3(c)(1) vs 3(c)(7): Investment Company Act Exemptions Explained

When structuring a venture capital fund, one of the most critical regulatory decisions you'll make happens before you accept a single LP commitment: choosing between a Section 3(c)(1) or Section 3(c)(7) exemption from the Investment Company Act of 1940. This choice fundamentally shapes your fund's investor base, growth trajectory, and operational flexibility for years to come.

While most emerging fund managers have heard these terms thrown around in structuring conversations, the nuances of each exemption and their practical implications are often poorly understood. The wrong choice can cap your fund size, exclude valuable institutional investors, or create unnecessary compliance headaches. The right choice aligns with your fundraising strategy and positions your fund for sustainable growth.

This guide breaks down both exemptions in practical terms, explaining not just what the law says, but how experienced fund managers think about this decision and structure their funds accordingly.

The Investment Company Act Problem

Before diving into exemptions, it's crucial to understand what you're avoiding. The Investment Company Act of 1940 was designed to regulate mutual funds and similar publicly-offered investment vehicles. Registration under the Act subjects an entity to extensive regulations: limits on leverage, restrictions on transactions with affiliates, board composition requirements, detailed disclosure obligations, and SEC examination authority.

An entity becomes an "investment company" under the Act if it is primarily engaged in investing, reinvesting, or trading in securities and more than 40% of its assets (excluding cash and government securities) consist of investment securities. Most venture capital and private equity funds clearly meet this definition based on their activities.

Registration is not just burdensome. It's functionally incompatible with how venture funds operate. The Act's restrictions on illiquid investments, affiliate transactions, and leverage would make typical VC fund activities impossible. The compliance costs would consume a meaningful percentage of a small fund's management fees.

This is why virtually all private funds rely on exemptions from the Investment Company Act rather than attempting to comply with it. Sections 3(c)(1) and 3(c)(7) provide the two primary exemption paths for venture funds.

Section 3(c)(1): The 100 Beneficial Owner Exemption

Section 3(c)(1) provides an exemption for funds that do not make a public offering and have no more than 100 beneficial owners. This has historically been the standard exemption for smaller venture funds, particularly those raised by emerging managers.

The key requirements are straightforward in concept but require careful execution:

No Public Offering: The fund must be offered and sold in a manner that doesn't constitute a public offering under securities laws. In practice, this means relying on Regulation D exemptions (typically Rule 506(b) or 506(c)) and limiting general solicitation unless specific safe harbors apply.

Maximum 100 Beneficial Owners: The fund cannot have more than 100 persons who are beneficial owners of its securities. This is where complexity enters the picture. "Beneficial owners" is a term of art with specific counting rules that don't always align with intuition.

No Minimum Investor Qualification: Unlike 3(c)(7), there's no requirement that investors be "qualified purchasers." Investors still must meet accredited investor standards under Regulation D, but these are significantly more accessible than the qualified purchaser threshold. This makes 3(c)(1) funds accessible to a broader range of investors, including successful entrepreneurs who may have high net worth but not necessarily $5 million in liquid investments.

The lack of minimum qualification requirements is what makes 3(c)(1) attractive for funds seeking to include angel investors, successful founders, or other individuals who bring strategic value beyond capital but may not meet the qualified purchaser standard.

Practical Implications of the 100-Person Limit

At first glance, 100 investors seems like plenty for a smaller fund. A $10 million fund with average LP commitments of $100,000 needs only 100 investors. However, the beneficial owner counting rules can quickly eat into this limit in ways that surprise first-time fund managers.

Consider a typical emerging manager scenario: You raise a $15 million fund with 60 direct LPs. But 10 of those LPs are themselves small funds or SPVs that invest in your fund. Depending on how those entities are structured, you may need to "look through" them and count their underlying investors toward your 100-person limit. Suddenly, your 60 LPs might count as 85 or 95 beneficial owners, leaving little room for growth or follow-on funds.

This is why sophisticated fund managers track beneficial owner counts meticulously from day one and think carefully about which investor structures they'll accept.

Section 3(c)(7): The Qualified Purchaser Exemption

Section 3(c)(7) provides an exemption for funds that do not make a public offering and are owned exclusively by "qualified purchasers." This exemption was added in 1996 to enable larger, more institutionally-focused funds.

The defining characteristics are:

No Public Offering: Same requirement as 3(c)(1). The fund must be privately offered.

