Venture Capital IS a Regulated Industry
A Lawyer’s Guide To VC Regulation
VENTURE CAPITAL IS A REGULATED INDUSTRY
A Lawyer’s Guide To VC Regulation
This week, I thought I would do just a quick 101 primer on laws and regulations around Venture Capital. I thought it would be quick & dirty (like diligence at most funds.) Y’all there was no way on earth to make this quick. At all. (So I apologize in advance because this is a looooong-ass post. Muh Bad.) Every time I spoke with someone in the VC community, I became more and more disillusioned by how little some knew of the regulations that affected their own jobs and industry. It’s pretty bleak out there y’all. But at the same time, it became more and more apparent that this post is about 15 years too late for some people.
Next week I am releasing my podcast episode with Nik Talreja, the CEO of Sydecar and we dive even deeper into the topic, so stay tuned after this week for even more educational content around this really important topic.
Okay so let’s just go for it. It’s not the quick & dirty post I imagined when I started writing but it’s what we need. Get a glass of your favorite tipple and settle in.
Basically, this is the best way to summarize this post…
Contrary to what the most popular fail-sons on Twitter believe, there are serious laws and regulations for Venture Capital that impact the startup and larger tech ecosystem significantly.
In the past 10 years, it’s felt like everyone and their mother started a venture capital fund. And I do mean EVERYONE. I’m pretty sure we were on the cusp of Karl Lagerfeld’s cat Choupette starting a VC fund before the markets turned downwards. (Y’all…in your spare time today explore Choupette and his life…I’m not joking when I say that cat lives A LIFE!)
A lot of folks started funds because they wanted to fund their boys’ stupid ideas, or because they wanted some extra deal flow in their dating lives. Not very many folks started funds because they ACTUALLY were good investors or because they had any idea of how to turn a nascent idea into an IPO-worthy company. And now, because of those things, and a lot of other really dumb things, we now have way more funds than necessary.
As of 2023, there are approximately 10,000+ active venture capital firms in the United States. Unsurprisingly, the largest venture capital firm in the U.S. is Andreessen Horowitz, with an AUM of over $35 billion! Currently, the top 10 largest venture capital firms in the U.S. are:
Kleiner Perkins Caufield & Byers
Tiger Global Management
New Enterprise Associates
The U.S. venture capital industry has approximately $235 billion invested annually. The industry is projected to grow at a CAGR of 20.1% through 2027. The growth of the venture capital industry is being driven by a number of factors: the rise of new technologies, the increasing number of startups building with those new technologies, and the growing demand for venture capital funding for those startups.
If these numbers hold true, then Andreessen Horowitz’s AUM accounts for a biiiiig chunk of the entire venture capital industry. This is a mind-boggling statistic.
A lot of folks think about venture funding from a very linear perspective—the roadmap for venture funds is to start small and raise bigger and bigger funds. But if 1 fund accounts for a lot of AUM within the entire industry, it sort of flips a lot of preconceived notions on its head. It’s probably more similar to wealth inequality, where 99% of wealth is trapped in the 1% of people. A16Z accounts for a huge chunk, and the rest of us are playing for scraps. And on top of that, the venture ecosystem as a whole is probably really dependent on Andreessen Horowitz, for better or worse. If A16Z is capturing more of the venture AUM, that not only means that there are fewer big dollars for other funds, but also that if you aren’t in the A16Z ecosystem, you’re not “in the cool clique.” This also makes sense why Andreessen Horowitz is exploring things like fund of funds; that’s a lot of AUM for one fund to deploy, and with the startup ecosystem flatlining, they need to figure out other asset classes to deploy into, like emerging managers. (Let me just say, I applaud A16Z for doing a great job of market capture, but the industry numbers do make me think as an LP. It should also make fund managers think a lot about diversification and what startups are being covered. Turns out portfolio diversification matters to LPs too.)
