With the bankruptcy of Silicon Valley Bank, the US startup ecosystem lost a key business partner. But the bigger ramifications could be what comes next: a wave of tighter regulation targeting not only medium-sized banks like the SVB, but also private companies and funds. While the SVB’s failure cannot be blamed on the venture ecosystem, some policymakers have joined the general public in defaming the bank’s depositors – largely venture-backed startups. This negative narrative has huge implications for the entrepreneurial community.
This is an inflection point. In a shift over the past two decades, policymakers and regulators had already begun to scrutinize private markets. If more lawmakers become convinced that Silicon Valley companies need more oversight, the consensus could encourage the SEC to accelerate its agenda for increasing regulation in private markets and fundamentally transforming companies as we know them. And the magnitude of the reforms proposed by the SEC should alarm entrepreneurs, investors and workers in the innovation economy.
Three key areas of proposed SEC intervention provide examples of why the corporate community should pay attention.
The SEC’s current agenda — a public list of the regulations the agency is considering — include proposals that will increase capital barriers for companies and funds, limit investor access, and potentially push more companies from private to public. In short, the SEC’s actions could slow down one of our biggest engines of innovation.
Three key areas of proposed intervention by the SEC provide examples of why the corporate community should pay attention:
Contents
Increasing barriers to capital for companies and funds
Public and private markets are regulated differently per set-up. The policy framework for private issuers — companies and funds — is designed to streamline their ability to raise capital, operate and innovate with fewer regulatory constraints. Because private companies are typically earlier in their lifecycle, they are subject to fewer compliance and disclosure requirements.
Regulation D
The SEC is trying to change that by making changes Regulation Dthe mechanism that allows private companies and funds to raise capital without registering their securities or going public – it is the framework most startups and funds use to raise capital. Signals suggest that the Commission could require companies raising capital under Reg D to disclose more financial and corporate information. But these disclosures come at a significant financial cost to small, private companies – and they come with the added risk of revealing sensitive financial information to competitors and large incumbents. In addition, fines for non-compliance can permanently impair a company’s ability to raise capital.
Private Funds
Last year, the SEC did too proposed rules that could make it more difficult for emerging fund managers to raise capital by introducing new bans on venture capital advisors, which are typically not regulated by the SEC. Congress purposely removed venture capital from SEC registration, but the SEC nonetheless proposed rules that would indirectly regulate VC by banning common industry practices. Two in particular that are worth highlighting:
- A lower bar for litigation: The SEC has proposed barring VC advisors from simple negligence damages — meaning GPs can sue for failed investments made in good faith and under proper due diligence if a deal falls through. It would also be riskier for GPs to support portfolio companies as more involvement would lead to more accountability.
- Ban on side letters: The SEC proposal would also effectively ban the use of side letters, a common practice in corporations. Side letters help fund managers attract larger, often more established LPs by adjusting deal terms, such as access to information and fee structure. Restrictive side letters may not drastically affect the largest funds, but would have a huge impact on emerging, smaller funds, which often use them to secure anchor LPs as they grow their funds. This will likely have the effect of funneling money into the larger funds that have less perceived risk.
Restricting investors’ access to investment opportunities
Investments in the private market usually occur earlier in a company’s lifecycle and contain less information than investments made by public companies. As a result, they are considered riskier than investing in real estate or the public markets. To protect investors, federal securities laws limit participation to high net worth individuals, as well as those with financial certifications demonstrating sophistication. Currently, the income threshold for accredited 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 is likely to propose raising these thresholds, possibly indexing them for inflation to reflect the regulatory’s 40-year history, and limiting which assets qualify for the asset test. This would exclude a large part of the population from private market investment. This would discourage more people from investing in growth stage companies that can deliver strong returns and from diversifying their investment portfolios. It is investor protection through investor exclusion.
Furthermore, higher wealth thresholds would have a disproportionate impact in smaller markets where wages and costs of living and asset values are lower. Such action would further entrench the coasts as the capital centers for the private markets – even as promising entrepreneurial centers begin 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 public markets
Perhaps the most influential amendments the SEC is considering are Section 12(g) under the Securities Exchange Act of 1934, which defines the number of “holders of record” a company may have before being pushed into the public markets by be subject to the same reporting obligations.
While the SEC can’t change this fixed number (currently 2,000) because it’s enshrined in congressional statute, it’s considering changing the way “holders” are counted or adding new triggers to essentially force larger private companies to go public to go. One possible change would be to look through investment vehicles, such as special purpose vehicles or SPVs – currently counted as one ‘holder’ – to count each beneficial owner. This change would penalize diversification and penalize lower-net-worth investors pooling their capital to compete with the larger investors who dominate the space.
Other proposed changes through 12(g) may create earlier triggers based on business valuations or earnings. These artificial boundaries would undermine a growth-stage company’s ability to raise capital by effectively limiting returns on investment. They can also have the unintended consequence of increasing market concentration by making growth-stage companies more vulnerable to takeover by competitors as they approach a valuation or revenue threshold.
What to do about it
Founders and investors should stay informed about these proposed changes: You can follow the latest SEC news and make your voice heard by participating in the regulatory process by submitting written comments.
Private markets have been central to the recovery of the US economy after the Great Recession and continue to drive innovation and healthy competition in US markets. Restricting entrepreneurs’ access to capital and their ability to grow into large and profitable ventures would impose enormous costs on innovation and job creation.
