Many venture capital investors I've spoken with are pleased with the news that the Securities and Exchange Commission may be loosening rules on capital raising by private companies.
But they should be careful. This change might wind up threatening the business model of venture capital firms.
The SEC is reportedly considering raising the 500-shareholder limit on private companies, which would mean that companies could allow more investors to contribute capital without being forced to adopt the burdensome regulatory and disclosure regime that applies to public companies.
Venture capitalists believe this change will make it easier to at least partially cash out of companies they've invested in. For years, the dearth of initial public offerings has made it hard for venture capitalists to realize the gains in tech companies they invest in, even while those companies bring in profits, add users, and have skyrocketing valuations.
If it were easier for companies to raise new capital on private markets, venture capitalists could ride along with those stock sales, selling part of their own stakes in tech companies at what I'll call the Non-Public Offering—or NPO.
But the same reforms that allow these venture capitalists to realize gains on past investments might also limit opportunities for future investments. Rising tech stars might find it cheaper to turn to an NPO rather than go through another round of capital raising with VC firms.
Venture capital is notoriously expensive. Even hot tech firms often find themselves giving up tremendous portions of equity, rights to control, and future gains to bring in capital from VC funds.
One of the reasons for this has been the barriers to entry in the venture capital world. Regulations gave VC firms a lock up on providing capital to fledging non-public companies. Outside investors needed to agree to pay VC firms for the privilege of investing with them, while tech companies had to turn to the VCs to raise capital.
A lifting of the limit on investors could provide new sources for funding—and new competition for venture capitalists. If instead of investing in a VC fund, a wealthy individual could call his broker to get a stake in a hot, non-public tech firm, some VC investments will no doubt dry up. And if start-ups can turn to a broader investing public, they can better hold down their cost of capital.
In short, the new rules may provide exits for venture capital. But they may also close off new entrances.
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