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Scott Orn

Scott Orn, CFA

Michael Bjorn Huseby of DLA Piper explains some of the legal issues of venture capital

Posted on: 06/27/2023

Michael Bjorn Huseby

Michael Bjorn Huseby

Investment Funds Attorney - DLA Piper


Michael Bjorn Huseby of DLA Piper - Podcast Summary

Michael Bjorn Huseby of DLA Piper explains some of the legal issues of venture capital, including 506(b) regulations, capital calls, VC partnership structures, management fees, carried interest, and more.

Michael Bjorn Huseby of DLA Piper - Podcast Transcript

Scott: Welcome to Founders and Friends Podcast. Before we get to our guest, special shout out to Kruze Consulting. We do all your startup accounting, startup taxes, and tons of consulting. We’re whatever comes up like financial models, budget to actuals, maybe some state registration, sales tax, VC due diligence support. Whatever comes up for your company, we’re there for you. Seven hundred and fifty clients strong now, $10 billion in capital raise by our clients, I can’t believe it, $2 billion this year. It’s been a crazy awesome year. So, check us out at kruzeconsulting.com and now onto our guest. 
Singer: (singing)
Healy: Hey, welcome to the Founders and Friends podcast. I’m your host, Healy Jones, standing in for our Kruze Consulting COO, Scott Orn, who’s taking a well-deserved vacation after the end of the tax filing season. I am joined by Michael Huseby of DLA Piper. Michael is a well-known expert in venture capital legal matters, including fund formation and helping VCs and emerging managers set up their legal documents and raise their venture capital funds. Michael, welcome to the podcast. How are you?
Michael: Thank you. I’m doing well. Thanks for having me, Healy.
Healy: It’s great to have you here. Would love to just have you explain to the audience a little bit about who you are and what you do and how you got there.
Michael: For sure. I’m a fund formation lawyer at a law firm called DLA Piper now. I started off at a firm called Latham & Watkins in Los Angeles, where I did all sorts of corporate lawyerings like M&A, emerging companies work, tech transactions. After that I took a year off and lived outside the US mostly in Colombia and Belgium. And then after that I came back to the US, came back to the law, and now I do exclusively fund formation work.
Healy: That seems like a really interesting place to focus. What are some of the most interesting things you think there are about working with managers as they’re raising their venture capital funds?
Michael: For me, I just really enjoy talking to these venture capitalists. It’s a lot of fun. It’s like talking to founders. They have a lot of interesting things to say, a lot of interesting ideas about the world. You start hearing about pretty crazy ideas like putting solar panels in space or data centers on the moon and all sorts.
Healy: That sounds like a pretty interesting fund.
Michael: Yeah, it’s cool. We work with emerging managers a lot. That’s something that I really like doing, and it’s always fun to counsel people and help them to get off the ground and start something new. It’s always fun to start fresh.
Healy: That’s really cool. And I think that we are seeing a huge tidal wave of emerging managers. And just for the audience who may not be aware, an emerging manager is a term that refers to a new venture capital fund, so someone who is not part of a larger well established fund. Everyone’s heard of a lot of the longer running funds in Silicon Valley like Sequoia and Kleiner and Jason, and people like that, but there’s a whole new tidal wave of folks who are hanging up their own shingle and raising funds on their own, and that’s a really neat innovation that we’re seeing. Within the Kruze client base, we see a lot more of these smaller funds on the cap tables, particularly at the seed or the pre-seed level, which are pretty cool parts of the cap table for a founder because you’re raising your pre-seed or your seed. Those are the investors who are really going out on a limb and supporting you when you’ve got an idea. Michael, coud you talk a little bit about the difference between a pre-seed fund, a seed fund, a series A, where someone plays in the cap table, and then in the life cycle of a startup?
Michael: Yeah, for sure. So a lot of the managers we work for are seed, which is essentially some of the earliest capital startup might get. As far as the venture capitalist side of this, it’s often evaluating founders and their story and their idea, that’s what they focus on mostly. You can get further towards series A or also what we call growth equity, which is series B, series C, and then there it’s more there may have already been some investments in the company, they might have revenue, whereas seed maybe they don’t. And from a venture capitalist point of view, the job, you’re still evaluating founders, but you also might be looking at financial statements and growth and seeing how that company has progressed. So from a venture capitalist point of view, it’s two different jobs. Some people are good at both, but often venture capitalists will focus on one or the other.
