With the failure of the Silicon Valley bank, the US startup ecosystem has lost an important business partner. But the biggest ramifications may be what comes next: a series of tougher regulations directed not just at medium-sized banks like SVB — but also at companies and private funds. Although the failure of SVB cannot be blamed on the venture ecosystem, some policymakers have joined the general public in hurting the bank’s depositors – largely venture-backed startups. This negative narrative has massive implications for the project community.
This is an inflection point. In a shift from the past two decades, policymakers and regulators have already begun to scrutinize private markets. If more lawmakers become convinced that Silicon Valley companies require greater oversight, the consensus could encourage the SEC to accelerate its agenda to increase regulation in private markets and fundamentally change the enterprise as we know it. The scale of the SEC’s proposed reforms should alarm entrepreneurs, investors, and employees in the innovation economy.
Three major areas of intervention proposed by the SEC provide examples of why the project community should be concerned.
The SEC’s current agenda — a public list of regulations the agency is considering — contains proposals that would increase barriers to capital for companies and funds, restrict investor access and possibly push more companies from private to public. In short, SEC actions can slow down one of our greatest engines of innovation.
Three major areas of intervention proposed by the SEC provide examples of why the project community should be concerned:
Increased barriers to capital for companies and funds
Public and private markets are organized differently by design. The policy framework is designed for private issuers – corporations and funds – to streamline their ability to raise capital, labor and innovate with fewer regulatory restrictions. Because private companies are usually early in their life cycle, they are subject to fewer compliance and disclosure requirements.
Regulation d
The SEC is looking to change that with changes to Regulation D, the mechanism that allows companies and private funds to raise capital without listing or going public—it’s the framework most startups and funds use to raise capital. the money. Signs are that the Commission may require companies that raise capital under the Reg D to disclose more financial and company information. But such disclosures carry significant financial costs for small and private companies — and they also carry the added risk of exposing sensitive financial information to competitors and large incumbents. Furthermore, penalties for non-compliance can permanently harm a company’s ability to raise capital.
private funds
Last year, the SEC also proposed rules that could make it more difficult for startup fund managers to raise capital by introducing new bans on venture capital advisors, who are not usually regulated by the SEC. Congress deliberately withheld venture capital from SEC filing, but the SEC nonetheless proposed rules that would indirectly regulate venture capital by banning common industry practices. Two in particular are worth highlighting:
- Bottom line for lawsuits: The SEC has proposed banning VC advisors from compensation for simple negligence — meaning general practitioners could face lawsuits for failed investments made in good faith and under due diligence if the deal goes south. It would also be riskier for GPs to support portfolio companies, as more involvement would lead to more liability.
- Blocking side messages: The SEC’s proposal would also effectively ban the use of side messages, which is common practice in the project. Side messages help fund managers attract larger, more established liquidity providers by customizing transaction terms, such as access to information and cost structure. Specific side messages may not greatly affect large funds but will have a significant impact on smaller emerging funds, which often use them to secure primary LPs as they grow their money. This likely has the effect of shifting money to larger funds that present less perceived risk.
Restricting investors’ access to investment opportunities
Private market investments tend to be early in a company’s life cycle and without as much information as public company investments. Thus, it is seen as riskier than investing in real estate or public markets. To protect investors, federal securities laws restrict participation to high net worth individuals, as well as those with financial certifications demonstrating sophistication. Currently, the income limit for approved status is $200,000 for individuals ($300,000 for married couples) or a net worth of at least $1 million (excluding primary residence).
The SEC will likely propose raising these thresholds, and they will likely be indexed to inflation that reflects the regulation’s 40-year history and limits assets eligible for the wealth test. Doing so will exclude a large segment of the population from investing in the private market. This will restrict more people from investing in growth stage companies that can generate strong returns and from diversifying their investment portfolio. It is protecting the investor by excluding the investor.
Moreover, higher wealth thresholds will have a significant impact on smaller markets where salaries, cost of living, and asset values are lower. Such action would increase the attractiveness of the coasts as major centers for private markets — even as centers of promising projects are emerging 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 traditional networks of wealth and power.
Forcing companies to enter the public markets
Perhaps the most impactful changes under consideration by the SEC are Section 12(g) under the Securities Act of 1934, which limits the number of “holders of record” a company can have before it can be catapulted into the public markets by being subject to the same Reporting requirements.
Although the SEC will not be able to change this fixed number (currently 2000) because it is set by an act of Congress, it is considering changing the way “holders” are counted or adding new incentives to force larger private companies to offer its shares for public subscription. One possible change is to “look through” investment vehicles, such as special-purpose vehicles or special-purpose vehicles – which are currently counted as one “owner” – for each beneficial owner’s account. This change will penalize diversification and hurt less affluent investors who are pooling their capital to compete with the larger investors who control the space.
Other proposed changes to 12(g) could create ex ante triggers based on company valuations or revenue. These artificial limits would undermine the ability of the company in the growth stage to raise capital by placing a maximum limit on the return on investments. It can also have the unintended consequence of increasing market concentration by making growth-stage companies more likely to be acquired by competitors when they approach a valuation or revenue threshold.
What to do about it
Founders and investors need to stay informed about these proposed changes: You can stay up to date on the latest SEC news and make your views heard by engaging in the rulemaking process by submitting written comments.
Private markets were central to the US economy’s recovery from the Great Recession and have continued to drive innovation and healthy competition in US markets. Restricting entrepreneurs’ access to capital and their ability to grow into large, profitable enterprises would come at an enormous cost to innovation and job creation.