Exit Early

Great opinion piece in the WSJ today criticizing the Obama administrations proposed changes to securities law and the effect these changes will have on VC and Angels:

As part of their regulatory redesign, Team Obama and Congress still don’t have a plan for reforming the giant taxpayer-backed institutions like Fannie that caused the credit crisis. Yet they’re moving to rewrite the rules for investing in tiny technology companies that had nothing to do with the meltdown. Under the proposed rules, venture firms will be declared systemic risks until they can prove themselves innocent. The typical venture capital (VC) firm has nine principals plus five support staff and doesn’t use leverage. Yet Treasury Secretary Timothy Geithner wants VCs to be regulated as investment advisers by the Securities and Exchange Commission.

This means the firms will be required to send heaps of data to the SEC and be subject to unannounced examinations that can last days, weeks or months. The firms will also have to appoint a chief compliance officer, create written procedures to comply with the various securities laws, and follow new regulations on record-keeping, privacy of client information, marketing, and so on. Information gathered by the SEC will then be analyzed by the Federal Reserve or some other systemic-risk regulator to decide if there is a hidden danger buried deep inside these companies. Never mind that VCs don’t trade derivatives, or much else for that matter.

The article goes on to propose a sensible alternative….

Treasury’s position is that if it doesn’t drag VC firms into the bureaucratic swamp, then high-rolling hedge funds playing with borrowed money will present themselves as venture funds to avoid regulation. Yet any firm calling itself a VC is already subject to the antifraud provisions of federal securities laws. VCs also have to describe the funds they raise in annual Form D filings with the SEC. Washington could let the SEC address any concerns simply by adding three questions to the form: Do you use leverage? Do you trade equities or debt? Do you trade derivatives? Anyone answering “no” to all three would be free to go find the next Microsoft.

The National Venture Capital Association comissioned a review of the impact of the proposed legislative changes on VC fims and their report is available here.

Aside from the compliance costs, which will be significant, their is also a provision that doesn’t allow performance fees (carried interest included) to be charged on funds from investors with < $750k invested in the fund. The lawyer’s memo linked above details this. That implies that a minimum investment in the fund from any LP needs to be $750k or greater to comply (or else the performance fees have to be restructured in some way to be compliant). This obviously will make angel funds (many investors and smaller dollar amounts) much more difficult to structure.