SEC Eyes Big Changes That Could Affect Venture Investors And Growing Unicorn Herd

Although much talk in recent months has been around the regulatory environment involving the Federal Trade Commision and dealmaking in tech, the Securities and Exchange Commission in recent weeks has made its own noise about new rules that could affect the sector.

The commission has started to look into the possibility of requiring large private companies to routinely disclose information about their finances and how they operate, according to reporting in The Wall Street Journal reported in early January. Such a change would likely have the most impact on the growing number of companies that have reached unicorn status.

According to Crunchbase numbers, there are now more than 1,200 such companies globally—nearly half in the U.S., including Stripe, Instacart and SpaceX.

In addition to the changes that could affect large private startups, at the end of last month the commission also proposed new rules regarding private funds, which include required quarterly reporting regarding performance.

Private funds

While many have viewed the proposed changes around funds as the commission wanting to look at hedge funds and private equity more closely, some venture capital would also be affected by the same increasing regulations, said Ken Joseph, managing director for financial services, compliance and regulation at Kroll.

The proposed changes all appear to be geared at making the private markets less opaque.

“I think the SEC under Gary Gensler has been pretty clear that it wants more transparency and more disclosure,” said Joseph, who worked at the agency for more than 20 years.

The commission is seeking changes on private fund reporting to better “assess systemic risk” and protect investors regarding private funds, which have substantially grown in size.

“The private fund industry has grown in size to $11 trillion and evolved in terms of business practices, complexity of fund structures, and investment strategies and exposures,” said SEC Chair Gary Gensler in a release about the proposed changes.

Some of the proposed changes that would affect some venture capital advisers include:

• New quarterly reporting requirements concerning performance metrics and fees charged to both investors and portfolio companies
• Reporting adviser-led secondary transactions
• Disclosure to all investors of so-called preferential treatment for some limited partners

The proposed rules, however, would mainly impact advisers at larger firms who are registered with the SEC—not those who have exemptions, typically those at smaller venture firms, said Gautham Deshpande, an audit partner at EisnerAmper’s San Francisco office who specializes in venture capital funds among other types.

However, since larger firms control the majority of money, the proposed rules could have some effect on the venture world. Deshpande said he is advising clients to make sure they have the “infrastructure” in place if the rules are adopted and more reporting is necessary.

“My take is that the VC community is robust and resilient, and follows the regulations they need to follow,” Deshpande said. “I think it’s important to remember that VC funds make money from investing, not from investors.”

While new regulations can add a bit of a burden—especially to smaller funds—Deshpande said it is a fine line the SEC must walk. Too much regulation is not good, but neither is too little regulation, he said.

The proposed rules will remain in their comment period until mid-April, when the SEC will proceed based on that feedback.

“My guess is that this will happen by the 2024 election cycle,” said Joseph. “They’ll act on it within the next year.”

More transparency on large private companies

While the commission awaits feedback on those proposed rules, its plans around more transparency and disclosure for large private companies still seems to be at a much earlier stage, with Democratic SEC Commissioner Allison Lee leading the charge, the WSJ reported.

Part of the deeper look likely will involve how shareholders of these companies are recorded. Right now, the regulations under the JOBS Act require companies with more than 2,000 shareholders to register their securities with the SEC and have tighter disclosure requirements. However, shareholders who use the same broker or investment vehicle can be counted as one—which can drastically change the total.

Such changes will likely make more reporting necessary by larger private entities—think unicorns—since they have raised a lot of capital and therefore likely have a larger amount of investors

Although last year saw a record number of IPOs, the private market has grown with companies staying private longer and reaching higher, $1 billion-plus valuations. The SEC would love to see more companies go public earlier, and if companies face enhanced reporting requirements, it is possible they may look at doing just that. Ironically, some argue it is the heightened reporting requirements for public companies that turn many still-private companies off from seeking a Wall Street exit.

Joseph said while less has been disclosed about the possible changes, it seems to follow the same basic theme of the newly proposed private fund rules.

“It’s the same approach and the same attitude,” said Joseph, adding Gensler has been open about his desire for increased transparency in the markets. “These are large companies, and there could be benefits from better disclosure.”

Views vary on the enhanced regulations. Some are in favor of more transparency and disclosure in the private market. Others say the commission is overstepping its bounds into a market with sophisticated investors and risks stifling innovation.

Joseph points out that the SEC’s mandate includes informing and protecting all investors—as well as facilitating capital formation, which does not just mean the public markets.

“The mandate of investor protection does not carve out for sophisticated investors,” he said. “It does not differentiate between investors. The same goes for capital formation; it does not differentiate between the private and public.”

Illustration: Dom Guzman