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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.
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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:
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Overcoming the Hurdles: Navigating the Increasing Barriers to Capital for Companies and Investment 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.
Breaking Free from Constraints: How to Overcome Investor Access Barriers for Greater Investment Opportunities
Private market investments are typically made in the early stages of a company’s lifecycle and often lack the amount of information available in public company investments. As a result, they are considered riskier than investing in real estate or the public markets.
The potential high risk associated with these investments is what drives some investors to participate, but the lack of information means that not everyone can invest in these markets.
In order to safeguard investors, the federal securities laws limit participation in private market investments to high net-worth individuals or those with financial certifications that demonstrate a certain level of sophistication in their investment decisions.
The income threshold for accredited status is currently set at $200,000 for individuals or $300,000 for married couples, or a minimum net worth of $1 million (excluding primary residence).
The Securities and Exchange Commission (SEC) is considering raising these thresholds and linking them to inflation reflective of regulation’s 40-year history.
Additionally, the SEC may also limit the assets that qualify for the wealth test. While these measures are intended to protect investors, they could exclude a significant portion of the population from private market investment opportunities.
Raising the accredited investor thresholds could prevent more people from investing in growth-stage companies that have the potential to deliver strong returns and help to diversify their investment portfolios.
This would mean that fewer investors have access to the benefits of private market investments, potentially leading to further economic inequality.
The impact of higher wealth thresholds for accredited investors would be more pronounced in smaller markets where salaries, cost of living, and asset values are lower.
This could disproportionately affect the ability of investors in these areas to participate in private market investments.
Furthermore, raising the thresholds for accredited investor status could perpetuate the dominance of coastal regions as the capital centers for the private markets. Despite the emergence of promising venture hubs in places like Texas, Georgia, and Colorado, raising the thresholds could prevent investors in these areas from accessing private market investment opportunities.
Finally, these changes could limit access to capital for underserved and underrepresented founders and fund managers who often lack access to traditional networks of wealth and power.
This could perpetuate systemic inequalities in the investment industry and hinder the growth and development of startups owned by underrepresented groups.
Private or Public: The Pros and Cons of Going Public for Companies Forced into the Public Markets
The Securities and Exchange Commission (SEC) is currently considering changes to Section 12(g) under the Securities Exchange Act of 1934. This particular section determines the number of “holders of record” that a company can have before it is pushed into the public markets by being subject to the same reporting requirements.
While the SEC can’t change the fixed number of 2,000 holders because it is set by a congressional statute, it is exploring other ways to count “holders” or add new triggers to force larger private companies to go public.
One of the proposed changes to Section 12(g) would be to “look through” investment vehicles such as special purpose vehicles (SPVs), which are currently counted as one “holder,” and count each beneficial owner instead.
While this change may seem like a good way to ensure transparency and accountability, it would penalize diversification and disadvantage less affluent investors who pool their capital to compete with larger investors who dominate the space. It may also discourage private market investments by making it more difficult for smaller investors to participate in such ventures.
Other suggested changes to Section 12(g) could create earlier triggers based on company valuations or revenues. These changes may undermine a growth-stage company’s ability to raise capital by capping the return on investments. This is because artificial boundaries would be created that could potentially harm the growth potential of such companies.
Additionally, such changes could increase market concentration by making growth-stage companies more vulnerable to acquisition by competitors when they approach a particular valuation or revenue threshold.
Ultimately, these changes could negatively impact the private markets and make it harder for smaller investors and growth-stage companies to thrive.
As a founder or investor in the startup sector, it is important to stay informed about the proposed changes being considered by the Securities and Exchange Commission (SEC).
These changes have the potential to impact the private markets and the ability of startups to access capital and grow into successful businesses.
To stay informed, you can follow the latest news from the SEC and engage in the rule-making process by submitting written comments.
It is important to make your voices heard and advocate for policies that support innovation and job creation in the startup sector.
The private markets have played a significant role in the American economy’s recovery from the Great Recession and continue to drive innovation and healthy competition in the U.S. markets.
Limiting access to capital for entrepreneurs and restricting their ability to grow their businesses could have a detrimental impact on innovation and job creation, ultimately hurting the overall economy.
Therefore, it is crucial for the startup sector to keep a close eye on the SEC’s proposed changes and actively participate in the rule-making process to ensure that policies are enacted that support growth and innovation in the private markets.
By doing so, we can help to create a more vibrant and successful startup ecosystem that benefits everyone.