Contrary to what some folks believe, venture capital investing is not an unregulated domain. There is a complex web of laws and regulations that govern it. These rules aim to strike a delicate balance between protecting investors that fund VC firms (limited partners or LPs); maintaining fair, orderly, and efficient markets; and facilitating capital formation.
While these rules are pretty complicated, they’re also readily available. Unfortunately, not a lot of folks have taken the time to dive deep into them. A lot of associates and new VCs have entered the venture landscape with a real lack of understanding of the regulatory framework and are setting themselves and their investments up for possible disaster. (I pray to G-d that a low of folks who are blindly operating in VC read this post and get at least something of value from it. If you can’t name one regulation that applies to VC and you say you are a VC investor this is you btw…)
Overview of Venture Capital and its Significance in the Tech and Startup Ecosystem
First off, let’s back up and talk about what exactly IS venture capital. I’m gonna be real honest…as an LP, I have met more than a few VC investors who could not actually explain what venture capital is. That speaks volumes about the level of education we required over the past few years for entry into this type of investing.
Venture capital is a subset of private equity (surprise!) that refers to equity investments made for the launch, early development, or expansion of a potentially high-growth business. These investments are generally characterized by high risk and potentially higher returns. A venture capital firm usually raises funds from institutional investors, family offices, and high-net-worth individuals, which are then invested in a portfolio of startups or early-stage companies that demonstrate significant growth potential. (Don’t get me started on the fact that most investments made over the past 10 years rarely meet this basic standard. That’s a rant for another day.) Unlike traditional forms of financing, venture capital is often willing to invest in startups that lack tangible assets or a track record but have high growth potential due to their disruptive ideas or technologies. A venture capital firm should not only provide necessary capital but also value-added services such as strategic advice, networking, operational support, and assistance in future funding rounds. Seriously, there should be some actual “value add” and if there, isn’t please move on to another type of investing.
Venture capital has had a significant impact on the technology sector, the broader startup ecosystem, and the overall economy as well. VC plays a pivotal role in driving economic growth essential financing and strategic support to high-potential startups, and serves as a cornerstone for technological advancement and economic dynamism.
Venture capital has become more and more critical to economic growth, and there’s no other place that embodies that philosophy more than Silicon Valley. In the Bay Area, venture capital has played an instrumental role in the emergence and growth of tech giants that now define our day-to-day life, such as Apple, Google, and Facebook, among others.
The willingness of venture capitalists to invest large sums in unproven, innovative ideas has led to breakthroughs that have defined the digital age. We owe most of our modern lifestyle to ground-breaking venture capital investors (for better or worse.)
However, (in theory) the venture capital investment process is highly selective and subjective, with only a fraction of companies that seek venture capital actually receiving funding. According to a study by CB Insights, only about 0.05% of startups that seek venture capital funding actually get funded. This means that for every 20,000 startups that seek venture capital funding, only one startup will actually get funded.
As a founder, even if you do everything right, there is still no guarantee that you will be able to secure venture capital funding. (So for the sake of everyone…don’t go into fundraising expecting to get funded out of a sense of entitlement to funds. Just a personal pet peeve at the moment…)
What Laws & Regulations Apply To VCs Right Now?
As I warned y’all already, VC operates within a comprehensive regulatory framework, predominantly established to safeguard limited partner investors and maintain market integrity.
The Securities Act of 1933 and the Securities Exchange Act of 1934 are THE foundational securities laws in the U.S. The Securities Act requires that any offer or sale of securities be registered with the Securities and Exchange Commission (SEC), unless an exemption is available. In venture capital investing, exemptions such as Rule 506 of Regulation D are often used, permitting private placements of securities to accredited investors without public disclosure. Most startups raise capital through processes that fall under 506 D regulations—which is why startups don’t have to publicly disclose any information about their fundraising. Announcing funding rounds is much more about PR and marketing than adhering to VC and startup regulations.
