The SEC slams venture capital

Larry Ribstein —  19 November 2010

Dodd-Frank imposed registration requirements on advisors of hedge funds.  The act exempted venture capital funds but left it to the SEC to define these funds.  The SEC has now proposed a definition as part of new rules implementing Dodd-Frank’s hedge fund provisions.  According to the SEC’s press release,  a venture capital fund is a private fund that:

       Represents itself to investors as being a venture capital fund.

       Only invests in equity securities of private operating companies to provide primarily operating or business expansion capital (not to buy out other investors), U.S. Treasury securities with a remaining maturity of 60 days or less, or cash.

       Is not leveraged and its portfolio companies may not borrow in connection with the fund’s investment.

       Offers to provide a significant degree of managerial assistance, or controls its portfolio companies.

       Does not offer redemption rights to its investors.

The rule grandfathers existing funds that have represented themselves as venture capital funds “because it could be difficult or impossible for advisers to conform existing funds, which generally have terms in excess of 10 years, to the new definition.”

But the SEC feels comfortable locking new funds into terms that could constrain their activities for long periods in a dynamic investment environment.  Although today’s VC funds may conform to the SEC’s definition, it is not clear that they will always want to, say, avoid debt or redemption rights.  The costs associated with this inflexibility are especially problematic given VC funds’ need to adjust to the drop in initial public offerings, which traditionally provide a critical opportunity to exit from investments.  

Real unemployment is climbing toward 20% and new firms with new ideas can create jobs.  Venture capital is a key mechanism for funding start-ups.  Somebody should pass this information onto the SEC.

Larry Ribstein

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Professor of Law, University of Illinois College of Law

14 responses to The SEC slams venture capital

  1. 

    The SEC is still a bunch of clowns, but venture capital may be dead long before the SEC finalizes a regulation:

    November 22, 2010, 9:11 pm Venture Capital | DealBook Column
    http://dealbook.nytimes.com/2010/11/22/a-dim-view-of-betting-on-start-ups/
    A Dim View of Betting on Start-Ups
    By ANDREW ROSS SORKIN

    “According to the Cambridge Associates U.S. Venture Capital Index, venture capital returned a paltry 8.4 percent to investors in the last decade, starting in 1999. Ernst & Young reported last month that venture capital investing had fallen off a cliff this year, down 47 percent in the first half of the year compared with the period a year earlier.”

  2. 

    I know this is a stupid question, but why is the SEC proposing a different definition of venture capital that the one used under ERISA by DoL?

    29 C.F.R. 2510.3-101(d)(1)

    Is there any reason not to defund these clowns?

  3. 

    Odd that the VC community here in Silicon Valley has been a big supporter of President Obama and the Democratic Party and that NOW the SEC decides to close the regulatory gate on NEW venture capitalists.

    That certainly fits with their investments in government-supported and regulated businesses, especially “green energy.”

    How did this bunch of capitalists decide to become whole hog rent seekers?

    A pox on them all.

  4. 

    Thank God the 2 biggest dem crooks in congress, Dodd and Frank (up to their ears in bribery and incompetance, who repeadedly ignored warnings about the real cause of the crisis, Fanny Mea), with lots of demagaguery help from Obama, were able to give us banking/financial reform (with loads of new regulation that had nothing to do with the crisis, but nothing about Fanny Mea, the main cause of the crisis). These boobs have just killed the goose that lays the golden egg, venture capital, the only real hopw to create enough jobs to drag us out of this mess. Its almost like these guys dont beleive in capitalism, and only want to grow government. No, that couldn’t be true, the MSM always tells us how silly people are when they say Obama and the dems are socialists.

    We already know Obamacare is trash, and should be repealed. The financial reform bill is almost as bad, and should be repealed as well.

  5. 

    The SEC is a bunch of boobs. They totally missed Maddoff and did not fullfill their obligation to make sure 10-Ks of Citi, Merril, Bear, Lehman were honest.

    There will not be much VC without a robust IPO market and going public looks pretty stupid give SarbOx and other regulations, including taxes on cap gains.

    If anything regulations and taxes will continue the march of private equity.

  6. 

    TheBuckWheat above, is correct. I’ve presented to angel investors and received angel investment which was – and still is – essential to growing my company. Based on my research and what I understand right now, none of the angels who have invested in my company to date would have been able to do so under the SEC’s proposed changes to the requirements for “Qualified Investors”.

    If anything, they should lower the requirements…

  7. 

    And if this were not bad enough, the SEC is pondering raising the financial levels required to meed their definition of a Qualified Investor. You know, the rules that consider Lindsay Lohan to be Qualified to invest in startups because of her income. But the SEC seems deaf to the facts of angel investing: that napkin-stage companies have only angel investors and friends/family to look to for funding. Yet who make up angels? In my experience, angel investors are largely people who have done well in life but are not spectacularly wealthy. Based on the angel pools I have presented to, should the SEC raise the minimum assets from $1 million to $2 million, it will cut the number of angel investors in half.

    In other words, if the SEC was planning to kill new company formation in this country, this would be one of the steps it must take.

    We are going to starve to death on this kind of hopium.

  8. 

    > not to buy out other investors

    Lots of VC funds do that today. They do it so the founders can take some money off the table, to get rid of “troublesome investors”, to get stock back from folks who left early before their 803(b) stock vested, etc.

    I suppose that it’s too much to expect that the SEC understand how the entities that it regulates actually work.

  9. 

    This will make it very difficult for private equity funds to cross over into PIPE and other investments, something that the largest and most successful venture funds have done for years. It also appears to restrict the ability of VC funds to provide bridge debt to portfolio companies, something quite critical in many cases where new fundraising is not in sync with cash balances.

    Lastly, this is bad for entrepreneurs who as a result of the terrible IPO climate have accepted offers from VC firms where the invested capital was used not just for business expansion but also to buy out shares of founders and other key employees. It would appear that under this definition that activity would not be legal.

  10. 

    I am much more concerned about the fuzzy nature of

    “Offers to provide a significant degree of managerial assistance, or controls its portfolio companies.”

    What is significant? How does this apply to funds that “follow” larger funds but cannot (indeed are not allowed) to be on the board? Also, how many funds really can provide significant degree of managerial assistance–as opposed to direction at the board level?

    This is completely insane and counterproductive. The bureaucrats have no idea what they are doing and will only break up one of the most efficient creators of new jobs and wealth in the world with their meddling.

    btw, the reason that there are no public equity exits any longer is because SEC meddling has turned being a public company from an opportunity to a huge risk that is too expensive for any company with less than $100million in revenues. So access to public equity is limited to only the existing gigantic companies. Good job, regulators! You passed counter-productive laws like SarBox which only protect large donators while refusing to apply SarBox regulations to criminal operations like Fannie/Freddie.

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