Healy: Very cool, very interesting. And one of the other things that has happened that has enabled some of these newer funds to show up and be successful at a smaller level is some changes to the legal frameworks that are allowed for different types of funds structures. And I think it’s particularly interesting because we do see 10 million dollar, 20 million dollar, 50 million dollar funds, whereas a few years ago those were harder to market, harder to raise. What has changed from a legal perspective that has allowed these different funds to emerge and want to talk a little bit around… In particular, I know there’s been some changes around what’s allowable from a fund marketing perspective, and I’d love to understand what are those changes and what’s enabled that to happen?
Michael: So I think there’s two main things that are connected, but both of them are contributing to this explosion that you’re talking about. So one is the difference about how you can actually market the fund. So to take a step back to lawyering day one, if you have securities, you can’t sell those securities unless you register them with the SEC, and that’s S-1, it’s an IPO. Now, there are many, many, many exceptions to this rule, and so most companies don’t actually do an IPO. A fund, when it’s offering securities to investors, which are called limited partners, they have to deal with these laws too. So if a fund is going to offer their securities, they’re not going to do an IPO over their fund usually, so they need to find an exemption so they don’t have to do the full-blown SEC registration. So traditionall this means that you can only offer these fund securities in a private placement, which means to people you already know. So the current law that encapsulates this is called 506(d), and I just made this up for this podcast and it’s stupid, but we can call it 506 be quiet, because you can’t talk about the fund.
Healy: That’s pithy. I like it.
Michael: So 506(b), be quiet, you cannot talk about the fund, and this is traditionally how these funds have been raised. Now, you can’t talk about the funds, and another thing is that most of your investors have to be accredited, and this term accredited investor gets thrown out a lot, it’s something that’s important in the securities laws, and [inaudible 00:07:26]
Healy: And it’s something that startups need to care about as well.
Michael: Certainly. Yes, exactly. Startups have to deal with all these same laws as well. And so an accredited investor, the two main ways that an investor can be accredited are they make $200,000 a year or $300,000 a year with their spouse, or they have one million dollars of net worth excluding the value of their primary residence. So those are the two main ways you can be accredited. And this is important because being accredited is a big part of this explosion that we’re talking about, because in 506(b), as is in be quiet, like I said, you cannot talk publicly about your funds, most of your investors have to be accredited, but you can have 35 non-accredited investors, and then finally you don’t actually have to verify whether your investors are accredited or not, so it makes it a bit easier for the person running the funds.
Healy: Yeah, for sure.
Michael: If you think there’s fraud afoot or something, and they say, “I’m not an accredited investor, but I’m saying I am,” then you have a problem. But in general, you don’t have to verify.
Healy: So let’s just make sure, we’re not providing accounting or legal advice in this podcast, so you should consult with your attorney and your CPA when you are raising funds for your startup or venture capital fund, but please keep going here. This is pretty cool. And actually I think we should interject. The theory behind the government forcing the investors to be accredited, from my understanding, is that in theory if you make a lot of money or have a lot of money, you are sophisticated enough to be less likely to get caught up in a scam. I don’t know if that’s necessarily true, and we’ve definitely seen some pretty high profile investment scams that have caught up some pretty rich people in endowments, but I believe that’s the theory there. Is that is your understanding?
Michael: That is my understanding of the SEC’s theory. And we can talk all day about whether that actually makes sense and whether just having a higher income means that you understand investments more, but that’s a conversation for another day, I think.
Healy: Yeah, for sure. Although it is nice in theory to help keep your grandma from losing her retirement savings.
Michael: That’s true. So one of the things actually that has helped more people be able to invest in startups and funds and everything of that nature is that the SEC actually added some more ways that you can be an accredited investor. So one way is if you’re a securities professional, you pass your series seven or something like that. Also, if you are part of the group that’s issuing the securities, though for a startup if you’re a founder, or for venture capital funds if you are part of that management team of the venture capital funds, then you can be an accredited investor. So that helps. So that’s one way that now more people have access to these private deals that previously they wouldn’t.
Healy: I feel like there’s something else that’s happened as well. If you’re ever on Twitter, you do see people with large Twitter accounts suddenly announcing that they’re raising a fund or they have a fund, and sometimes they even have little calls to action in there, which my understanding, having worked for venture capital funds before, was a big no-no. What is allowing for that? How can you say on Twitter, “I’m raising a fund, check it out.”? That’s very different than what was possible 10 years ago, I think.
