With the collapse of Silicon Valley Bank, the US startup ecosystem lost an important business partner. But the biggest fallout may be what comes next: tighter regulations directed not only at medium-sized banks like SVB, but also at private companies and funds. Although SVB’s failure was not blamed on the venture ecosystem, some policymakers joined the crowd in demonizing the bank’s depositors—mostly venture-backed startups. This negative narrative has huge implications for the venture community.
This is a turning point. Over the past two decades, policymakers and regulators have begun to scrutinize private markets. If more lawmakers believe Silicon Valley companies need more oversight, the deal could encourage the SEC to accelerate its agenda to increase regulation in private markets and fundamentally change the way we know it. And the magnitude of the SEC’s proposed reforms should alarm entrepreneurs, investors and workers in the creative economy.
Three key areas of the SEC’s proposed intervention provide examples of why the venture community should pay attention.
The SEC’s current agenda — a list of rules the agency is considering — contains proposals that would increase capital barriers for companies and funds, limit investor access and push more companies from private to public. In short, the SEC’s actions could slow down one of our greatest engines of innovation.
Three key areas of intervention proposed by the SEC provide examples of why the venture community should pay attention.
Increasing capital barriers for companies and funds
Public and private markets are regulated differently by design. For private issuers – companies and funds – the policy framework is designed to facilitate their ability to raise, operate and create capital with less regulatory constraints. Because private companies are earlier in their life cycle, they are subject to less compliance and transparency requirements.
The SEC is looking to change that with Regulation D, a mechanism that allows private companies and funds to raise capital without registering their securities or going public — the framework most startups and funds use to raise capital. Indications are that the Commission may require companies raising capital under Reg D to disclose additional financial and company information. But these disclosures carry significant financial costs for small and private companies—and the added risk of exposing sensitive financial information to competitors and large corporate executives. Moreover, penalties for non-compliance can permanently impair a company’s ability to raise capital.
Last year, the SEC introduced new restrictions for emerging fund managers to raise capital, making it harder for venture capital advisers not typically regulated by the SEC. Congress intentionally excluded venture capital from SEC registration, but the SEC nevertheless proposed rules that indirectly regulate VC by prohibiting common industry practices. Two in particular deserve attention:
- Low Bar for Judgment: The SEC has proposed barring VC advisors from indemnification for simple negligence — meaning GPS could face lawsuits over failed investments made in good faith and due diligence if a deal goes south. It also becomes riskier for GPS to support portfolio companies, as more involvement exposes itself to greater liability.
- Prohibition of side letters; The SEC proposal also effectively prohibits the use of side letters, a common practice in venture capital. Side letters help fund managers attract large and often established LPs by customizing deal terms, such as information access and fee structure. Limiting side letters won’t affect the big funds, but it will have a big impact on new smaller funds that use anchor LPs to protect them as they grow their funds. This may have the effect of moving money into larger funds that offer less perceived risk.
Blocking investors’ investment opportunities
Private market investments tend to be earlier in the company’s life cycle and without as much information as public company investments. Consequently, they are considered riskier than investing in real estate or the public markets. To protect investors, federal securities laws limit participation to high-income individuals and those with financial credentials that demonstrate sophistication. Currently, the income threshold for a recognized 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 may propose raising these limits, reflecting the rule’s 40-year history of inflation and limiting assets that qualify for the wealth test. Doing so excludes the general public from private market investment. This prevents many people from investing in growth-stage companies that can generate strong returns and diversifying their investment portfolios. Withholding by investors is investor protection.
In addition, higher wealth thresholds affect smaller markets where wages and the cost of living and property values are lower. Such a move would make the coasts hotbeds for private equity markets, as promising venture capital hubs began to emerge in places like Texas, Georgia and Colorado. It also limits the availability of capital to founders and fund managers who often lack access to traditional networks of wealth and power.
Forcing companies into the public market
The most important changes to be considered by the SEC are It may be under Section 12(g) of the Securities Exchange Act of 1934, which defines the number of “holders of record” a company can have before being pushed to the public markets. Subject to the same reporting requirements.
While the SEC can’t change this fixed number (currently 2,000) because it’s mandated by law in Congress, it’s considering changing the way “holders” are counted or adding new triggers to force large private companies to go public. A potential change would “treat” investment vehicles, such as special purpose vehicles or SPVs – which are currently considered a single “holding” – to account for each beneficial owner. This change will penalize and harm the diversity of small, wealthy investors who pool their capital to compete with the large investors who dominate the space.
Other proposed changes in the 12(g) may result in earlier triggers based on the company’s valuations or earnings. These artificial boundaries undermine the ability of a growth-stage company to effectively capture investment returns and raise capital. It can also have the unintended effect of increasing market concentration, making growth-stage companies more vulnerable to competitors as they approach valuation or revenue thresholds.
What to do about it
Founders and investors should stay informed about these proposed changes: you can monitor the latest SEC news and make your voice heard by participating in the rulemaking process by submitting written comments.
Private markets were central to the American economy’s recovery from the Great Depression and to maintaining innovation and healthy competition in American markets. Limiting entrepreneurs’ access to capital and ability to grow into large, profitable enterprises comes at a huge cost to innovation and job creation.