The legal threat coming for venture capital
By SAM SUTTON
Politico
01/06/2023 08:00 AM EST
After being battered by rising interest rates and choppy markets, the venture capital industry is sweating new regulations that could expose fund managers to legal risks.
The SEC is putting the final touches on a rule that would make it easier for investors to sue VCs for bad behavior, negligence or recklessness. It would “open up all types of litigation risk to being a venture capitalist,” Justin Field, the National Venture Capital Association’s senior vice president of government affairs, told MM.
The proposal, which could be finalized as soon as this quarter, would “drive a wedge between VCs and portfolio companies that will hurt both innovation in this country as well as [investor] returns, which is what the SEC is supposed to be trying to protect,” he added.
Of course, the rule wouldn’t just apply to venture capitalists. It would also cover private equity firms, hedge funds and certain real estate investment companies – any private investment fund that’s already subject to SEC oversight.
But the proposed changes might be especially vexing for VCs because of their investment model. Most venture-backed companies fail. And while the vast majority of those businesses peter out because they can’t attract a buyer (or make beaucoup bucks via public markets like Facebook or Google), a handful will go under because their founders are either frauds or comically inept.
And as we’ve learned over the last years, venture firms don’t always catch that in due diligence.
“As an investor, when the environment is ‘frothy’ you are much more likely to run into these problems,” Bill Gurley, a general partner at the Silicon Valley venture fund Benchmark, wrote in a recent blog post. “Ironically this is also the precise time when raising concerns will make you look like a washed up veteran who is unable to adjust to the new ‘realities.’”
It gets a lot harder to cover up those mistakes when markets go down. With economists pegging the odds of a recession at 70 percent — that’s hardly an inevitability, writes our Victoria Guida — more bad bets will be exposed and, in all likelihood, some venture-backed CEOs will be found to have cut corners.
When that happens, investors are going to have questions about the fund managers who boosted those businesses. (Lawmakers posed similar questions during last month’s FTX hearings, and Reuters is reporting the SEC is also probing the matter).
From the NVCA’s perspective, exposing VC to new legal claims wouldn’t do much to change that. And it might make it that much more difficult for new startups to attract capital in the meantime.
“This is going to significantly increase the cost of operating a venture capital fund without materially impacting outcomes,” Field said.
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