Michael: Yep, that’s exactly right. So there’s another option. Instead of 506 be quiet, we have another bad saying I’ve created, which is 506(c), which is CR fund.
Healy: We’re going to be huge on TikTok with this, I’m sure.
Michael: Yeah, for sure. So 506(c) changed the game. It put this middle ground between a traditional public offering like an IPO and then this 506(b), hush-hush, you can only tell your friends. So 506(c) is this new thing, a little under 10 years ago, and what this is is it’s still technically a private placement, but you can publicly solicit investors. So you can go on a podcast, you can take an advertisement out in a newspaper, you can message people on social media, you can do all these things to find investors.
Healy: Well, that’s got to make fundraising a lot easier, but I assume there’s some sort of a catch associated with this ability to make some noise.
Michael: The catch is everyone in your fund has to be accredited, so no 35 investor limits. Honestly, most of our funds that we work with don’t accept non-accredited investors anyways, so that’s not that much of a difference, at least from our perspective. The big difference is remember before I said with 506(b) you don’t actually have to verify whether the investor [inaudible 00:12:30] and 506(c), you have to take a reasonable effort to verify that every one of your investors is accredited.
Healy: So how do you do that? Is it a bank statement check, or are there services that do this, or is it the lawyers get to do this, or how do you figure this?
Michael: So there’s a few ways that are actually written into the law that are like, “If you do this, you’re good.” For example, the one that we do most often is we prepare a little letter and it says the investor gives this to their lawyer, their accountant, their CPA, their financial advisor, those are the main ones, and they fill out that document for the investor and they basically say, “I verify that this person is an accredited investor,” and they sign it.
Healy: Got it. Okay. Perfect.
Michael: And if you do it that way, that’s it. The thing is you’d be surprised at how much pushback investors give with respect to this form.
Healy: As in they don’t want to sign it or they don’t want to have their lawyer look at it or an accountant look at it, stuff like that?
Michael: So part of what you just said, Healy, a few minutes ago is that this is something very new. It’s a new way that investors are raising funds and a lot of times LPs, which is another word for the investors in the fund, they’ll be like, “I’ve never seen anything like this before. Nobody’s ever asked me to do this.” And some people just say, “Oh yeah, I’ve done it. It’s all good.” But a lot of people, it’s just something they’ve never had to do before because they’ve always been in these 506(b) funds, so sometimes they get a little bit of pushback.
Healy: Well, I can imagine if you’re feeling like you’re pretty well off and suddenly be asked to verify that you’re rich or whatever, it could be annoying, particularly if you are at a large endowment or something where it’s obviously you have a lot of money to invest and you’re accredited. So that leads me to a question I’ve had for a long time that I’ve never had anyone to be able to answer this, so now I [inaudible 00:14:28], so I’m going to ask it. An accredited investor has the income limits and the asset value or wealth limit, or how does that impact if you’re married? Does it double or is it just the same?
Michael: If it’s the income test, then it ratchets up a little bit. So if you’re an individual, it’s $200,000 a year, technically it’s $200,000 a year that you’ve made for the past two years with a reasonable expectation that you’ll keep making at least $200,000 a year. If you’re married, that ratchets up to $300,000 a year. And then that one million dollar limit for net worth, that’s the same if you’re married. And just a little aside on that, so there’s complicated rules about whether you can include your residence. You typically cannot include your primary residence, but you also don’t include the debt on that primary residence unless you’re underwater and then you have to include the amount of debt you’re underwater [inaudible 00:15:31]
Healy: It gets a little complicated there, okay. All right, cool. Well, thank you for answering that question. For some reason that’s been one of those things that I wake up in the middle of the night wondering, so now I know. I think something that might be helpful for the audience, particularly a lot of the founders who you don’t necessarily get a chance to look behind the curtains of a venture capital fund, is to define… You threw a couple terms around the LP and the GP. What is the LP? What is the GP? What’s the difference between those two inside of a venture capital fund?
Michael: For sure. A little fun vocabularies, sounds like a good idea. So first you have the fund itself, so this is typically a Delaware Limited partnership, although sometimes you form this outside of the US, we can talk about that later if you want.
Healy: That sounds like a tax thing.
