Holli Heiles Pandol
With the failure of Silicon Valley Bank, the U.S. startup ecosystem lost an important business partner. But the greater fallout could be what’s coming next: a spate of tighter regulations directed not just at midsize banks like SVB — but also at private companies and funds. Although SVB’s failure can’t be blamed on the venture ecosystem, some policymakers have joined the general public in maligning the bank’s depositors — in large part venture-backed startups. This negative narrative has immense implications for the venture community.
This is an inflection point. In a shift from the last two decades, policymakers and regulators had already begun to scrutinize the private markets. If more lawmakers become convinced that Silicon Valley companies require greater supervision, the consensus could embolden the SEC to accelerate its agenda for increasing regulation in the private markets and fundamentally altering venture as we know it. And the scale of the SEC’s proposed reforms should alarm entrepreneurs, investors and employees in the innovation economy.
Three key areas of proposed intervention by the SEC offer examples of why the venture community should be paying attention.
The SEC’s current agenda — a public list of the regulations the agency is considering — contains proposals that will increase barriers to capital for companies and funds, constrain investor access and potentially push more companies from private to public. In short, the SEC’s actions could slow one of our greatest engines of innovation.
Three key areas of proposed intervention by the SEC offer examples of why the venture community should be paying attention:
Increasing barriers to capital for companies and funds
Public and private markets are regulated differently by design. The policy framework for private issuers — companies and funds — was built to streamline their ability to raise capital, operate and innovate with fewer regulatory restrictions. Because private companies are typically earlier in their lifecycle, they are subject to fewer compliance and disclosures requirements.
The SEC is looking to change that by making changes to Regulation D, the mechanism that allows private companies and funds to raise capital without registering their securities or going public — it is the framework that most startups and funds use to raise capital. Signals suggest the Commission could require companies that raise capital under Reg D to disclose more financial and company information. But these disclosures carry significant financial costs for small, private companies — and they carry the extra risk of exposing sensitive financial information to competitors and large corporate incumbents. Moreover, penalties for noncompliance could permanently damage a company’s ability to raise capital.
Last year, the SEC also proposed rules that could make it harder for emerging fund managers to raise capital by introducing new prohibitions for venture capital advisers, who are not typically regulated by the SEC. Congress purposely carved out venture capital from SEC registration, but the SEC nonetheless proposed rules that would indirectly regulate VC by prohibiting common industry practices. Two in particular that are worth highlighting:
- A lower bar for lawsuits: The SEC has proposed banning VC advisers from indemnification for simple negligence — meaning GPs could face lawsuits for failed investments that were made in good faith and under proper due diligence if a deal goes south. It would also be more risky for GPs to support portfolio companies, as more engagement would lend itself to more liability.
- Prohibition of side letters: The SEC proposal would also effectively ban the use of side letters, a common practice in venture. Side letters help fund managers attract larger, often more established LPs by customizing the deal terms, such as access to information and cost structure. Limiting side letters may not drastically impact the largest funds but would have an outsize impact on emerging, smaller funds, who often use them to secure anchor LPs as they’re growing their funds. This will likely have the effect of money funneling to the larger funds that present less perceived risk.
Constraining investor access to investment opportunities
Private market investments tend to be earlier in a company’s life cycle and without as much information as public company investments. Consequently, they are seen as riskier than investing in real estate or the public markets. To protect investors, the federal securities laws restrict participation to high net-worth individuals, as well as those with financial certifications that demonstrate sophistication. At present, the income threshold for accredited status is $200,000 for individuals ($300,000 for married couples) or net worth of at least $1 million (excluding primary residence).
The SEC is likely to propose raising these thresholds, potentially indexing them for inflation reflective of regulation’s 40-year history and limiting what assets qualify for the wealth test. Doing so would exclude a large swath of the population from private market investment. This would restrict more people from investing in growth-stage companies that can deliver strong returns and from diversifying their investment portfolio. It is investor protection through investor preclusion.
Further, higher wealth thresholds would have an outsized impact on smaller markets where salaries and cost of living and asset values are lower. Such action would further engrain the coasts as the capital centers for the private markets — even as promising venture hubs have begun to emerge in places like Texas, Georgia and Colorado. It would also limit access to capital for underserved and underrepresented founders and fund managers, who often lack access to more traditional networks of wealth and power.
Forcing companies into the public markets
Perhaps the most impactful changes under consideration by the SEC would be to Section 12(g) under the Securities Exchange Act of 1934, which defines the number of “holders of record” a company can have before it is pushed into the public markets by being subject to the same reporting requirements.
While the SEC won’t be able to change this fixed number (currently 2,000) because it’s set by a congressional statute, it is considering changing the way “holders” are counted or adding new triggers to essentially force larger private companies to go public. One potential change would “look through” investment vehicles, such as special purpose vehicles or SPVs — which are currently counted as one “holder” — to count each beneficial owner. This change would penalize diversification and disadvantage less affluent investors who pool their capital to compete with the larger investors who dominate the space.
Other suggested changes to 12(g) could create earlier triggers based on company valuations or revenues. These artificial boundaries would undermine a growth-stage company’s ability to raise capital by effectively capping the return on investments. They could also have the unintended consequence of increasing market concentration by making growth-stage companies more vulnerable to acquisition by competitors when they approach a valuation or revenue threshold.
What to do about it
Founders and investors need to remain informed about these proposed changes: You can follow the latest SEC news and make your voices heard by engaging in the rule-making process by submitting written comments.
The private markets were central to the American economy’s recovery from the Great Recession and continue to drive innovation and healthy competition in U.S. markets. Restricting entrepreneurs’ access to capital and their ability to grow into large and profitable enterprises would come at the tremendous cost of innovation and job creation.