The Securities Exchange Act regulates a lot—everything from fraud and manipulation to registering exchanges and brokers dealing with secondary trading of securities. For venture-backed startups, the most applicable part of the Act is ensuring that companies comply with strict and thorough reporting requirements when these startups go public. Usually, this means getting a lot of information from venture capital firms, which means VCs need to keep detailed reports and documents on the off chance one of their portfolio companies goes public. This is why VC funds have massive back-office departments—mainly to handle things like this.
The Investment Advisers Act of 1940 governs investment advisers (duh), which typically include venture capital fund managers. However, the Dodd-Frank Act provided an exemption for venture capital fund advisers from the bulk of the regulatory burdens of the Advisers Act, subject to certain conditions. So, while VCs back in the day had to deal with the Investment Advisers Act, most modern-day VCs are largely exempt.
Some of the top funds—like Andreessen Horowitz, Sequoia, Benchmark, ICONIQ, Coatue, and plenty more—are also registered investment advisors (RIAs…here’s a list from October 2022 from Venture Capital Journal.) Why? The main reason is to allow these funds to dedicate more than 20% of their fund into “non-traditional” investments, like public market stocks or crypto. As more tech startups go public, these VCs are being asked to manage public positions on behalf of their LPs. And with the recent boom in crypto and emerging funds, a lot of larger funds wanted the flexibility RIAs offer. The downside? This leads to a lot more regulatory scrutiny, harsher rules, and more regular reporting to the SEC and other regulators.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 brought significant regulatory changes affecting private fund advisers, including those to venture capital funds. Although venture capital fund advisers are generally exempt from registration under the Advisers Act, they are required to maintain records and provide reports to the SEC under Dodd-Frank. These include things like Form D filings, which funds need to make before they start actually fundraising.
The Jumpstart Our Business Startups (JOBS) Act of 2012 made several changes beneficial to venture capital-backed companies. Title III of the JOBS Act, often referred to as the "Crowdfunding Regulation," permits companies to raise capital through online crowdfunding platforms, opening new avenues for fundraising. There are a ton of nuances for crowdfunding platforms helping startups raise, so if you’re interested, hit the link above. (Just a reminder: I’m not your lawyer!)
These laws and regulations provide a robust framework within which venture capital operates, balancing the need to foster entrepreneurial activity and protect limited partners. Their impact on the conduct of venture capitalists, the deal-making process, and the broader startup ecosystem, however, warrants a much closer look, so let’s get to that.
What Impact Do These Rules Have On Startups, The Tech Ecosystem, And Venture Capital?
“But Stevie,” you exclaim. “These regulations are so old! Why do they apply to me?” While rules like the Securities Exchange Act are almost 100 years old, they still not only apply but are strictly enforced. And honestly, they work pretty well, considering there hasn’t been a huge scandal in venture capital (outside of FTX.) And that’s actually pretty rare for an entire asset class throughout the history of financial services. Despite that, a ton of VCs advocate for less regulation and less reporting. Bless their hearts.
But we have to call a spade a spade—while these regulations have a lot of benefits, they also pose certain challenges that folks should be aware of.
The biggest benefit of these rules is the environment of trust and transparency that they foster within the venture capital industry. Historically, most investors have trusted VC investors, mainly because venture capital and startups are playing on the same field as public companies and other businesses. I would be remiss to omit that this trust has dissipated quite a bit recently. Poor returns on misguided and negligent investments have made a lot of LPs second guess the decision-making at some VC firms.
Additionally, the Investment Advisers Act of 1940 sets a baseline of expectations for ethical conduct among fund managers (even though Dodd-Frank exempts a lot of the Investment Advisers Act). This trust plays a crucial role in attracting capital to the sector from professional investors, other larger funds, and institutions. This trust has helped the venture capital sector get larger and attract more AUM over time.
Regulations such as the JOBS Act have also opened up new funding avenues for startups. By allowing equity crowdfunding, it has broadened the access of smaller, innovative companies to necessary capital.
On the flip side, regulatory compliance can be costly and time-consuming, especially for early-stage startups that lack resources.
