SEC Small Business Capital Formation Advisory Committee Meeting

Securities and Exchange Commission

Small Business Capital Formation Advisory Committee Meeting

Tuesday, February 4, 2020


Opening Statements

Jay Clayton, Chairman, Securities and Exchange Commission

Clayton said that the committee’s discussion is timely, given that the Securities and Exchange Commission (SEC) looks to help facilitate capital formation. He highlighted the Office of the Advocate for Small Business’s (OASB) Capital Formation 2019 annual report and encouraged others to read the report. Clayton said the report helps inform small business capital raising as well as outline the challenges that small businesses face, such as geographic imbalance, bank reductions, and limited access to early-stage venture debt. Clayton added his support for the work of Pamela Gibbs, Director, Office of Minority and Women Inclusion (OMWI). Clayton concluded by encouraging the committee to look at the SEC’s amendments to the Volcker rule, specifically noting the portion regarding covered funds.

Commissioner Allison Herren Lee, SEC

Lee expressed gratitude and respect for the committee’s work, specifically for their recommendation to index the accredited investor definition to adjust for inflation. She added her desire for the committee to provide their view on the SEC’s Form D proposed rule. Lee echoed her support for the work of Gibbs’ work on the inclusion of minority and women-owned businesses.

Panel I: Overview of Annual Report from the SEC’s Office of the Advocate for Small Business Capital Formation

Panel Presentations

Jenny Riegel, Special Counsel, Office of the Advocate for Small Business Capital Formation, focused on the OASB’s Capital Formation 2019 annual report, which provides context concerning the Office’s engagement with small businesses across the U.S. She summarized the OASB’s initiative to upload short videos about capital formation rulemaking to their website to better assist companies in understanding securities laws and rulemakings. Riegel highlighted that the report provides additional data on private placement offerings and initial public offerings (IPOs) as well as other registered public secondary offerings. She said that according to data about the top six industries in the U.S., significant capital formation comes from registered public offerings, followed by Regulation D and A offerings.

Riegel noted that high net worth and high-income individuals are typically offered personal funds and retained business earnings. Riegel highlighted the decline of community banking and the challenges facing rural communities, which has increased the importance of angel investors to early-stage companies seeking equity in these communities. She explained that angel investors are often accredited investors, mentioning that the SEC has made amendments to the definition of accredited investors and welcomed public feedback on the proposal. Riegel noted the emerging role of venture capitalists (VC) and private equity for companies that aim to go public and need assistance in maturation. Riegel also shared that there are current challenges for women and minority-owned companies in attracting investors and that women and minorities are underrepresented in the investor community. She also explained the challenges rural areas confront when working to raise capital and the importance of crowdfunding in those communities.

Riegel concluded by highlighting the five recommendations made in the OASB report. These recommendations are: 1) harmonize the exempt offerings framework; 2) increase investor participation in private offerings; 3) engage investors via finders; 4) put forward updates to crowdfunding rules; and 5) scale obligations for smaller, less complex reporting requirements for companies.

Panel II: Exploration of Small Business Capital Markets Data and Challenges Faced by Small Businesses and Their Investors

Panel Presentations

James Gelfer, Senior Strategist, Lead Venture Analyst, PitchBook, provided an overview of venture capital funds. He noted the evolution of the industry, specifically referencing the size of seed deals. Gelfer said the last few years have been the highest years on record for venture capital investment. He added that megadeals over $100 million have accounted for 250 transitions totaling $60 billion of deal values and noted that most financing occurs in late stages. Gelfer emphasized that the west coast of the U.S. is the main driver of deal activity and that more capital is available in California than anywhere else in the U.S. Gelfer emphasized the need for capital raising in these regions as well as for female and minority-owned businesses. He also suggested that the committee discuss venture debt.

Gelfer outlined the importance of successful exits for entrepreneurs and the need to address gaps in nomenclature, such as for pre-seed, as venture strategies evolve. Gelfer highlighted the “unprecedented” size of private companies and the growth of private equity for non-venture backed businesses, alongside other non-traditional entities such as asset management, corporate venture, as well as government and sovereign wealth funds. He highlighted the impact of “unicorns” last year on the secondary market and direct listings. Gelfer expressed that companies are currently raising less capital while initial public offerings (IPOs) are both expanding the number of private shareholders and resulting in these companies staying private longer.

Question and Answer

Jason Seats, Robert Fox, and Carla Garrett, Small Business Capital Formation Committee, inquired about late-stage versus early-stage funding and geographical disparities. Gelfer said the early-stage investment depends on the size of the investors participating in seed rounds. He added that venture capital allocation is difficult to obtain and is easier to obtain in Silicon Valley or through Silicon Valley connections. He said that often venture capitalists invest in later stages, citing company revenue levels and the desire to obtain a board seat as motivating factors for this trend.

Youngro Lee, Small Business Capital Formation Committee, asked about retail investor risk exposure in venture capital and pooled funds for non-accredited investors. Gelfer stated that venture capital is one of the riskiest asset classes, with very high variability for returns. Gelfer also recommended that it will be difficult for a one-off retail investor to invest at the local level effectively. He emphasized the need to utilize a fund-to-funds vehicle for non-accredited investors at the local level.