Unlimited Number of Investors: There is no cap on the number of beneficial owners. A 3(c)(7) fund can have 500 LPs, 1,000 LPs, or more. This unlimited capacity is what enables mega-funds to scale without structural constraints.

Qualified Purchaser Requirement: Every beneficial owner must be a "qualified purchaser" as defined in the Act. This is a significantly higher bar than accredited investor status.

Understanding the Qualified Purchaser Definition

The qualified purchaser definition is where 3(c)(7) funds become exclusive. The statute provides several categories, but the most relevant for typical venture fund LPs are:

Individuals: A natural person (including joint investments with spouse) who owns not less than $5 million in investments. "Investments" is defined specifically to exclude primary residences and property used in a trade or business. This must be $5 million in liquid, investable assets like stocks, bonds, fund interests, and similar securities.

Family Companies: A company owned exclusively by qualified purchaser family members that owns not less than $5 million in investments.

Trusts: A trust that was not formed for the specific purpose of investing in the fund, where the trustee or other authorized person is a qualified purchaser, and the settlor and all contributors are qualified purchasers.

Entities Owning and Investing $25 Million: Any entity, acting for its own account or the accounts of other qualified purchasers, that owns and invests on a discretionary basis at least $25 million in investments. This is the standard that most institutional investors (endowments, foundations, pension funds, fund-of-funds) easily meet.

Qualified Institutional Buyers: Certain qualified institutional buyers (QIBs) acting for their own account.

The practical impact is significant. While many successful entrepreneurs, executives, and professionals qualify as accredited investors (requiring only $1 million net worth excluding primary residence or $200,000+ annual income), far fewer meet the $5 million liquid investment threshold for qualified purchaser status.

Why the Higher Bar Enables Larger Funds

The policy logic behind 3(c)(7) is straightforward: investors with $5 million or $25 million in liquid assets are presumed sophisticated enough to evaluate investment risks without the protective regulations of the Investment Company Act. By limiting the fund to these highly sophisticated investors, Congress allowed funds to grow without the 100-person cap that could otherwise constrain institutional capital formation.

This trade-off makes perfect sense for larger funds. A $500 million venture fund isn't seeking $100,000 checks from angel investors. It's raising $10 million to $50 million commitments from endowments, pension funds, sovereign wealth funds, and fund-of-funds. These investors all easily meet qualified purchaser standards, and the fund benefits enormously from unlimited investor capacity.

Beneficial Owner Counting Rules: Who Counts?

For 3(c)(1) funds, beneficial owner counting is both an art and a science. The rules are found in Section 3(c)(1)(A) and further elaborated in SEC guidance and no-action letters. Getting this wrong can inadvertently push a fund over the 100-person limit, destroying the exemption.

Basic Counting Principles

General Rule: Each LP counts as one beneficial owner. If John Smith commits $250,000 to your fund, that's one beneficial owner.

Joint Accounts: A husband and wife investing jointly (or any joint investors with shared investment objectives) typically count as one beneficial owner, not two.

Corporations and Partnerships: A corporation, partnership, or LLC investing in the fund generally counts as one beneficial owner, provided it wasn't formed for the specific purpose of investing in the fund.

Look-Through Rules for Funds Investing in Funds

Here's where complexity increases. If another fund or investment vehicle invests in your fund, you may need to "look through" that entity and count its underlying investors toward your 100-person limit.

The Trigger: Look-through is required when an entity was formed for the specific purpose of investing in your fund (or funds like yours). The test is whether the investing entity was created primarily to invest in your fund or similar private funds, rather than having independent business purposes.

Practical Examples:

Scenario 1 - SPV Formed to Invest: Five angel investors form an LLC specifically to pool their money and invest $500,000 in your fund. This entity was clearly formed for the purpose of investing in your fund. You must look through and count all five angels as beneficial owners.

Scenario 2 - Existing Fund-of-Funds: An established fund-of-funds with 30 LPs invests $2 million in your fund. The fund-of-funds has been operating for years and invests in dozens of different funds. It was not formed for the purpose of investing in your fund specifically. You count the fund-of-funds as one beneficial owner, not 30.

Scenario 3 - Family Office: A family office manages investments for a single extended family (12 family members). The family office invests in your fund. If the family office qualifies as a "family client" under SEC rules (essentially managing money only for family members), it typically counts as one beneficial owner.