Furthermore, the definition of "accredited investor" in Rule 506 of Regulation D has been criticized for limiting the pool of potential investors for startups. This limitation may inhibit the flow of capital to the sector.
But, frankly, there aren’t that many negatives for regulations in venture capital. Sure it means more reporting and keeping things organized on the back-end, but you should really be doing that if you’re adhering to your fiduciary duties. The only time these rules are negative is if you’re doing shady shit, which you really shouldn’t be with other people’s money (or at all, but not my circus, not my monkeys.)
Venture Capital Investing & Advertising
One of the more under-discussed topics in venture capital is the effect regulations have on advertising. I’ve gotten a ton of questions about that over the years. Venture capital firms in the United States operate under pretty specific regulatory guidelines when it comes to advertising and solicitation. So let’s take a gander!
Historically (Yay history!), private placements of securities, which is the usual route for venture capital investment, were subject to a ban on "general solicitation" and "general advertising," under Rule 506 of Regulation D of the Securities Act of 1933. This meant that VC firms could not publicly advertise investment opportunities (including their own funds, but also direct investments organized by the fund) and could only offer them to individuals with whom they had a pre-existing relationship.
However, the Jumpstart Our Business Startups (JOBS) Act of 2012 brought a few changes to these rules. Title II of the JOBS Act lifted the ban on general solicitation and advertising, but only for offerings to accredited investors. Accredited investors are typically high-net-worth individuals or institutional investors who meet certain income or asset thresholds defined by the Securities and Exchange Commission (SEC).
VC firms that choose to engage in general solicitation under Rule 506(c) must take "reasonable steps" to verify the accredited investor status of their investors. This is a more stringent requirement than under Rule 506(b), which allows self-certification by investors of their accredited status. I will be really honest here…most investors are not doing enough to verify this status. Some of y’all are a disaster just waiting to happen with that.
Also, VC firms that are registered as investment advisers (RIAs) with the SEC or a state regulator may be subject to additional advertising rules under the Investment Advisers Act of 1940 or similar state laws. So yes, regulations on regulations. Get on that folks.
Even with the lifting of the ban on general solicitation and advertising, VC firms must still adhere to anti-fraud provisions under federal securities laws. They are required to provide accurate, non-misleading information about themselves and the investment opportunity. This is where I have also seen some pretty shady behavior. Let’s be real - “Fake it til’ you make it” can actually be pretty gosh darn illegal, particularly with other people’s money.
The anti-fraud provisions of the federal securities laws are designed to protect limited partners from fraud and misrepresentation. These provisions apply to ALL persons who offer or sell securities, including venture capital firms.
The most important anti-fraud provision is Section 10(b) of the Securities Exchange Act of 1934, which prohibits the use of "any manipulative or deceptive device or contrivance" in connection with the purchase or sale of a security. This provision is broad and can be interpreted to cover a wide range of conduct, including making false or misleading statements, omitting material information, and engaging in insider trading.
The SEC can bring civil enforcement actions against violators of these provisions, which can result in fines and other penalties. In some cases, the SEC can also bring criminal charges against violators.
Venture capital firms must be very aware of the anti-fraud provisions of the federal securities laws and take steps to comply with them. This includes, but is not limited to, the following:
Making sure that all communications with investors are truthful and accurate.
Disclosing all material information to investors.
Avoiding insider trading.
Obtaining the proper registration or exemption from registration for any securities that they offer or sell.
By following these steps, venture capital firms can help to protect themselves from liability under the anti-fraud provisions of the federal securities laws.
Here are some specific examples of anti-fraud violations that venture capital firms can commit:
Making false or misleading statements about a company's financial performance or prospects.
Omitting material information about a company's business or operations.
Trading on inside information about a company.
Failing to register securities with the SEC.
Venture capital firms that commit anti-fraud violations can face a number of penalties, including:
Disgorgement of profits.
Damages to investors.