Michael: It’s a tax thing. It’s often a crypto thing. There’s a number of reasons. So you have the fund itself, then you have the investors in that fund, so they send their money to the fund, and those investors are called limited partners. Limited because they have limited liability and limited because they have limited ability to decide anything. So we have the funds, the limited partners invest in the fund, then we have the people who run the fund, and there’s all sorts of names that people give to this person, or people, you can call them the general partner, the sponsor, the manager, it depends on the specific structure, but the general partner will call them runs the fund. And sometimes you might have something else called the management company, but I don’t know if you want to get into it.
Healy: We don’t have to get that deep, but at a high level, there’s the GP, or the general partners, those are the folks that are making investment decisions and pushing the buttons, keeping the fund running. And then the limited partners, that’s the money.
Michael: That’s right. That’s exactly right. And often, most of the time the general partner will also have a minimum amount that they invest too. It’s not legally required, but it’s a good marketing point to say we’re putting in 1%, 2%, 5% of the money, so our interests are aligned and we’re all on the [inaudible 00:17:40]
Healy: Yeah, that makes sense. Put a little get in the game, right?
Michael: Yeah.
Healy: So are there any particular terms that the limited partners, the investors in the fund, ask the general partners for when they’re making an investment that would matter to the founders who are raising money from that venture capital fund, or the portfolio companies of that fund?
Michael: Okay, interesting. That would matter to the limited partner… Or excuse me…
Healy: To the founders.
Michael: To the founders, okay.
Healy: So stuff like the lifetime of the fund or how capital calls work. [inaudible 00:18:11]
Michael: So I do know that there’s that many terms that would necessarily affect the founders themselves. One thing that is important to them is how much money does the fund have, how much capital they do they have to deploy. Something else that’s something that might affect the founders is whether the fund plans to do follow on investments. So this is something that’s quite common where the fund maybe in year two of the fund’s life, will make an investment in a portfolio company or a startup. And then many funds will reserve amounts specifically to do later stage investments in that same company. So maybe in year two, the fund invests in a series A, and then maybe a few years later the fund reserves some money that specifically they’ve retained to invest in that same portfolio company. So that’s something that could affect the founders. Another thing which is pretty common and becoming more common I would say is lots of investors, limited partners, have a big list of stuff that they require if they invest in any fund, and this can include all sorts of things, but one thing that directly very much impacts these startups is limited partners will often say, “We are not going to invest in this, this, this, this, and this.” And they’re called excluded investments. And there are some that are weapons, drugs, pornography, those are very common ones. Some other common ones are maybe we don’t want to invest in digital assets, maybe we don’t want to invest in companies based outside the US, or maybe only a certain percentage of companies based outside the US, so those can all affect the founders.
Scott: It’s Scott Orn of Kruze Consulting, taking a quick pit stop to give some of the groups at Kruze a big shout-out. First up is our tax team, amazing. They can do your federal and state income tax returns, R&D tax credits, sales tax help. Anything you need for state registrations, they do it all. We’re so grateful for all their awesome work. Also, our finance team is doing amazing work now. They build financial models, budget actuals, and help your company navigate the VC due diligence process. I guess our tax team does that too on the tax side, but the finance team is doing great work. They build financial models, budget actuals, and help your company navigate the VC due diligence process, I guess our tax team does that too on the tax side, but the finance team is doing great work. And then I think everyone knows our accounting team is pretty awesome, but want to give them a shout-out too. Thanks, and back to the guest.
Healy: That makes a lot of sense. And so actually we should back up just a second around the reserves, because when I was a venture capitalist we did talk a lot about reserve management and how we use the reserves, particularly for funds that were five or six years old, and also particularly for as we went into a downturn, because particularly as you go into a downturn, there’s a limited amount of money set aside to continue to support the existing investments, and the VCs have a lot of math to do and to decide which portfolio companies are still going to… They used to say stay in the lifeboat versus not. And so what are the terms you commonly see about how much concentration a fund can have into an individual investment? Is that something that you see it’s pretty common?