Integration Rules

Integration is another counting complication. If you operate multiple funds or investment vehicles that are essentially part of a single offering or investment strategy, the SEC may "integrate" them and aggregate beneficial owners across all integrated funds.

When Integration Applies: Funds are more likely to be integrated if they invest in the same or similar portfolios, target the same investors, are offered at the same time, and share management and fees. Side-by-side funds investing in identical portfolios with only fee term differences are prime integration candidates.

Safe Harbors: Separate vintage year funds (Fund I, Fund II, etc.) with different investment periods and portfolios are generally not integrated. Parallel funds with genuinely different investor categories (e.g., a domestic fund and an offshore fund for non-US investors) are typically not integrated if properly structured.

Practical Tip: If you're running parallel structures or multiple funds, work with fund counsel to ensure clear separation in offering materials, timing, and investor communications to avoid integration issues.

Side-by-Side Comparison: Key Differences

Understanding the exemptions individually is important, but the choice between them becomes clearer when viewed side by side:

Investor Capacity: This is the most obvious difference. 3(c)(1) caps you at 100 beneficial owners with all the counting complexity that entails. 3(c)(7) has no limit. For funds expecting to raise from hundreds of investors, 3(c)(7) is the only viable option.

Investor Qualification Standard: 3(c)(1) funds require only accredited investors (or can even accept sophisticated but non-accredited investors in some Regulation D scenarios). 3(c)(7) funds require every investor to be a qualified purchaser. This is a dramatically higher bar that excludes many potential LPs.

Minimum Check Sizes: The qualified purchaser requirement doesn't legally mandate minimum investment sizes, but it practically correlates with larger checks. An investor with $5 million in liquid assets is typically writing larger checks than someone who barely meets accredited investor thresholds. 3(c)(1) funds often have lower minimums ($25,000 to $100,000), while 3(c)(7) funds typically set minimums of $250,000 to $1 million or more.

Investor Verification Burden: Both exemptions require investor qualification verification, but the process differs. Accredited investor verification is relatively straightforward (tax returns, W-2s, account statements, or third-party verification letters). Qualified purchaser verification requires detailed documentation of investment holdings, which is more invasive and time-consuming.

Flexibility with Strategic Investors: 3(c)(1) funds can more easily accommodate strategically valuable investors who bring more than capital. The successful founder who sold a company for $3 million might be an incredible LP addition (providing deal flow, expertise, and network access) but wouldn't qualify as a qualified purchaser. A 3(c)(1) structure includes them; 3(c)(7) excludes them.

Institutional Accessibility: Major institutional investors (large pension funds, endowments, sovereign wealth funds) universally qualify as qualified purchasers and have no issue with 3(c)(7) structures. Many actually prefer 3(c)(7) because it signals the fund is institutionally-focused. However, these institutions can also invest in 3(c)(1) funds if they choose.

When to Use 3(c)(1): Optimal Scenarios

Despite the attractions of unlimited capacity, 3(c)(1) remains the right choice for many funds. Here are scenarios where it makes strategic sense:

Smaller Fund Sizes ($5M to $50M)

If you're raising a $10 million or $25 million first-time fund, 100 beneficial owners provides more than enough capacity. With average check sizes of $100,000 to $250,000, you'll have 40 to 100 LPs, which fits comfortably within the limit even accounting for some look-through issues.

The benefit is access to a much broader investor base. You can accept checks from successful entrepreneurs, senior tech executives, and other high-earning professionals who are accredited but not qualified purchasers. These investors often become valuable long-term relationships for future funds.

Diverse LP Bases Including Strategic Angels

Many emerging managers intentionally cultivate LP bases that include operators and entrepreneurs, not just financial investors. These LPs provide deal flow, diligence support, portfolio company hiring assistance, and customer introductions.

A 3(c)(1) structure enables this diverse ecosystem. You can mix institutional investors, family offices, successful founders, and industry executives without excluding valuable contributors who don't meet qualified purchaser thresholds.

First-Time Fund Managers

For managers raising their first institutional fund, 3(c)(1) is often the default choice. First-time funds rarely exceed $50 million, and the broader investor base helps diversify fundraising risk. If raising gets difficult, you have more potential investors to approach.

