The entire question of Regulation of Venture Capital funds is on the table, as part of the discussion regarding whether hedge funds and private equity funds should be regulated. I believe that this is a discussion that needs to be thoughtful and wide-ranging, but is likely to consist of knee-jerk reactions and name-calling.
Should VC be regulated? To get to that question, we need to consider the goal of regulating any financial services companies. In the US, we have two different types of regulations for securities and financial services companies: federal regulations promulgated and enforced by the SEC and state-by-state “blue sky” regulations. The philosophy behind these types of regulations is completely different, resulting in different types of regulations designed to achieve very different purposes.
The regulatory scheme embodied in the ’33 Act and the ’34 Act, which provide the underpinning for the entire set of SEC-managed regulation system since the Great Depression assumes that investors are smart and able to make decisions for themselves, as long as they have necessary and complete information. Thus, with a very few exceptions (think ponzi schemes and other forms of outright fraud), promoters and investors can do pretty much anything as long as they are open and honest about what they are doing. There is also the recognition that not all investors are the same – so certain highly risky forms of investment are restricted to more sophisticated investments to avoid the naive from being hurt.
Almost all of the federal regulations for issuers of securities deal with disclosure of information: what, when, where, how, etc. The system really is a “trust the market” form of regulation, in which the regulation system makes sure that the market is able to make decisions, but the SEC does not try to make decisions for the market.
I find the SEC to be a fascinating organization. If you are interested in learning more about the SEC’s history, its regulatory authority, its organization, etc., wikipedia has an excellent entry on it at U.S. Securities and Exchange Commission – Wikipedia.
State Blue Sky Regulations
In addition to the federal system described above, each state has its own set of securities regulations, which are generally know as “blue sky” regulations. Unlike the federal system, the Blue Sky regulators examine individual securities offerings to decide whether they are safe enough to be investments for the citizens of their state.
This is truly the “nanny state” at work, and it makes me wonder whether ANY Blue Sky regulators prohibited investments in the asset-backed securities that are now being blamed for triggering the current recession. If not, from what possible situations are they actually protecting society? Do they have any value at all, or are they just an additional cost added onto our system? But I digress – that is a topic for a completely different discussion on another day.
To be honest, I always found Blue Sky regulations to be a major pain in the a$$ back when I was practicing corporate and securities laws. I have enough self-awareness to know that I am not an unbiased commentator with respect to these these regulators or the regulations that they promulgate and enforce. If you would like to learn more about the system, take a look at the coverage at Blue sky law – Wikipedia.
VC Regulation in the Past
To hear the screams from lobbying organizations like the National Venture Capital Association (National Venture Capital Association), any form of regulation that gets applied to the VC industry has a risk of destroying the value-creating engine that is venture investing in innovative, entrepreneurial companies. For example,
Mark Heesen, president of the National Venture Capital Association, said the venture industry doesn’t pose a threat to financial stability and doesn’t affect everyday investors. Since the industry invests about $30 billion a year, mostly using assets from institutions such as endowments and pension funds, Heesen said it is a small slice of the overall financial system that affects mostly sophisticated investors.
“Secretary Geithner has to use a broad brush and we understand that, but at the end of the day we hope that broad brush will be followed by a thinner pencil,” said Heesen. He added that there have been other attempts to regulate the venture industry, particularly following the Patriot Act earlier this decade, but that Congress and regulators ultimately recognized that venture capital operates differently than other financial sectors, such as hedge funds and private equity.
Nat Goldhaber, a managing director at venture capital firm Claremont Creek Ventures in Oakland, Calif., said that regulation could provide a strong disincentive for some people to go into venture capital.
Venture capitalists “enable young people to turn ideas into reality and jobs are created, and we return the lion’s share of profits to institutions like universities who fund us,” Goldhaber said. “If we’re regulated or taxed to the point where it no longer makes sense for us to participate, then the (Obama) administration will be breaking one of the economy’s best golden eggs.”
[Disclosure note: I am a member of the NVCA and think that it does great work. Like all organizations that lobby in Washington, however, it represents only one aspect of a policy issue and depends on the listener to find the other aspects from different sources.]
Before we collectively go off the deep end, however, lets all pause to take a collective breath and realize that the VC industry is already regulated. When my organization raises money for a new fund, we don’t go to the public markets. We don’t advertise. We don’t take IRA money that people will need for their retirement. We only raise money from sophisticated, accredited investors – typically investors that have more than $5 million in liquid investments. This places our fundraising efforts into a particular classification under SEC regulations, which exempts us from many of the requirements that we would otherwise face as an entity raising money. We avoid raising money in certain states because of their “Blue Sky” regulations, which deem venture capital as a very risky investment (which it is!) and thus make it difficult or impossible to deliver to citizens of their state.
Make no mistake about it – the SEC has authority to regulate the VC industry, and it has already done so. The SEC regulations have taken the approach of allowing the industry to provide very little information directly to the SEC in situations in which the investments are offered only to those investors best able to take care of themselves – and best able to negotiate with the VC funds to obtain access to the information that the sophisticated investors this is most important to them.
Venture Regulation for the Future
The regulation system applied to the VC industry in the past has generally worked pretty well. I cannot think of any instances in which investors were outright defrauded by a scheme. I attribute that to the relative negotiation strength of the investors in VC funds and the managers of those funds.
Unfortunately for the VC industry, the system of regulation for private hedge funds has depended on the same type of investor sophistication that the VC regulation depends upon. That system did not especially work well in the case of Bernie Madoff, which raises the specter of a similar situation happening for investors in a VC fund.
I think it is both understandable and to be expected for the SEC to attempt to guard against a VC fund doing what Madoff did. I also think it is foolish for the VC industry to fight it. Instead, the industry should embrace the situation an as opportunity to have an impact on what form new regulations might take, and to use the platform to promote the impact that Venture Capital investing has had over the past 50 years in driving the economic growth of the US.
I believe that good VC investing is a national treasure, and one that needs to be appreciated by our government and public. But no one can appreciate something that they do not understand. And it is very difficult to understand something that chooses to remain completely hidden from view.
Many VC investors are experts in marketing – and help their portfolio companies manage the public discussion about themselves, their technologies, and their products. Let’s use that same expertise to manage the public discussion about VC investing itself and its value.