Michael: Yep, very common, pretty much every fund. It’ll usually be somewhere around about 10 to 20% of the fund’s capital can be invested in any single portfolio company, and the portfolio company [inaudible 00:22:01] way for a startup. But one thing to keep in mind about that is that’s usually measured at cost. So if you invest 10% in portfolio company A and then 10 x is, it’s not like you’ve gotten yourself into trouble, it’s based on how much the investment was made at the time. And sometimes you could say this doesn’t apply to follow on investments. There’s all sorts of different things you can do. Again, almost everything in these fund agreements is not a legal requirement, it’s just a matter of business and negotiating between [inaudible 00:22:36] used in a GP.
Healy: So another thing that I think is mysterious for a lot of founders is a lot of founders don’t necessarily understand where the cash is that a venture capitalist has when they say they have 200 million dollar fund. A lot of folks might imagine that there’s a safe inside the venture capital’s office where all this money sits, and it’s not at all like that. There’s closings, there’s capital calls. Do you want to explain the mechanics of how the money gets from the limited partners, the investors, to the fund so that they can deploy it?
Michael: Yeah, for sure. So typically how it works is the fund will hold an initial closing, and this is basically the first time that it accepts limited partners into the fund. And so what this is is each limited partner at the closing has made a commitment to fund a certain amount of money to the fund. So for example, we might have 10 limited partners who each make a commitment, that’s the legal term, commitment, a 10 million dollar commitment to the fund. So now the fund, now it’s a $100 million fund, 10 LPs, each has a 10 million dollar commitment. Now, at this initial closing, it’s possible that no money moves anywhere at all. It’s not like the closing of an M&A deal or something like that. At that point, he venture capitalist knows I have 100 million dollars of dry powder that I can invest in companies once I’m ready and once I find them, but in practice they don’t actually call capital, is what it’s called. They don’t actually say, “Hey, LP, send me your money,” until they find a deal that they want to invest in. So a common way that this will happen is after the first closing, maybe a month or two later, or maybe immediately if they already have a deal, the general partner will say, “Hey, limited partners, we found a deal. We’re going to call 10% of the money you promised that you would fund over the life of the fund.” So then in this case that would be 10 million dollars, they get 10 million dollars from the limited partners, and then they can invest that money. And they also use that money to pay fund expenses and things of that nature too. Typically, in most venture capital funds, you can’t make new investments over the whole life of the fund. So a venture capital fund is typically about 10 years long, it lasts 10 years. But usually the general partner agrees we’re only going to make investments, new investments in the first five years. So usually if you’re a limited partner, you can expect that most of your capital is going to be called in that first five years. Although oftentimes general partners will still make follow on investments on existing portfolio companies throughout the life of the fund if that’s the deal.
Healy: So just as the venture capital fund has to think about managing their cash with the follow on investments, the limited partners have to think about managing their commitments to the fund. And then if they have a big portfolio, there’s probably a lot of balancing and math that goes on there as well, just to figure out which funds are going to be asking for capital when, et cetera, et cetera. Have you seen any best practices from the managers in terms of communicating when the capital calls might come? Because I can definitely imagine, particularly in a moment when the stock market’s melting down a little bit, some of the investors may not have as much cash sitting around as they had when they made the commitment last year.
Michael: That’s absolutely right. It’s important for general partners to keep the LPs, the limited partners, in the loop about when they expect to call capital. Because like you said, many big limited partners who have a lot of money to manage like pension funds or endowments or things of that nature, they have to manage their cash to make sure that they can fund these commitments when necessary. So you’re right, it’s something that it’s always good practice for the general partner to talk about their pipeline, what they might be investing in, and give advanced notice. Right now we’re dealing with an LP who wants to invest in a fund but hasn’t managed their cash especially well, and so now we’re trying to find out some creative way to help them be able to make a new commitment to a new fund because they haven’t been able to manage their cash effectively.
Healy: So that actually reminds me of a time when I was at Summit Partners, which is a well known venture capital fund, and as the junior folks there, we got to invest in the companies that Summit was investing in, and it was a great opportunity. We weren’t the technical accredited investor with the million dollars in assets. We were in our early twenties and suddenly having access to these types of investments was amazing. And so there was a period of time where the investments were just coming fast and furious, maybe one or two a month, and it started to stretch some of our limited resources. And I remember one of my coworkers had just gotten those credit card checks in the mail, it’s like you could cash them and they have a zero interest rate for six months or whatever, and he’s like, “Maybe I should use one of these.” And so we sat him down and had a long conversation about that.