Gregory Yadley, Small Business Capital Formation Committee, asked about ways for companies to find successful exits. Gelfer said angel investors that provide deal flow help, especially outside of Silicon Valley, offer promising opportunities.

Solomon asked Gelfer questions about direct listings, industry variation, and other challenges to accessing capital. Gelfer reiterated the challenges of attracting a venture capitalist outside of Silicon Valley and suggested that direct listing capital listing is a tool that is needed to help a company to go mainstream.

Miller asked if PitchBook has collected regional data, to which Gelfer responded that PitchBook is happy to provide the committee their analysis for varying state-level ecosystems.

Panel III: SEC Office of Minority and Women Inclusion

Panel Presentations

Gibbs highlighted the work of the OMWI under three significant workstreams: 1) workforce diversity; 2) supplier diversity; and 3) cross regulatory engagement. Gibbs noted the progress being made via targeted outreach and engagement, increased contract use for OMWI businesses, development of diversity practice standards, and the collection of diversity data from other regulating entities. Gibbs added that she has continued to partner with Miller to better educate minority and women-owned businesses about capital raising rules.

Question and Answer

Sara Hanks, Small Business Capital Formation Committee, raised a question about OMWI’s outreach efforts. Gibbs said her work includes travel for educational purposes as well as forums and coordinated efforts with Miller and others.

Seats asked Gibbs if OMWI track their capital allocation decisions. She responded that the short answer is no, but the office is looking at diversity practices in the investment management space.

Solomon asked if OMWI has published any best practices. Gibbs said the office internally develops their base set of performance metrics and progress before producing an annual diversity assessment report for Congress.

Stephen Graham, Small Business Capital Formation Committee, asked how OMWI measures success. Gibbs said the office has tried to develop different benchmarks to determine if they are moving in the right direction. She also said OMWI reviews federal benchmarks across other regulators.

Panel IV: Local Capital Availability for Early Stage Companies and the Role of Regional Funds

Panel Presentations

Poorvi Patodia, Small Business Capital Formation Committee, discussed the business she started and challenges she faced throughout the process. She noted that a big challenge was knowing who to court in order to attract funding. Patodia added that she had to consider how best to market and discuss her strategic plan in order to attract seed round funding. She highlighted the need to attract investors based on investor and business model alignment, as well as the need to hire a quality legal team.

Darcy Howe, Founder and Managing Director, KCRise Fund LLC, emphasized how her firm helps connect investors to regional companies. She stated that 80 percent of all new jobs in Kansas City come from startups. Howe highlighted that KCRise has funded 23 investments with $39 million through two central funds. She added that 76 percent of the raised funds for the 23 investments have come from outside of Kansas City.

John C. McIlwraith, Managing Director and Co-Founder, Allos Ventures, expressed that local funds in the Midwest need capital. He stated that his firm has three venture capital funds and has committed over $105 million in capital to 18 core investments and 14 seed investments. McIlwraith suggested that the SEC could improve small fund capital formation by modifying the SEC’s 99-investor rule and the general solicitation framework.

Darnell Smith, Founder and CEO, Mojo, emphasized that his business has faced the challenges that accompany early-stage venture capital funding. He said this is mostly because his company is service based, which limited his potential investment opportunities for the private markets and banks. He added that he has faced the challenge of running a business that is both minority and women-owned, as well as being located in the Midwest.

Sapna Mehta, Small Business Capital Formation Committee, spoke about the challenges she faced when her firm aimed to provide a fund-to-funds hybrid investment tool to companies seeking capital through seed funds. She said that under Dodd-Frank, the venture capital exemption rule has specific asset management requirements for non-qualified investments to be met. Mehta said her management firm ran into the challenge of meeting the non-qualified investment requirements, as well as the challenge of determining whether to register or not. Mehta said the 20 percent non-qualified investment requirement became a “headache” that was not worth her firm’s investment goals.

Question and Answer

Seats asked for recommendations to modify the SEC’s 99-investor rule. McIlwraith said changing the $10 million cap to $50 or $100 million would help remove friction. He added that modifications to the general solicitation and accredited investors frameworks would help improve fundraising for 506-c funds and startups.

Garrett and Yadley asked Patodia to expand on the challenges new companies face. Patodia said that her most significant challenges was finding investors who were aligned with her companies’ goals and to have the legal knowledge necessary to run a business.

Fox asked about the challenges of attracting money from the coasts for midwestern companies. Howe said it is difficult to attract capital from the west coast, especially for entrepreneurs who have raised less than $4-6 million. McIlwraith echoed those points and noted the venture capitalist’s desire to hold a company board seat.

Fox asked for clarification about the fund-to-funds hybrid and challenges for an investment advisor to register. Mehta said the challenge she faced was the 20 percent non-qualifying transactions aspect. Howe noted that registration prevents retail investor participation in small fund investment.

Commissioner Elad Roisman, SEC, said this conversation is an excellent example of why this committee is essential in helping the SEC consider what capital formation gaps to address.

Wrap Up Discussion

The group recommended the committee start to focus on how to help small funds and managers generate capital, as well as geographical disparities for businesses. Other members suggested that the committee further discuss the general solicitation framework, unintended consequences from legislation and regulation, as well as the size and scale of funds. Lastly, the committee discussed modification to the SEC’s 99-investor rule and the SEC’s amendments to the Volcker rule.

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