September 12, 2009
Securities Law Impediments to Entrepreneurship
Posted by Darian Ibrahim

My research has focused on how sophisticated entrepreneurial parties – including angel investors, venture capitalists, venture lenders, and entrepreneurs – structure their relations, and how the corporate, securities, and commercial laws respond to their unique needs. In my venture debt paper, I discuss how lender liability and equitable subordination rules shape venture lender practices. In this post, I’ll focus on the securities laws.

First, there’s the exit structure of venture capital (with credit to Gordon for an excellent paper of the same name). In the past, hot IPOs allowed VCs to return big gains to their fund investors. In this recent public policy proposal (click on the Apr. 29, ’09 doc), the National Venture Capital Association laments that there were only six IPOs total in the U.S. in 2008. The securities laws aren’t helping the situation. As Larry Ribstein and others have observed, the costs of going public thanks to Sarbanes-Oxley have dampened the IPO market, and there’s a legal minefield we teach in the securities course known as the gun-jumping rules that makes the IPO process far more cumbersome and error-prone than the process for seasoned public offerings. Sure, a start-up needs to provide more disclosure than Microsoft, but it’s not like no one has vetted these companies. They have been subject to rigorous and repeat scrutiny from (venture) capital markets from their inception. Why are the gun-jumping rules so complex?

Second, long before exit, private placement rules and broker-dealer laws might be impeding optimal levels of funding from angel investors, the precursor to venture capital. In my last paper, Financing the Next Silicon Valley, I explored both the ban on general solicitations in private placements and the reach of the broker-dealer laws to see whether angels had reason to fear the application of these laws to their activities. I concluded that there is a plausible case that the letter of these laws, if not the spirit, are indeed violated by routine angel group practices. First, when entrepreneurs approach angels (and VCs) without a “preexisting relationship,” as they do whenever they send a business plan cold, there appears to be a general solicitation. This leads to a host of potentially bad outcomes including recission rights, dissuading follow-on VC financing, and delaying an IPO. Second, when individual angels take the lead on a start-up’s due diligence for their group and receive extra stock in the start-up as compensation, they arguably fit within the definition of a broker-dealer. I can’t imagine that the broker-dealer laws were meant to apply to this situation, and granted the SEC hasn't enforced either of the laws I mention (to my knowledge), but the cloud of uncertainty they hang over angel group practice certainly isn’t enticing more angel investments, at least according to my sources.

Bottom line: with our traditional economic engines like Wall Street finance and the auto industry in crisis, we need start-ups more than ever, and there won't be start-ups without angels and VCs. Market forces have already hit these investors hard; the securities laws shouldn’t exacerbate the problem. The SEC and Congress should re-examine these laws and ease up a bit to help keep our entrepreneurial culture going strong.

Economic Development, Entrepreneurship, IPOs, Law & Entrepreneurship, Securities, Venture Capital | Bookmark

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