Why we shouldn’t regulate venture capitalists

With any downturn in the economy, there are always new rules and regulations that are discussed or passed to prevent the previous calamity from occurring again. The same is true for this latest downturn with a variety of efforts and attention being shown to the banking and mortgage industries.

Now attention is also being shown to the venture capitalists. This is not necessary. Nothing in this current downturn can have VC activity pointed to as the cause. In fact, VCs are fairly well self-regulated by the activity of the stock market and they take a sizeable set-back when the tech bubble bursts (most notably in the early part of this decade).

No VC is too big to fail and no VC has a huge majority of the market. It simply doesn’t make sense to overly regulate this industry when so much of what we enjoy on a regular basis is the result of VC activity (nearly the entire IT industry including the technology that makes this blog possible and your ability to read it).

Here are a few thoughts taken from a column at the Wall Street Journal:

Just when the economy needs risk-taking the most, risk-takers are under the most threat. The Treasury now wants venture-capital firms declared as systemic risks and put under tight restrictions as part of the broader re- of financial firms. Venture capitalists argue that since they don’t use debt and their firms are comparatively small, they shouldn’t come under rules designed for highly leveraged, too-big-to-fail banks.

How this debate turns out matters, because some 20% of U.S. gross national product is created by companies that were formed through venture backing. They include Intel, Apple and . How policy makers treat is a measure of the amount of innovation and enterprise that happens in an economy, with more regulation leading to less innovation.

This is a tough time for venture capital, with investments by firms falling more than 50% in the second quarter. The 700 or so venture-capital firms in the U.S. are mostly small partnerships, with a modest voice in Washington. They say the industry as we know it can’t survive if firms are regulated as investment advisers, which would mean complying with rules for disclosure, compliance, record keeping and privacy designed for huge firms.

Uncertainty about which regulations applied to early-stage investing slowed the growth of venture capital. It wasn’t until deregulation in the late 1970s that the industry took off. The capital gains rate was cut to 28% from nearly 50% in 1978, and for the first time pension funds and other fiduciaries could include venture capital as part of an overall portfolio. During this vital period venture firms began to nourish what are today’s high-tech leaders, from information technology and the Internet to genetic research and health care.

The proposal now to tighten how venture firms operate suggests that we are in a stage of the regulatory cycle closer to the New Deal than to the entrepreneurial era that followed. Adding regulatory burdens would do nothing to help the investors in venture funds who are willing to take the big risks, knowing that about half of venture-backed companies fail. It would only increase the costs of doing business and make risk-takers more risk-averse.

No venture capital firm has asked to be bailed out, and none are too big to fail. As hard as it is for regulators to understand, the nature of venture capital is such that it should not even aspire to be a low-risk enterprise.

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