2 posts categorized "June 2009"

Regulation of VCs: What's the Impact on Startups & Emerging Companies?

The Treasury Department's whitepaper on financial regulatory reform, released last week, includes a proposal to require venture capitalists to register with the SEC as investment advisers.  VC industry reaction has been negative.  My buddy Joe Wallin thinks such reforms could impair the flow of capital to startups.

Here exactly is what the Treasury Department proposes, at page 37 of the whitepaper:

All advisers to hedge funds (and other private pools of capital, including private equity funds and venture capital funds) whose assets under management exceed some modest threshold should be required to register with the SEC under the Investment Advisers Act. The advisers should be required to report information on the funds they manage that is sufficient to assess whether any fund poses a threat to financial stability.

Many professionals who manage other peoples' money already register with the SEC as investment advisers.  As I've noted before in this blog, it seems prudent to eliminate gaps in coverage in the overall regulation of financial products.  RIAs (registered investment advisers) I've communicated with in recent days -- professionals who are registered with the SEC and are very active in financing startups -- have told me they don't see why VCs should object to similar registration.

At the same time, one RIA cautioned that certain reporting requirements that now apply to RIAs might, if extended to VCs in certain ways, have negative effects on startups.  This person noted that RIAs have to disclose all investment entities that they manage, and state current valuations.  Were such regulations extended to VCs and construed to require valuations of startup companies within a given VC portfolio, startups and emerging companies could be harmed.

At this point, I haven't seen a Treasury proposal for periodic valuations of VC portfolio companies.  It does not seem to be a feature of what the government proposed last week.  Below is an excerpt from further discussion in the Treasury whitepaper, also on page 37, describing recordkeeping and reporting requirements for VC (and other) funds.

We further propose that all investment funds advised by an SEC-registered investment adviser should be subject to recordkeeping requirements; requirements with respect to disclosures to investors, creditors, and counterparties; and regulatory reporting requirements. The SEC should conduct regular, periodic examinations of such funds to monitor compliance with these requirements. Some of those requirements may vary across the different types of private pools. The regulatory reporting requirements for such funds should require reporting on a confidential basis of the amount of assets under management, borrowings, off-balance sheet exposures, and other information necessary to assess whether the fund or fund family is so large, highly leveraged, or interconnected that it poses a threat to financial stability. The SEC should share the reports that it receives from the funds with the Federal Reserve. The Federal Reserve should determine whether any of the funds or fund families meets the Tier 1 FHC criteria. If so, those funds should be supervised and regulated as Tier 1 FHCs.

Emphasis added.  By my reading, it looks as though the Treasury is contemplating that reporting requirements will differ for different kinds of investment pools (e.g., hedge funds and VC funds might report differently), and that information about "assets under management," where required, might be reported on a confidential basis.

The National Venture Capital Association argues that venture capitalists should be altogether exempt from new regulation because the industry as a whole is too insignificant to possibly pose a systemic threat to the financial system.  The NVCA's position is that Form D filings (the same kind of filings startups and emerging companies make for private offerings) made by VCs in the course of fund formation represent appropriate and adequate regulation.

My opinion is that VCs and the startup community should focus, not on opposing regulatory reform altogether, but on making the case that a VC's registration and reporting should not encompass detailed information about its funds' portfolio companies.  There is still time to draw the right lines in this debate; startups and emerging companies, and not financial investment professionals, need the shielding.

Lawyers & Term Sheets

This post is, in a way, a riff on the recent "Term Sheet Manners" post on Fred Wilson's blog.  My message to entrepreneurs is, "always include your lawyer in the first build."  (And to the lawyers among my readers, I say, "call your clients out when you catch them being penny wise and pound foolish.")

In his post, Fred emphasizes the value of direct, principal to principal communication when it comes to negotiating deal terms.  He notes the damage that can be done to business relationships when lawyers' redlines are used, not to finesse language to agreed upon points, but to signal changes in material terms that have not yet been discussed.

I don't have a problem with any of this.  Fred's points are sound and reflect good business and personal manners.

What I find missing in the discussion (Fred's post and the twenty or so comments on it I have read so far), though, is express acknowledgement of how very prudent it is to involve your lawyer in the initial brainstorming and shaping of proposed terms.

There is a subcurrent--no, it is really its own channel, or a separate river building into a rage--in business discussions these days, espousing the thesis that lawyers are vendors or, as I saw it put in a NY Times article this week, "factors of production" (quoting NY lawyer Philip K. Howard).  Exciting changes are afoot in the way transactional lawyers will practice, and I agree that many standard terms and even entire transactional documents could and probably should be commoditized.  

But entrepreneurs who are creating new paradigms and upsetting established ones still use lawyers to mediate encounters with the workaday world and its existing rules and conventions.  Every savvy New Internet entrepreneur I know treats his or her lawyer as a best friend and essential advisor.  Where you simply have to cut costs, it's often better to forego the 40 page document and get a simple agreement cut from an informed, well-built term sheet that leverages all of your lawyer's experience and analytical skill.

Put it this way:  if you are drafting a term sheet or making changes to it without your lawyer's involvement, and your lawyer doesn't slap you upside the head when she or he finds out, you need to get a new lawyer.  

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