Jan 10, 2023 - Economy

Venture capital may have a liability problem

Illustration of the eagle from the SEC logo with arrows in both talons instead of an olive branch.

Illustration: Shoshana Gordon/Axios

Regulators are coming for venture capital. And it could get messy.

Driving the news #1: Reuters reports that the SEC "is seeking details about FTX investors' due diligence," including information on firm policies and if those policies were followed.

Driving the news #2: The SEC is working on a rule that would eliminate private funds from seeking indemnification for simple negligence, effectively making it easier for limited partners to sue.

What to know #1: The FTX-related inquiries are unlikely to amount to much, even if some VC fund managers did little more than blindly follow Sequoia Capital into the abyss.

  • Limited partners are rarely promised specific due diligence procedures, or requirements that investments only go to startups with boards, CFOs, or similar sorts of corporate governance. LPs know this is a high-risk asset class, and that general partners often have little time to access the most popular deals. If they're dissatisfied, they vote with their feet during follow-on fundraising.
  • Yes, there could be exceptions on FTX. Such as if any funds invested more than they were allowed, as a percentage of committed capital, or if they subsequently lied to investors about actions taken during diligence. But neither seems likely.

What to know #2: The negligence change, which is loudly opposed by venture's trade lobby, would matter much more to the industry than has FTX.

  • Already, limited partners are allowed to sue for gross negligence, which covers reckless or purposeful acts. But expanding liability to simple negligence would effectively enable LPs to sue every time a deal goes bad.
  • To be clear, most LPs wouldn't take advantage of this new ability; particularly large institutional investors who'd be scared of getting a litigious reputation that would preclude them from accessing other funds.
  • But some smaller LPs, like high-net-worth individuals, are a different animal, and often represent a larger percentage of micro venture funds that would struggle to handle the legal bills and distraction. At worst, an LP variant of patent trolls could emerge.

The bottom line: The SEC has never really paid much attention to venture capital, which perhaps explains its clumsy efforts. But it clearly wants more oversight over this ever-growing asset class, in whatever form that may eventually take.

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