Additionally, the legal and administrative setup for 3(c)(1) is slightly simpler. While both require sophisticated fund counsel, the qualification verification and ongoing tracking for 3(c)(1) is less burdensome.

Regional or Specialized Funds

Funds with specific geographic or sector focuses that want to include local strategic LPs often benefit from 3(c)(1). A climate tech fund might want to include sustainability executives and entrepreneurs. A Detroit-focused fund might want local business leaders. A healthcare fund might include physician-investors. These strategic LPs add value beyond capital but may not all be qualified purchasers.

When to Use 3(c)(7): Optimal Scenarios

As funds scale and institutionalize, 3(c)(7) becomes increasingly attractive or even necessary:

Larger Fund Sizes ($100M+)

Once you're raising a $100 million fund or larger, the math starts pushing toward 3(c)(7). Even with $1 million average LP commitments, a $100 million fund has 100 LPs. A $250 million fund with similar check sizes has 250 LPs, which is impossible under 3(c)(1).

While you could raise a large fund with fewer, bigger checks under 3(c)(1), that concentrates LP risk and limits diversification. Most managers prefer broader LP bases, which requires 3(c)(7) at scale.

Institutional-Focused LP Bases

If your target LPs are primarily endowments, foundations, pension funds, funds-of-funds, and sovereign wealth funds, you're dealing with a universe that universally qualifies as qualified purchasers. There's no downside to 3(c)(7) and significant upside in unlimited capacity.

Major institutional investors also appreciate the signal that comes with a 3(c)(7) structure. It tells them you're operating at institutional scale and seriousness.

Multi-Fund Managers with Complex Structures

As fund families grow, beneficial owner counting across multiple vehicles becomes increasingly complex under 3(c)(1). If you're running Fund III, Fund IV, opportunity funds, co-investment vehicles, and continuation funds, tracking and aggregating beneficial owners (accounting for integration risks) becomes a compliance nightmare.

3(c)(7) eliminates this counting complexity entirely. You can operate unlimited vehicles without worrying about how investors are aggregated or whether SPVs need to be looked through.

Funds Expecting Significant GP/LP Co-Investment

Some funds facilitate extensive LP co-investment rights or run parallel SPVs for opportunistic deals. Each SPV could potentially count toward beneficial owner limits if not carefully structured. With 3(c)(7), these co-investment structures operate freely without counting concerns.

Practical Structuring Considerations

Theory meets practice in fund structuring. Here are key considerations that emerge when actually implementing these exemptions:

Parallel Fund Structures

Many funds run parallel structures to accommodate different investor types. The most common is a 3(c)(7) main fund with a parallel 3(c)(1) fund for investors who don't meet qualified purchaser standards.

How It Works: You create two parallel funds investing side-by-side in identical portfolios with identical terms. Qualified purchasers invest in the 3(c)(7) fund (unlimited capacity), while accredited-but-not-qualified-purchaser investors go into the 3(c)(1) fund (capped at 100 owners).

Advantages: Access to broader investor base while maintaining unlimited institutional capacity. You don't have to choose between the two exemptions.

Drawbacks: Increased legal complexity and costs. Two sets of fund documents, subscription agreements, and K-1s. More administrative overhead. Integration risk if not properly structured. Most firms only adopt parallel structures when they have compelling reasons (substantial LP demand from both categories).

Feeder Fund Structures

Another approach uses a master-feeder structure where multiple feeder funds (potentially using different exemptions) invest into a single master fund that makes the underlying investments.

Common Configuration: A domestic 3(c)(7) feeder for US qualified purchasers, an offshore feeder for non-US investors, and potentially a 3(c)(1) feeder for US accredited investors who aren't qualified purchasers.

This structure is most common for funds with significant international LP bases where offshore tax and regulatory considerations require separate vehicles anyway.

Managing the Beneficial Owner Count

For 3(c)(1) funds, disciplined beneficial owner tracking from day one is essential:

Maintain a Detailed Register: Track not just direct LPs but the structure of each investing entity. Document whether each LP is a look-through entity. Update the register with each new investor admission.

Set Clear SPV Policies: Decide upfront whether you'll accept investor SPVs and under what conditions. Many funds prohibit SPVs entirely or require extensive documentation about their formation and purpose to avoid inadvertent look-through obligations.

Build in Buffer: Don't push to exactly 100 beneficial owners. Maintain a buffer (many funds cap at 80-90) to account for potential look-through issues, counting errors, or integration concerns that might later emerge.

