The Securities and Exchange Commission and venture capitalists have traditionally lived in two different worlds, but if a new rule from the regulatory agency advances, VCs could find their world under increased scrutiny.
Nearly a year ago, the SEC started looking at adding regulations around how private investors — think private equity firms, hedge funds, some real estate investment companies, and yes, venture firms — vet deals.
The added scrutiny would also open the door for LPs to push litigation against an investor if proper due diligence was not followed in a completed deal — something VCs have not had to worry about before.
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“The SEC has never really focused on venture capital or private equity before,” said Alan Wink, managing director of EisnerAmper‘s capital markets. “But I think FTX really opened the floodgates here.”
The sudden and complete collapse of crypto exchange FTX — and its affiliates — as well as the downfall of its founder Sam Bankman-Fried likely has generated even more interest by the SEC and others to examine the venture industry.
Earlier in the year, it was reported the agency wanted to probe what type of due diligence investors who poured nearly $2 billion into the failed exchange did before it declared bankruptcy.
What it means
The new push is not surprising, considering the tremendous growth the venture industry has realized, even in just the past decade. In 2021, venture funding hit more than $680 billion. While the SEC is normally associated with the public market, the amount of money and investors in venture make it ripe for regulation.
“The size and amount of money in the industry has changed,” Wink said. “It is a significant asset class.”
At the end of the day, the SEC is looking to protect investors’ returns, said Wink, adding that LPs include not just high-net-wealth individuals, but also groups such as pension funds and endowments.
However, not everyone is enthusiastic about possible new regulations.
The National Venture Capital Association penned a letter last April that stated “the proposed rules are profoundly flawed” and “represents a radical departure from Congress’s longstanding determination that private funds (including venture capital funds) … should not be subject to the type of granular and often intrusive regulatory requirements that generally apply to retail-level investment companies.”
Others do not seem too concerned about the new rules, but as with everything, the devil is in the details.
“I think there has to be more nuance as to how the due diligence is done,” said Yash Patel, general partner at Telstra Ventures. “If the SEC can be more thorough and thoughtful, it’s fine.”
The other aspect the agency has to remember is the very nature of venture. While something like private equity normally invests in the more mature, profitable companies, venture by its definition takes greater chances with young companies that can be nothing more than an idea.
“VCs have a higher mortality rate,” Patel said. “You have to remember that when looking at what happened to certain investments. You have misses but also greater returns.”
Patel adds he does not see the proposed regulations changing the industry greatly, especially since VCs are already doing more due diligence as VC has slowed since the salad days of 2021.
Things already changing
Also, the SEC has become more involved in some aspects of the venture world as investing has changed.
In recent years, large firms such as Sequoia Capital and Andreessen Horowitz have become registered investment advisers with the SEC for different purposes that include holding more publicly traded shares and crypto.
“I think the reality is that VCs expected more regulation,” Patel said. “This is an industry that, depending on the estimate you read, there’s $250 [billion] to $350 billion in dry powder right now. It’s large.”
Patel also does not believe the proposed rule will change the relationship between LPs and VCs. Both parties want to have good partners, and not have shareholders that put pressure on the fund, he adds.
One thing that could change is the expense side for VC firms.
Wink said he expects the new regulation — which could be instituted this calendar year — may mandate outside audits of new investments. New rules such as that likely will increase costs in venture.
“When it comes to compliance, you’ve heard about ‘the cost of being public,’” Wink said. “There will be ‘a cost of being VC-backed now.’”
Illustration: Dom Guzman
Correction: An earlier version of this story misstated the amount of venture funding in 2021.
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