The Madness of the Venture Capital Exemption

Confused man
Confused man

When Congress granted the Securities and Exchange Commission new powers to require private investment funds to register and make disclosures, it ordered the agency to create an exemption for venture capital funds.

The rules announced Wednesday include a venture capital carve-out. But the carve-out is so complex, many venture capital funds might just decide it isn't worth the hassle.

In order to qualify for the venture capital exemption, funds can not invest more than 20 percent of their capital in "non-qualifying investments." This limit was put in place in order to prevent every fund from simply declaring itself "venture capital" on the grounds that it holds some investments in a non-public company.

But this means that venture capital firms will have to monitor their investments not for their profitability but for where it puts them on the regulatory scales. Let's say, for example, that a fund was an early investor in LinkedIn. When LinkedIn has its IPO, do these shares suddenly become non-qualifying? What happens when the share price doubles immediately following the IPO? Technically, the firm's assets have jumped in value, which should be very good news. But that jump could throw the fund out of compliance with the "qualifying investment" exemption.

Has anyone considered what this could do to the IPO market? If venture capital firms are worried about holding equity in companies soon to go public, or will be forced to sell all of their stakes in a company once it is public, will they have incentive to keep companies private longer?

There's also a hidden advantage for already established venture capital funds. The ones that marketed themselves as venture capital before 2010 are "grandfathered" into the exemption. This means that new funds will be at a disadvantage to older funds.

All of this will make for great employment opportunities for compliance lawyers, of course. But every dollar spent on the lawyers is a dollar not put to work in a start-up or innovative private company.


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