Plan for Future Funds: Consider how your LP base will evolve. If Fund I has 75 beneficial owners, many of whom are SPVs or structures that might require look-through, you may hit capacity issues in Fund II even if you haven't technically exceeded limits in either fund individually.

Common Mistakes and Pitfalls

Experience teaches harsh lessons. Here are mistakes that have cost fund managers time, money, and in extreme cases, their exemptions:

Exceeding 100 Owners Through Poor SPV Management

The classic error: A fund manager accepts what they think are 85 LPs, comfortably under the 100-person limit. But 15 of those are small SPVs formed by angel groups specifically to invest in the fund. Suddenly, looking through those SPVs, the manager has 130 beneficial owners and no exemption.

Prevention: Implement clear policies on SPV acceptance before fundraising begins. Many funds flatly prohibit SPVs. Others accept them but require detailed due diligence on formation purposes and structure, counting conservatively.

Improper Look-Through Analysis

Determining whether to look through an investing entity is surprisingly fact-intensive. Managers sometimes make cursory judgments without adequate diligence.

Example: An LLC with 8 members invests in your fund. The LLC was formed two years before your fund existed and has made other angel investments. You count it as one beneficial owner. Later, you discover the LLC was actually formed primarily for the purpose of making private fund investments (not your fund specifically, but funds generally). Depending on how broadly "purpose of investing in the fund" is interpreted, this might require look-through.

Prevention: Work with experienced fund counsel to develop standard due diligence questionnaires for entity investors. Ask about formation date, purpose, other investments, and governance. Document your analysis for why each entity does or doesn't require look-through.

Inadequate Qualified Purchaser Verification

Some 3(c)(7) funds accept investor representations at face value without requesting supporting documentation. If an investor falsely represents qualified purchaser status and is later found not to qualify, the fund's exemption could be compromised.

Prevention: Require meaningful documentation. For individual investors, request account statements showing $5M in investments. For entities, request financial statements or certifications by appropriate officers. Maintain verification files.

Integration of Related Funds

Managers operating multiple funds sometimes fail to consider integration risk. Running a main fund and an opportunity fund targeting the same investors with overlapping strategies can result in aggregated beneficial owner counts.

Prevention: Structure multiple funds with clear distinctions. Different vintage years, different investment strategies, different target investors, and different offering timing all reduce integration risk. Document these distinctions clearly in offering materials.

Switching Mid-Stream

Some managers start fundraising under 3(c)(1), then realize they need 3(c)(7) and attempt to switch exemptions mid-raise. This creates complex issues around integrated offerings and investor representations.

Prevention: Make the exemption choice thoughtfully before fundraising begins. If you're uncertain about fund size or target LPs, model both scenarios with your fund counsel. Switching exemptions later is legally possible but operationally messy.

Conclusion: Matching Structure to Strategy

The choice between 3(c)(1) and 3(c)(7) isn't about which exemption is better in the abstract. It's about which structure aligns with your fund's size, growth trajectory, and target LP base.

For emerging managers raising smaller funds ($5M to $50M) with diverse LP bases including strategic angel investors and successful entrepreneurs, 3(c)(1) typically makes sense. The 100-person limit provides adequate capacity, and the broader accredited investor standard opens access to valuable strategic LPs who bring more than capital.

For established managers raising larger funds ($100M+) with institutionally-focused LP bases, 3(c)(7) becomes increasingly necessary. The unlimited investor capacity eliminates a major structural constraint, and the qualified purchaser requirement poses no barrier since target LPs (endowments, pensions, funds-of-funds) easily qualify.

The middle ground between $50M and $100M is where the choice becomes most strategic and fact-dependent. Fund managers in this zone should carefully model their expected LP composition, average check sizes, and growth trajectory before committing to a structure.

Remember that this choice, while important, isn't permanent across your fund management career. Many managers raise Fund I and Fund II as 3(c)(1) funds, then transition to 3(c)(7) for Fund III as the fund size and LP base institutionalizes. Some maintain parallel structures to accommodate both investor categories simultaneously.

Whatever structure you choose, the key is making an informed decision with experienced fund counsel, implementing it rigorously, and maintaining compliance discipline throughout the fund's life. The Investment Company Act exemptions are foundational to private fund formation. Getting them right from the start saves enormous headaches down the road.