Venture capitalists and their private equity firms are regulated by the U.S. Securities and Exchange Commission (SEC). Venture capital is subject to the same basic regulations as other forms of private securities investments. Venture capital is a form of financing through funding called private equity that's provided by investors who want to invest in a company's long-term potential.
Since a large amount of venture capital is provided by banks and other depository institutions, the regulations that banks must adhere to also apply to the venture capitalists.
Key Takeaways
- Venture capitalists and their private equity firms are regulated by the U.S. Securities and Exchange Commission (SEC).
- Venture capital is subject to the same basic regulations as other forms of private securities investments.
- Financial institutions that provide venture capital must adhere to anti-money laundering and know-your-customer (KYC) regulations.
- Venture capitalists are also regulated by the SEC's insider trading laws, which prevent the misuse of nonpublic information for financial gain.
Venture capitalists help fund higher-risk start-up firms and other small businesses that have a chance for high levels of long-term growth. Venture capitalists also invest in rapidly-growing companies that appear to be poised for accelerated earnings growth in the years to come.
Venture capitalists make their returns through the ownership of large numbers of company shares. Private equity firms typically provide venture capital, although banks are also involved. Since many of the investments are start-ups or unproven companies, venture capitalism is considered riskier than traditional equity investing.
Capital investments from private equity firms are typically held for 10 years or more. As a result, some private equity firms take an active role in determining the management of the company and the direction of the business. Other firms take minority stakes in the underlying company.
Venture Capital and Regulatory Oversight
Private equity firms must register with the SEC and are subject to information reporting requirements unless their funds are considered to be qualified venture capital. Qualified venture money managers include those who handle less than $150 million in assets.
Bank regulations apply to the financial institutions that provide venture capital, which can involve multiple government agencies in addition to the SEC. Venture capital provided via a bank must adhere to anti-money laundering regulations as part of the Bank Secrecy Act (BSA). The BSA helps institutions work together with regulatory agencies to thwart financial fraud and identify suspicious activity. BSA reporting requirements for banks are managed by the U.S. Treasury Department'sFinancial Crimes Enforcement Network (FinCEN).
Various know-your-customer (KYC) regulations also apply to venture capital. KYC includes identifying parties involved in private equity transactions, such as the verification of client identities and obtaining the proper Federal identification numbers. Proper KYC helps to prevent money laundering and is a prominent part of financial crime enforcement as stipulated in the USA Patriot Act.
One notable change in the regulations governing venture capital affects investment adviser advertisem*nts and payments to solicitors. The SEC announced in 2020 the reform under the Investment Advisers Act to modernize these rules. The reform lifts the ban on general solicitation and permits startups, venture capitalists, and hedge funds to openly advertise that they’re raising money in private offerings. The reform allows advisers to provide investors with useful information as they choose among investment advisers and advisory services, subject to conditions that are reasonably designed to prevent fraud.
Most regulations on equity investments and investors hinge on technical definitions that are written into securities legislation. Congress and the SEC have altered the definition of venture capital on multiple occasions, resulting in different equity financing practices along the way. In the past, for instance, investments that qualified as venture capital were only accessible to those who were similarly qualified as professional venture capitalists.
Insider Trading
Illegal insider trading is when a firm or member of an investment firm buys and sells securities while in possession of nonpublic information or material about the company or the security. Illegal insider trading can also involve when someone provides an information "tip" while in possession of nonpublic information and the person receiving the tip acts on it by entering into a trade.
Private equity firms providing venture capital are open to regulatory risks for insider trading since their employees are actively involved in the inner workings of the underlying company. Sometimes firms appoint a member to the Board of Directors, which provides oversight of the company's executive management. If the member also works for the private equity firm, it can lead to compliance issues.
The SEC's former Associate Director in the Division of Enforcement, Anita B. Bandy, commented on the unique compliance risks associated with private equity firms in May 2020.
“Investment advisers and private equity firms that place employees on the boards of public companies bear heightened risks that they will obtain nonpublic material information through their representative occupying dual roles. It is critical for firms... to have proper policies and procedures in place to address these risks and prevent the misuse of information obtained under these special circ*mstances.”
