How to diversify access beyond traditional coastal hubs
Issue
Venture capital is the economic and innovation engine of America. Its reach should extend beyond the traditional coastal hubs.
Greater geographic diversification of venture capital allocation would strengthen competition in the innovation economy, create more opportunity for innovators in more regions, and bring more innovative products and services to more people.
Public policy can help accomplish these objectives. To date, however, public policy has often slowed the diversification of the industry beyond traditional coastal hubs for capital and talent.
Background
In the U.S., the venture capital economy emerged and became firmly established in Silicon Valley as a result of twentieth-century government spending on universities, research laboratories, and military installations in that region. After policymakers witnessed the success of the venture-capital business model in this context, they enacted policies to stimulate its growth and support its recovery from economic downturns.
These policies have had tremendous net-positive effects for the U.S. economy, for American competitiveness and productivity, and for many people’s standard of living. But they’ve also had the unintended effect of concentrating venture capital—and venture entrepreneurship—in existing hubs of capital and talent. Rather than encourage the venture-backed economy to arise and flourish across the country, public policy to stimulate the tech sector has encouraged entrepreneurs and skilled workers to flock to Silicon Valley, New York, and Boston to build innovative companies.
This phenomenon may appear to be a natural consequence of the labor market. In fact, the public policies that undergird the venture economy have reinforced the geographic concentration of venture capital dealflow, venture entrepreneurship, and asset ownership. These policies can and should be reformed to support venture entrepreneurship at every stage in markets across the country.
The accredited investor definition
Under current law, the SEC decides which individuals and institutions may invest in private assets. Individual investors who meet these criteria are called accredited investors.
The vast majority of accredited investors qualify automatically under the SEC’s rules, which primarily use a wealth and income threshold to determine who qualifies. This is because the SEC uses wealth and income as proxies for investor sophistication. But while people with a higher net worth or annual income are better able to sustain losses, they are not necessarily more sophisticated investors. This is a national standard. So individuals in higher income locales such as San Francisco and New York are more likely to qualify, while those in other regions across the country find it harder. Essentially, these proxies have had the effect of stymying the development of innovative companies in less wealthy regions of the country.
These investors also contribute to the pool of capital that is allocated to entrepreneurs and emerging managers. And while capital is mobile, proximity still matters. The uneven distribution of accredited investors means that the pool capital is much deeper in coastal financial hubs than in other parts of the country, which effectively draws more companies and entrepreneurs to relocate to those hubs.
Carta supports reforming the accredited investor criteria to ensure innovators and investors across the country have equal access to private-market investments
Read more: Issue brief: The accredited investor definition
Qualifying venture capital fund parameters
To stimulate the innovation economy, Congress created a special regulatory exemption for qualifying venture capital funds. These smaller funds focused on venture capital investments are exempt from SEC registration by remaining within certain size restrictions. This exemption was created in part to help emerging managers, including those from less capital-dense regions of the country, enter the market and successfully compete against more established competitors. But Congress failed to right-size the size limits for qualifying venture capital funds and has never updated the statute. Today, limits on the number of investors these funds can disincentivize managers from accepting small checks because they will hit the cap of beneficial owners faster. As a result, smaller investors are excluded and left behind while larger investors gain access and the opportunity to further amass wealth.
Carta supports reforming the qualifying venture capital fund parameters to better support emerging managers across the entire country.
Read more: Issue brief: Qualifying venture capital fund parameters
Employee ownership
Venture-backed private businesses have had a transformative effect on the U.S. and global economies. They have also transformed the lives of many of their employees: Through the employee-ownership models that became standard across the venture economy, many venture-sector employees have been able to earn meaningful equity in the companies that employ them.
For many employees, equity ownership provides the capital they need to buy a house, pay down student loans, or start a family. While public and private equity ownership continues to concentrate in the wealthiest 10% of American households, the employee-ownership model in the venture sector has proven an effective method for redistributing asset ownership in a way that also creates alignment between employee performance and company goals.
Diversifying the geography of venture capital investment will also diversify private asset ownership of innovative companies into more local economies. Over time, this will also deepen the pool of investment capital available to startup entrepreneurs in those local networks.
Policy outlook
Accredited investor
Under current leadership, the SEC has indicated it may revise the criteria for qualifying as an accredited investor. If the SEC raises the wealth and income thresholds as expected, it could radically reduce the number of accredited investors in each state. While this would have negative impacts on the private markets generally, it would have much more drastic effects in regions with lower median incomes. As a result, startups in those regions could find themselves starved of capital. This would reverse recent progress in geographic diversification for the innovation economy.
Bipartisan members Congress, however, have expressed support for expanding onramps for becoming accredited beyond the wealth and income tests. In spring 2023, the House passed several bills that together would codify existing wealth thresholds and expand onramps for additional sophistication-based accreditation.
Qualifying venture capital funds
In April 2023, the House Financial Services Committee approved the Expanding Access to Capital Act. Among other provisions, it includes:
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DEAL Act: This bill would expand the definition of qualifying venture capital investments to include fund-of-fund investments and equity acquired in secondary sales. The current definition excludes such investments from qualifying.
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ICAN Act: This bill would increase the size limit on the amount of capital a qualifying venture capital fund can raise, and increase the number of investors it can have.
Read more: Issue brief: The DEAL Act
Carta supports passage of the Expanding Access to Capital Act.
Bottom line
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The venture capital industry has made significant strides in diversifying beyond its historical centers of influence in Silicon Valley, Metropolitan New York, and Greater Boston. However, flawed policies still encourage innovators and investors to aggregate in those regions.
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Targeted reforms can help diversify the sector beyond historic centers of influence. These include:
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Codifying the existing wealth and income thresholds for accredited investors into statute
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Creating more sophistication-based onramps for individuals to achieve accredited investor status
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Raising the fund size and beneficial owner limits on qualifying venture capital funds
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Enabling established funds to more easily invest in emerging managers across the country
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Codifying the existing wealth and income thresholds for accredited investors into statute
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Creating more sophistication-based onramps for individuals to achieve accredited investor status
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Raising the fund size and beneficial owner limits on qualifying venture capital funds
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Enabling established funds to more easily invest in emerging managers across the country
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