I am not exaggerating when I say that the most important prerequisite to starting to operate in the venture capital space should be an awareness of the anti-fraud provisions of the federal securities laws, and learning how to take serious steps to comply with them. By doing so, investors can help to protect themselves from liability and ensure that they are acting in the best interests of their limited partners. Like y’all. Stop pissing off your LPs with fraud. (I cannot believe I have to say shit like this sometimes lol.)
Don’t Be Stupid on the Socials
The use of social media and other online platforms by VC firms and their employees/agents also raises regulatory concerns. The SEC has issued pretty strict guidance stating that the use of social media is subject to the same rules as traditional advertising channels. The aforementioned Securities Act of 1933 and the Securities Exchange Act of 1934 restrict how VC firms can communicate with potential investors, and they can impose severe penalties for violations. This means that social media posts need to avoid a few very common regulatory pitfalls such as:
Insider trading: VC firms have access to material non-public information about the companies they invest in. This information can be used to make trades in the securities of those companies, which is illegal insider trading. Never post something on social media that is non-public about a portfolio company.
Market manipulation: VC firms can use their social media presence to manipulate the market for the securities of the companies they invest in. For example, they can make false or misleading statements about a company's financial performance or prospects in order to drive up the price of its stock. Y’all need to start really being careful about posting things about portfolio companies or their competition…TWITTER IS PUBLIC AND WE SEE Y’ALL DOING STUPID SHIT. There’s a fine line between hyping up your investments and market manipulation that I see a lot of emerging fund managers playing hopscotch on.
Privacy: VC firms collect a lot of personal information about potential limited partners and startup customers through their social media platforms. Nowadays, VCs pride themselves on their “social reach” and think this is a value add; because of that, they try to quantify the impact their tweets and other social posts have. This information can be used to track the investment activity of limited partners and other competing funds.
Be careful about what you are scraping and how you are utilizing personal information on people. Don’t share information. Even with your struggling portfolio company that just needs a lil’ bit of a leg up.
VC firms should take a few basic steps to address these regulatory concerns. This includes, but is not limited to, the following:
Developing and implementing policies and procedures for using social media and other online platforms. These policies should be designed to comply with all applicable securities laws and to protect investors from fraud and manipulation.
Training employees on the use of social media and other online platforms. Employees should be aware of the regulatory restrictions on their communications with potential investors and of the potential for insider trading and market manipulation.
Taking steps to protect the privacy of personal information collected through social media and other online platforms. VC firms should only collect personal information that is necessary for their business purposes and should take steps to secure that information from unauthorized access.
By taking these pretty easy steps, VC firms can help to protect themselves from regulatory liability and ensure that they are acting in the best interests of their investors.
Case Law & Case Studies
There are also a few pretty historic cases that have helped determine precedent for the legal responsibilities of folks involved with the VC ecosystem. A few that everyone should know are as follows:
Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. (1986): This case established the "Revlon duties," which require a board of directors to conduct a fair and open auction for the sale of a company when it is under threat of a hostile takeover.
Unocal Corp. v. Mesa Petroleum Co. (1985): This case established the "Unocal test," which is used to determine whether a board of directors has acted reasonably in defending against a hostile takeover.
Santa Fe Industries, Inc. v. Green (1976): This case held that a company's board of directors cannot use its fiduciary duties to protect itself from shareholder lawsuits.
In re Caremark International Inc. Derivative Litigation (1996): This case established the "Caremark duty," which requires a board of directors to exercise reasonable oversight of the company's management.
Stone v. Ritter (1999): This case held that a board of directors can be held liable for a breach of fiduciary duty if it fails to adequately investigate a material corporate event.
One can also look at the implications of all the laws and regulations on the tech and startup ecosystem through a couple of interesting case studies.
Facebook: Facebook's eventual transition to a public company, which brought about an increase in scrutiny and regulation, is an example of the impact of securities laws. While going public offered Facebook access to more capital, it also introduced new regulatory burdens, such as the obligation to file quarterly and annual reports.
