 16,430, 53 Fed. Reg. 22,602, 22,603 (June 10, 1988).

(61.) ICG Application, supra note 51.

(62.) Id.

(63.) Id.

(64.) Id.

(65.) Id.

(66.) ICG Order, supra note 49.

(67.) In re Bill Gross’ idealab!, Amendment No. 1 to the Application Pursuant to Section 3(b)(2) (Mar. 14, 2000) (on file with The Business Lawyer, University of Maryland School of Law) [hereinafter idealab! Amendment No. 1].

(68.) idealab! Application, supra note 52.

(69.) Id.

(70.) Id.

(71.) idealab! Amendment No. 1, supra note 67.

(72.) Id.

(73.) idealab! Application, supra note 52.

(74.) Id.

(75.) Entrepreneurial Assistance Group, Inc., SEC No-Action Letter, 1974 SEC No-Act. LEXIS 931 (Dec. 5, 1974).

(76.) Id.

(77.) idealab! Amendment No. 1, supra note 67.

(78.) Id.

(79.) Id.

(80.) idealab! Order, supra note 50.

(81.) In its [sections] 3(b)(2) application, idealab! felt itself obliged to offer the following apologia for having called itself an incubator:

In the past, idealab! and third parties have referred to idealab! as an

“incubator” of internet companies. Such references to idealab! were

intended to connote activities of creating and nurturing the development of

internet companies and reflect the fact that idealab! brings companies into

existence…. idealab!’s use of the term “incubator” does not mean that

idealab! intends to dispose of the Network Companies once they progress

beyond the initial development stage, and idealab! does not believe that

references to incubation should cause the public to misconstrue it as an

investment company.

idealab! Amendment No. 1, supra note 67.

(82.) Mike Garrity, Scrutiny Sought of Mutual Fund Alternatives, MUTUAL FUND MARKET NEWS, May 29, 2000, 2000 WL 4024705.

William D. Regner, Mr. Meredith Brown, Mr. Michael Harrell, and Mr. William Regner are lawyers in the New York office of Debevoise & Plimpton. Mr. Brown is co-chair of the firm’s Corporate Department and the firm’s Mergers & Acquisitions Practice Group. He received his J.D. magna cum laude from Harvard Law School and his A.B. summa cum laude from Harvard College. Mr. Brown is co-chairman of the Capital Markets Forum of the International Bar Association’s Section of Business Law. Mr. Harrell is a partner in the firm’s Investment Management Practice Group. He received his J.D. from the School of Law of the University of California at Los Angeles and his A.B. from Dartmouth College. Mr. Regner is an associate in the firm’s Corporate Department. He received his J.D. summa cum laude from Cardozo Law School and his A.B. from Colgate University.