FILE - This June 19, 2015 file photo shows the seal of the U.S. Securities and Exchange Commission at SEC headquarters, in Washington. The Securities and Exchange Commission on Wednesday, Aug. 5, 2015 voted to order most public companies to disclose the ratio between their chief executives' annual compensation and median, or midpoint, employee pay. The new rule will take effect starting in 2017. (AP Photo/Andrew Harnik, File)
In the name of greater transparency, the Securities and Exchange Commission (SEC) is looking to rewrite some of the basic rules that have long governed the world-class venture capital market in the United States. If the new regulations take effect, however, the result won’t be greater transparency, but increased costs that will lead to undesirable concentration in the VC industry and a steep contraction in capital for startups.
To top it off, the SEC move would deal a blow to the slow but measurable progress the VC industry has made in recent years to open its ranks to woefully underrepresented demographic groups. For the sake of maintaining innovation as the engine of U.S. economic growth, SEC Chair Gary Gensler must call off this ill-advised rulemaking.
VC firms generally raise their capital from highly sophisticated investors — pension funds, university endowments, foundations and family offices. These investors (i.e., limited partners) often commit to providing funding over the course of a decade or more to young, innovative companies. This long-term outlook allows VC firms to take an appropriate level of risk when investing in promising but unproven new ideas.
Despite the fact that VCs work with the most sophisticated investors in the world, Chair Gensler claims that new restrictions on how private funds negotiate with their investors are necessary.
For example, he wants to largely wipe out the ability to use “side letter” agreements in fund agreements. In reality, side letters are an especially important tool for first-time fund managers looking for an anchor investor willing to take a chance on an aspiring VC firm. Such pioneering investors warrant and expect added incentives to go first.
Side letters are also often used at the request of institutional investors to ensure they are meeting their own investment mandates — for example, such letters can provide non-public information on the demographic and geographic breakdowns for companies in the VC fund’s portfolio.
Adopting a “one size fits all” regulatory framework would harm efforts to increase diversity in the VC industry, which has seen slow but steady increases in the representation of women, people of color and other marginalized communities among investment partner roles.
A bright spot for diversity progress has been among newer and smaller firms. VC firms founded within the last 10 years have a larger percentage of historically underrepresented investment partners as compared to older firms: Black (8% vs. 1%), Hispanic (8% vs. 2%), and female (22% vs 17%). Similarly, a more significant percentage of investment partners at small firms are Black, Hispanic, or female than at larger firms.
Yet it’s these newer and smaller firms that will be most vulnerable to regulatory upheaval.
Gensler is advocating for a change that will crush newer, more underrepresented VC investors before they ever get off the ground — and in so doing, shut the door on startup funding for underrepresented founders. It’s a double blow to diversity.
The SEC’s proposal would also make it easier for limited partners to sue VCs when their investments in startups don’t work out. But this approach fundamentally mistakes how venture capital works: Investors know few startups will succeed. But they don’t know which ones. That’s why VC funds have a portfolio of investments. Changing the negligence standard, as the SEC proposes, will encourage junk lawsuits against VC firms.
Contrary to the Biden administration’s competition and diversity goals, the SEC proposal will raise barriers to entry for new VC firms and hamper the deal-making ability of existing ones.
The SEC should be nurturing the ecosystem for venture capital. This proposed rulemaking does the opposite.
Bobby Franklin is president and CEO of the National Venture Capital Association.
Originally published at Bobby Franklin