Michael: Liquidity is tough even for general partners in many cases. Remember earlier I said the general partner often invests in the fund too, but if the general partner has a big commitment and they have a lot of these general partners, and they might be on fund 2, 3, 4, they have a lot of hands in the pot here, so there are certain ways that are a little complicated, but ways for the general partner to actually fund their commitment without actually putting in any cash.
Healy: I’ve definitely heard about some of those that seem like there are nice ways to maybe even help you with your tax issues a little bit as well.
Michael: That’s right, yes.
Healy: We’re not providing any legal or tax advice, but let’s not go there on this call. But I think that there’s another interesting topic here, which is how VC funds get paid and people throw the term 2 and 20 around. You want to just describe in general what that means for our founders who might not be in the know?
Michael: Yep, absolutely. So 2 and 20, like you said, is standard. And what that means is there’s two main ways that general partners get paid. So the first one is called a management fee. And the management fee, in venture capital, it’s typically charged as a percentage of the commitments of the LPs. So in our 100 million dollar fund, there’s 100 million dollars of commitments. The most typical fee, like you said, is 2%. So that’s 2% a year times that 100 million dollar commitment, so that’s two million dollars in management fees a year.
Healy: So over 10 years, that adds up to be quite a bit, actually.
Michael: Well, yes. In venture, typically that fee steps down after that five year investment period that we talked about. So often it’ll be 2% for the first five years, but then it might go down to 1.5, and then one, and then 0.5. So the idea here is the management fee is to keep the lights on in the general partner, it’s to make sure you can pay the salaries so those people can go out and find investments and do their work. So the theory is that, well, after you’ve made all the investments, your job’s a little easier, you might not need so much management fee.
Healy: Sure. I’ve also heard that lawyers can be expensive too, so maybe there might be some legal fees there too. So one of the things that I always find interesting is that would be a drag on returns. So how does that intersect with the money that the fund hopefully will give back to the limited partners as they exit companies and make capital gains? We’ll talk about the 20% in a second, or maybe you want to leave it in there, but that’s not necessarily, quote unquote, free money, the 2%, it impacts your [inaudible 00:30:30]
Michael: Yeah, that’s exactly right. And I think we probably do have to get into the 20% for this to all make sense.
Healy: Okay, let’s go ahead. Go for it then.
Michael: There’s that management fee, and then the other way that the general partners get paid is what’s called carried interest, which is often in the news, and carried interest essentially means a share of the fund’s profits. So typically in a venture fund this will be 20%, and recently some people have been trying to get more, that’s another trend, but the way this works is it’s a share of the profits, so what are the profits? Basically if you sell an investment, let’s say the LPs put in 10 million dollars for an investment and it’s now worth 20 million dollars, so that’s good, the share of the profits basically means that all the money that limited partner’s put in, every dollar they’ve ever put in has to be given back to them before the profit split goes up. So in your example, let’s say it’s a 10 million dollar investment, it’s now worth 20 million dollars, so the LPs get their 10 million dollars back, but they also get back any management fees that they’ve paid, or really any other fees, lawyer’s fees, any sort of fees, the LPs have to get that money back before that profit split gets sent out. So let’s just say there’s a 10 million dollar investment let’s pretend there have been five million dollars of fees over the life of the fund, so now there’s really only five million dollars of profit left. And at that point it can be split 80/20 between the general partner who would get one million dollars, and the limited partners who would get four million dollars. So like you were talking about, there’s an incentive to keep fees low, because if fees are lower, then the general partner can get their profit split earlier. And that’s good because the profit split, this carried interest for general partners, as you well know, is capital gains income, which is better than management fees, which are ordinary.
Healy: There’s definitely been a lot of political wrangling around that that maybe is beyond the scope of this podcast, but there’s apparently some powerful groups that like the carried interest taxed as capital gains there. Well, Michael, thank you for joining us. Anyone who wants to reach out to Michael can reach him at DLA Piper, Michael Huseby. Additionally, Michael has a very cool website called investinglawyer.com, so if you’re interested in VC legal issues, you should definitely check that out. Thank you, Michael. Take care.
Singer: (singing)

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