Startups and Venture Capital Under Federal Law
Venture capital (VC) is a method some businesses use to raise money. Typically, it is sought after by relatively new, privately held companies that would not be able to raise capital by other methods, such as obtaining a business loan from a bank. Companies successful in raising VC funds are usually poised for quick growth and have an innovative invention or idea that has the potential to lead to large profits. In the last two decades, several successful technology startups have relied on VC to raise money.
Venture capitalists, which are those who invest in the growing businesses, are often wealthy individuals, investment funds, or subsidiaries of investment banks. VC investors generally have a longer outlook for return on their investment and are willing to take a greater risk by providing unsecured loans to the target companies. In exchange, VC investors generally seek a larger portion of equity ownership in the company, a seat on the board of directors, and an active role in managing the company’s operations.
Since venture capital is a type of private equity investment, the laws and regulations that affect private equity also apply to many aspects of venture capital investment.
Historically, private equity investments were lightly regulated. The Dodd-Frank Wall Street Reform and Consumer Protection Act (12 U.S.C. § 5301 et seq.) was passed in 2010, and it introduced several new requirements for investment banks, fund managers, and others in the financial industry. One important aspect of Dodd-Frank is a provision called the Volcker Rule. The Volcker Rule prohibits banks from using their own money—as opposed to money on deposit from customers—to make certain investments, including private equity. This means that generally banks cannot serve as VC firms.
After Dodd-Frank, hedge fund managers and private equity fund managers were required to register with the Securities and Exchange Commission (SEC). Venture capital managers were not required to register, but because of how the law defined venture capital funds, many entities that were primarily engaged in venture capital investments but had other holdings were subject to Dodd-Frank regulation.
In 2011, the SEC redefined what constitutes a venture capital fund, relieving many VC firms of the registration requirement and the need to provide detailed information to the SEC. Now, venture capital firms must have at least 80 percent of their money in qualifying investments, which are generally shares in private companies. As much as 20 percent may be in shorter-term investments for the firm to be exempt from the SEC registration requirement.
Banking and Finance Law Center Contents