The Venture Capital Shakeup: Adapting to the AI Era and New Rules

The venture capital (VC) landscape is undergoing significant transformations, influenced by the rapid advancements in artificial intelligence (AI) and new regulatory changes by the Securities and Exchange Commission (SEC). These shifts present both challenges and opportunities for VC firms, startups, and their employees.

Writing this short article presented me with the opportunity to review the VC landscape and new SEC regulation, as well as dusting off my Series 7 and Series 63 knowledge and even recalling insights from my "Legal Concepts of Business Organizations" class during my MBA (an interdisciplinary course that equips students with legal literacy and the ability to navigate the complex relationship between law and business).

With my background as a founder and employee of several startups, coupled with experience in AI and quantitative finance in highly regulated industries, this article explores the implications of these developments, offering insights into how VC firms could adapt and thrive in this new era.

AI's Impact on Venture Capital

The rise of AI is drastically reshaping the venture capital (VC) landscape and challenging traditional investment models.

Startups now benefit from reduced development costs and accelerated timelines, empowering technically skilled founders to bring products to market quicker and at lower costs.

However, this shift poses challenges for VC firms accustomed to large investments in early-stage startups. With more startups generating revenue before seeking VC funding, firms struggle to maintain their previous exposure levels. Consequently, VC firms must adapt their strategies to remain relevant, focusing on specialized sectors or forming strategic partnerships to add value beyond capital infusion, or find new ways to capitalize on existing investments so early stage VCs remain viable.

New SEC Regulations: A Double-Edged Sword for VCs

The SEC has introduced new rules aimed at increasing transparency and fairness in the VC ecosystem. These regulations require VC firms to disclose more information about their fees, expenses, and preferential terms offered to certain investors. While these changes are designed to protect investors, they also impose additional compliance burdens on VC firms, potentially complicating fundraising efforts and operational practices.

One significant aspect of the new SEC rules is the emphasis on fair treatment of all investors, which could limit VC firms' flexibility in offering preferential terms to anchor investors. This shift may level the playing field for smaller investors but could also deter large institutional investors, affecting the overall fundraising landscape. Furthermore, the new regulations will incentivize 409a valuations, ensuring that employees have a clearer understanding of the value of their option packages and preventing unethical accounting tricks that some VCs have employed in the past.

409A Valuations: Ensuring Fairness and Compliance

A 409A valuation is an independent appraisal of the fair market value (FMV) of a private company's common stock. This valuation is crucial for companies that plan to offer equity to employees or service providers, as it helps determine the price at which stock options can be issued. The process and necessity of a 409A valuation are governed by Section 409A of the Internal Revenue Code (IRC), which was established to ensure that stock options and other forms of deferred compensation are issued at or above the FMV of the company's stock at the time of grant.

Obtaining a 409A valuation from a qualified independent appraiser provides a "safe harbor," meaning the IRS will presume the valuation is accurate unless they can prove it is "grossly unreasonable." This shifts the burden of proof to the IRS and provides legal protections for the company. By requiring 409A valuations, the new SEC regulations promote fairness and transparency in the VC ecosystem, ensuring that employees receive equitable compensation and are aware of the true value of their equity packages.

Benefits for Founders and Employees

The evolving VC landscape offers several advantages for startup founders and employees. AI's ability to reduce development costs and accelerate the journey from idea to revenue empowers founders, enabling them to launch and scale their ventures with greater efficiency. Additionally, the new SEC regulations promote transparency, ensuring that employees have a clearer understanding of the value of their option packages and fostering a more equitable startup ecosystem.

Navigating the Future

VC firms must adapt to these changes by embracing AI and aligning their practices with the new regulatory environment. This involves investing in AI technologies to enhance their investment strategies and operational efficiency, while also ensuring compliance with SEC regulations to maintain investor trust and confidence.

Moreover, VC firms should view these developments as an opportunity to foster a more transparent and equitable investment landscape. By supporting startups that leverage AI and adhering to the principles of fairness and transparency, VC firms can contribute to a vibrant and innovative ecosystem that benefits all stakeholders.

The shift in the early-stage startup ecosystem will likely lead to a decrease in the number of startups available for later-stage investments. In fact, as of September 30, 2023, US VC deal activity (by count and by value) had decreased drastically with respect to 2021, specially for the fintech/insuretech sectors.

My prediction is that this trend will continue, and only those lean startups with a product or service already launched, with market validation via paying clients, and with technical founders knowledgeable in ML/AI will become the "new unicorns"; but again, these startups might not need VCs capital at all, but some of their expertise and relationship, however, at a much lower cost than in the "pre AI" era.

While this landscape may be challenging for VCs, it presents an opportunity for promising startups to secure better terms and experience lower dilution.

Conclusion

The AI era, coupled with new SEC regulations, is reshaping the venture capital industry. While these changes present challenges, they also offer opportunities for VC firms to innovate and for startups to thrive. By navigating these developments strategically, the VC ecosystem can continue to be a driving force for technological advancement and economic growth.