If you’re a VC with a foreign LP or have foreign co-investors, then you should know the law is about to change.
Later this week, Congress is expected to pass legislation that will impact foreign investment into the venture and startup ecosystem in new ways. President Trump is expected to sign the Foreign Investment Risk Review Modernization Act (FIRRMA), as he chose to back the bill rather than move forward with China-specific restrictions. NVCA is pleased to see key changes in the final bill, but it still stands to affect VC funds with foreign limited partners and/or co-investors. We will continue to engage on your behalf and encourage you to be in touch with questions or comments.
The purpose of FIRRMA is to expand the power of the Committee on Foreign Investment in the U.S. (CFIUS) to scrutinize foreign investments into ‘critical technology’ for national security implications. FIRRMA was born out of U.S. government concerns that China is leveraging minority investments into startups to obtain sensitive information, like intellectual property, source code, and know-how. Currently, CFIUS reviews foreign investments for national security considerations when the investment results in foreign control of a U.S. entity. But minority investments used to obtain sensitive information about a company are outside the scope of CFIUS because those investments generally don’t deliver control to the investor. FIRRMA is intended to address this blind spot.
FIRRMA was introduced in November 2017 by Senators John Cornyn (R-TX) and Dianne Feinstein (D-CA) and Representatives Robert Pittenger (R-NC) and Denny Heck (D-WA). As introduced, FIRRMA gave CFIUS authority to review (and potentially reject) a minority foreign investment into a critical technology company, unless it was a ‘passive investment.’ The initial version of FIRRMA defined passive investment very narrowly, raising serious concerns that even foreign LP commitments to a venture fund might not qualify for the passive investment exemption. This would have resulted in a government filing, delay, and expense. And that expense is no small sum, as FIRRMA allows CFIUS to set the filing fee at 1 percent of the value of the transaction or $300,000—whichever is less. And that doesn’t include legal fees.
NVCA actively engaged during FIRRMA’s consideration, including testimony by former board chair Scott Kupor of Andreessen Horowitz before the Senate Banking Committee and NVCA’s formal submission to the House Financial Services Committee. Ultimately, significant changes were made to FIRRMA that go a long way to protecting passive investment into venture funds and directly into startups. Yet even with these changes, FIRRMA may change investment patterns and deal structures going forward. NVCA will be at the table throughout the process.
NVCA core equities maintained; rulemaking challenges lay ahead
Passive investment: As discussed above, the initial version of FIRRMA exempted passive investment from the scope of the bill. NVCA’s goal was for venture firms or their foreign LPs to avoid a CFIUS filing every time capital is raised, since these are passive investments by their nature. During FIRRMA’s consideration, several key changes were made to how passive foreign investment is treated, including 1) language that clarifies that indirect investments via a fund qualify for the exemption for passive investment; and 2) removal of language that deemed an investment non-passive if the investor had access to any non-public, non-technical information.
Under the final bill, CFIUS has jurisdiction over any investment by a foreign entity in a critical technology company that gives the foreign entity:
- access to any material nonpublic technical information of the company;
- membership or observer rights on the company’s board or equivalent governing body; or
- any involvement in substantive decision-making of the company, other than through voting of shares
VCs, LPs, and startups raising capital should be cognizant of these three factors because if any of these factors is triggered then a CFIUS filing is very likely necessary.
‘Material nonpublic technical information’ is a defined term in the statute, and importantly does not include financial information regarding the performance of a business such as that provided to LPs on a quarterly basis. As described above, a CFIUS filing can be triggered by a being on a company board or the “equivalent governing body.” This raised questions as to whether foreign LPs who sit on LP advisory committees would be subjected to CFIUS. Therefore, the final legislation includes a “Special Clarification for Investment Funds” specifying that foreign LP membership on an advisory committee is not a covered transaction if:
- the fund is managed by a GP that is not a foreign person;
- the advisory committee cannot approve, disapprove, or otherwise control investment decisions of the fund or the decisions of the GP; and
- the foreign person cannot otherwise control the fund.
Critical technology definition: A common criticism of FIRRMA has been that its definition of ‘critical technology’ was too nebulous, i.e. a “we’ll know it when we see it” definition would harm innovation. The final version of the bill includes the House’s critical technology definition, which is an improvement over the Senate definition. Critical technology under FIRRMA is now a limited set of categories which are mostly related to the export control regime. This includes “emerging and foundational technologies” that are controlled pursuant to the expanded export control regime under the bill. Importantly, CFIUS no longer has discretion to independently identify other categories of technology that would constitute critical technology. In practice, this means an agency that wants something designated as critical technology for CFIUS purposes must first navigate the new export control process to get it designated as such. This is an important check that will guard against critical technology becoming everything under the sun.
Countries exemption: A heavily debated difference between the House and Senate bills was the scope of countries impacted by FIRRMA. The Senate bill used a whitelist, meaning FIRRMA applied globally unless a country was exempted. The House bill favored a blacklist, thereby applying FIRRMA to a small group of countries (e.g. China, Russia). The final product went a third direction and created a “Country Specification” section that directs CFIUS to “specify criteria to limit the application of [FIRRMA] to the investments of certain categories of foreign persons.” The section goes on to say the criteria “shall take into consideration how a foreign person is connected to a foreign country or foreign government, and whether the connection may affect the national security of the United States.”
Our understanding is the goal of this provision is to allow CFIUS to exempt certain entities (e.g. a foreign pension) from FIRRMA, rather than exempting an entire country. It’s too soon to tell how this provision will work in practice. On the one hand, knowing an entire country is excluded would have provided certainty for investors. On the other hand, CFIUS would likely have been reluctant to exclude entire countries, and the final FIRRMA provision allows CFIUS to still exclude specific entities that may be large LPs or co-investors.
Next steps for NVCA
It is imperative NVCA and the venture industry remain vigilant on FIRRMA, as its passage kicks off a rulemaking process that will decide major issues and define terms in ways that affect the thrust of the bill. In the coming weeks and months, NVCA will engage with its board and broader membership to ensure the concerns of the VC industry are heard during FIRRMA’s rulemaking. We will also continue to educate our membership on how FIRRMA will alter the landscape of foreign investment into U.S. growth companies. This includes an upcoming webinar and events in the Fall to educate venture capitalists and policymakers on the nexus of national security and emerging technology. Details will be forthcoming.
We’ll be in touch and hope you will too. Please reach out to email@example.com with any questions.
Jeff Farrah served as General Counsel at NVCA, where he advocates before Congress, the White House, and agencies for pro-entrepreneurship policies and leads in-house legal matters for the association. He loves working at the intersection of venture, public policy, and the law. Jeff served as Treasurer of VenturePAC, the political action committee of NVCA.