With the failure of Silicon Valley Bank, the US startup ecosystem lost an important trading partner. But the biggest consequences could be what comes next: a series of tougher regulations targeting not just midsize banks like SVB, but also private companies and funds. Although SVB’s failure cannot be attributed to the ecosystem of companies, some lawmakers have joined the general public in smearing the bank’s depositors, largely corporate-backed start-ups. This negative narrative has immense implications for the risk community.
This is a turning point. In a change from the past two decades, policymakers and regulators had already begun scrutinizing private markets. If more lawmakers are 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 alter companies as we know them. And the scale of the SEC’s proposed reforms should alarm entrepreneurs, investors and employees in the innovation economy.
Three key areas of intervention proposed by the SEC offer examples of why the risk community should pay attention.
The SEC’s Current Agenda: A public list Of the regulations the agency is considering contain proposals that will increase barriers to capital for companies and funds, restrict investor access and potentially push more companies from private to public. In short, the SEC’s actions could slow down one of our biggest drivers of innovation.
Three key areas of intervention proposed by the SEC offer examples of why the risk community should pay attention:
Rising 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 created to optimize their ability to raise capital, operate and innovate with fewer regulatory constraints. Because private companies are often earlier in their life cycle, they are subject to fewer compliance and disclosure requirements.
The SEC is looking to change that by making changes to Regulation DThe mechanism that allows private companies and funds to raise capital without registering their securities or going public, is the framework used by most new companies and funds to raise capital. signs they suggest that the Commission could require companies raising capital under Reg D to disclose more company and financial information. But these disclosures carry significant financial costs for small private businesses, and carry the added risk of exposing sensitive financial information to competitors and large, established corporations. Additionally, penalties for non-compliance could permanently damage a company’s ability to raise capital.
Last year, the SEC also proposed rules that could make it more difficult for emerging fund managers to raise capital by introducing new bans on venture capital advisers, who are not normally regulated by the SEC. Congress deliberately removed venture capital from the SEC’s registry, but the SEC nonetheless proposed rules that would indirectly regulate venture capital by prohibiting common industry practices. Two in particular worth noting:
- A lower bar for demands: The SEC has proposed barring venture capital advisers from being compensated for simple negligence, meaning GPs could face lawsuits for failed investments that were made in good faith and with proper due diligence if a deal goes awry. It would also be riskier for GPs to support portfolio companies, as more involvement would lend itself to more liability.
- Side Card Ban: The SEC’s proposal would also effectively prohibit the use of side letters, a common practice in venture firms. Side letters help fund managers attract larger, often more established LPs by customizing deal terms, such as access to information and cost structure. Limiting side letters may not drastically affect larger funds, but would have a huge impact on smaller EM funds, which often use them to secure anchor LP as their funds grow. This is likely to have the effect of money being funneled into the larger funds that present less perceived risk.
Restriction of investor access to investment opportunities
Private market investments tend to be earlier in a company’s life cycle and less informed than public company investments. Consequently, they are considered riskier than investing in real estate or the public markets. To protect investors, federal securities laws restrict participation to high net worth individuals, as well as those with financial certifications that demonstrate 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, potentially indexing them for inflation that reflects the regulation’s 40-year history and limiting which assets qualify for the wealth test. Doing so would exclude a large part of the population from private market investment. This would prevent more people from investing in growth-stage companies that can generate strong returns and diversify their investment portfolio. It is the protection of the investor through the exclusion of the investor.
Also, higher wealth thresholds would have a huge impact in smaller markets where wages, cost of living, and asset values are lower. Such a move would further cement the coasts as capital hubs for private markets, even as promising risk hubs have begun to emerge in places like Texas, Georgia and Colorado. It would also limit access to capital for underserved and underrepresented fund founders and managers, who often lack access to more traditional networks of wealth and power.
Forcing companies to enter public markets
Perhaps the most impactful changes the SEC is considering would be Section 12(g) of the Securities Exchange Act of 1934, which defines the number of “registered holders” a company can have before being pushed onto the public markets at be subject to the same information 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 either changing the way “holders” are counted or adding new triggers to essentially force the largest private companies to go public. One potential change would be to “revise” investment vehicles, such as special purpose vehicles or SPVs, which are currently counted as an “owner”, to count each beneficial owner. This change would penalize diversification and disadvantage less wealthy investors who pool their capital to compete with the larger investors who dominate the space.
Other suggested changes a 12(g) could create earlier triggers based on company valuations or revenue. These artificial limits would undermine a growth-stage company’s ability to raise capital by effectively limiting investment returns. They could 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 news from the SEC and make your voice heard by participating in the standard development process by submitting written comments.
Private markets were instrumental in the recovery of the US economy from 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, profitable companies would come at a tremendous cost of innovation and job creation.