Regulations

The SEC Is Itching to Stretch Its Reach Into Venture Deals

The SEC Is Itching to Stretch Its Reach Into Venture Deals
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The U.S. Securities and Exchange Commission is hinting at a massive regulatory land grab into private-company investment, and, if it happens, Silicon Valley only has itself to blame.

In a speech at Stanford University, SEC chair Mary Jo White raised worries that investors were at risk by the sky-high valuations many of these private companies enjoy.

“The concern is whether the prestige associated with reaching a sky-high valuation fast drives companies to try to appear more valuable than they actually are,” she said, according to a copy of her speech, obtained by Reuters.

Related: Why Venture Capital Deals Stay in Silicon Valley

The SEC is designed to protect U.S. investors. That's its raison d'etre, after all. But there's an important distinction: the SEC has little impact on the venture-capital world and startup investment. Simply put, these kinds of investments are private, usually handled by sophisticated investors, so, unless there's outright fraud, the SEC doesn't have the regulatory authority (or the resources) to involve itself in these transactions. Private investments aren't a public problem.

Yet, White is hinting strongly that the SEC might be knocking on more doors of private companies, particularly the so-called unicorns, those startups valued at $1 billion or more. 

“Being a private company comes with serious obligations to investors and the markets," Reuters quoted her as saying. “For the new and evolving markets to be successful, all investors need confidence that they are being treated fairly and that the full range of risks are transparently disclosed.”

Related: How Venture Capital and Crowdfunding Can Be Mutually Beneficial

The last thing Silicon Valley, venture capitalists or the startup world should want is a regulator deciding it wants to meddle in private investment. For venture and private-equity firms, there's a cost to having to comply with regulations. For startups and private companies, the need for more disclosure to a wider range of investors could make it more difficult to raise capital, which isn't exactly easy right now.

It's true that the SEC would need changes in the law to become a full-fledged regulator of private investments, and that's unlikely, particularly with a Republican Congress. But what Silicon Valley, in its recent boom, has forgotten is that regulators don't so much slam down the front door as seep slowly through the windows and cracks in the foundation. It didn't take long for the SEC to announce an enforcement action in the crowdfunding world, which, prior to allowing for equity to be raised, was seen as escaping regulatory scrutiny. In that first case, against an oil company called Ascenergy, the SEC also suggested that crowdfunding platforms had some role in investor protection.

Crowdfunding has changed the game for startups, making it -- in theory, at least -- easier to get access to capital. But it also brings the SEC into mix much earlier. With this new capital comes a new sheriff to protect the investment.

Related: 8 Things You Need to Know About Raising Venture Capital

Even private companies that have raised traditional venture capital through purely private transactions could find themselves under retroactive enforcement the minute they file to sell public securities. Once a company files a registration statement to go public, the company has to disclose its risks, its past performance and the nature of its past investments. Under the law, the SEC could slap companies that somehow inflated their private valuations in the hopes of cashing out with an outsized initial public offering. On the surface, that approach appears to be what White and the SEC are telegraphing to the startup world.

The counter-argument to these large valuations is that there is simply nothing wrong with them. Smart, sophisticated and seasoned investors are evaluating the promise of these companies and setting valuations based on these calculations. If that gives a company a billion-dollar valuation -- or, in the case of Uber, north of $60 billion -- so be it. The fact that there are more unicorns nowadays is simply supply and demand. The name probably gets in the way, since unicorns were supposed to be rare and magical. We now know the startup ones are more common than ever, and the physical ones actually did exist after all.

But, for the SEC, it's less about the valuations than how these companies achieved them. White used the word "prestige" when she raised concerns about unicorn valuations, and that is a word packed with value judgment. She is, in effect, saying that the culture of Silicon Valley has made these valuations a problem, because they need to be achieved quickly. If venture capitalists and private companies create an environment that allows -- nay, encourages -- cut corners, inflated expectations and fast money, the SEC will force its way in. If that happens, the blame lies inward because there are serious problems with culture and valuations in the venture-capital world. Free markets should be the sole regulator, and can be, but only if the Valley and startups realize they have a responsibility to police themselves.

Regulatory relevance, at bottom, is based by the size and scope of the domain it overseas. Silicon Valley and venture investment represents a land grab Alexander the Great would envy. That's a real risk now. The startup world needs to act now to prevent it.