Kickstarter Projects: The influence of the JOBS Act can be seen through the rise of equity crowdfunding platforms, like Kickstarter and Republic. This legislation opened new doors for startups seeking funding, allowing them to tap into a broader investor base and democratizing access to capital.
Alexa, Play “New Rules” By Dua Lipa
As the venture capital landscape and broader financial markets continue to evolve, so too do the regulatory frameworks that govern them. There have been some interesting proposals for regulating venture capital, and they may have big impacts—both positive and negative for VCs.
One of the significant proposals involves changes to the definition of accredited investors by the Securities and Exchange Commission (SEC). Historically, individuals needed to meet specific income or net worth thresholds to qualify as accredited investors and participate in private offerings. However, the SEC has proposed amendments to expand this definition—potentially allowing individuals with certain professional credentials, designations, or other credentials issued by an accredited educational institution, and "knowledgeable employees" of the fund, to qualify as accredited investors.
If implemented, this change could expand the pool of potential investors for venture capital funds, increasing access to capital for startups. But, I’m hesitant to say that this expansion will actually occur if we see our economy continue to decline over the next few months/years. (Contrary to popular Twitter belief, we still are in a recession.)
Regulation around Initial Coin Offerings (ICOs) represents another area of proposed changes that will directly impact VC firms. ICOs have emerged as a novel fundraising method, particularly for tech startups, but the lack of clear regulatory guidelines should be a source of concern for investors. The SEC has proposed that ICOs should be treated as securities offerings and subject to relevant securities laws, a move that could bring greater investor protection but also increased compliance requirements for startups considering ICOs.
Based on my lobbying efforts and talking to folks in D.C., I expect that this will come to a head later this year, with most ICOs being treated as securities. It really is incredibly hard to argue that most ICOs aren’t securities with a straight face. (Sorry everyone.)
Another area under review is the application of the Foreign Corrupt Practices Act (FCPA) to venture capital. The FCPA prohibits U.S. businesses from bribing foreign officials. While it has historically been applied primarily to large multinational corporations, there have been suggestions that the Act should be applied more rigorously to smaller firms, including venture-backed startups operating internationally. Such a move could significantly increase the compliance burden for these firms, potentially impacting their international expansion strategies.
What Impact Will These Proposed Rules Have?
While expanding the definition of accredited investors can lead to a wider pool of limited partners and more capital flowing to startups (particularly early-stage ones), there are drawbacks too. People who meet the expanded criteria might not actually have the risk tolerance or the financial capacity that most other accredited investors have. Just because you meet the expanded criteria doesn’t mean that you have the financial foundation to suffer big losses (remember: 90% of startups fail, which means a lot of VC funds do poorly too.)
The regulation of ICOs as securities offerings could bring much-needed clarity and investor protection to this relatively new fundraising mechanism. With clear regulations in place, more startups might consider ICOs as a viable funding option. Conversely, this could also mean increased compliance requirements and potential legal risks for startups opting for this method, possibly deterring some from pursuing it. (Never forget the days of cheap compliance…like the 1700-1800 era lol.)
Lastly, the application of the FCPA to venture capital could have important implications for startups operating internationally. While it could encourage ethical business practices, it could also introduce additional compliance burdens. For startups, expanding internationally is already a big endeavor— these increased compliance requirements could represent even more hurdles, potentially limiting these lucrative growth opportunities.
Pwew! Y’all…we made it! Clearly, regulations are important in venture and help us create a transparent and growth-minded industry. Hopefully, everyone learned at least one thing (or more!) Let me know your thoughts or if you have some questions about what we should or shouldn’t be doing in the venture capital space. I can’t give you legal advice but I can help set ya down the right path ethically. As I continue to raise our first fund for Vol. 1 Ventures this topic is becoming more and more near and dear to my heart, so happy to chat about what’s up in this corner of the regulatory space.