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Supporting Innovation Through the Commission’s Mission to Facilitate Capital Formation

Commissioner Kara M. Stein

Stanford Rock Center for Corporate Governance, Stanford Law School<br/>Stanford, CA

March 5, 2015

Thank you, Jina [Choi], for that kind introduction.

Before I begin my remarks, I am required to tell you that the views I am expressing today are my own, and do not necessarily reflect those of the Commission, my fellow Commissioners, or the staff of the Commission.

I’m pleased to be here with you today and in the Bay Area. I arrived on Tuesday and have been meeting with so many interesting and wonderful people. Thank you to everyone that has worked to put this conference together. The great collaboration between our San Francisco Regional Office and the Stanford University Rock Center for Corporate Governance is providing all of us with an opportunity to meet and discuss emerging issues affecting capital formation and private funds. So, thank you to both for coordinating this conference. Thanks especially to the San Francisco SEC staff for giving me an office-away-from-the office the last couple of days — I really appreciate it.

On Tuesday, I met with the Financial Women of San Francisco. This organization is focused on women investing in, mentoring, and helping other women. I know that you just spent some time during the previous panel discussing private equity and venture capital regulation. Something to add to the list of important issues facing this industry is the lack of women in private equity and venture capital firms, especially at the senior level. A recent survey found that only four percent of senior venture capitalists are women.[1] This issue has received a lot of attention recently, and I understand that industry groups are focused on it.[2] I think that people have become more aware of both the numbers and the issue — and are thinking about not only how firms can open up the door but also how to create a welcoming environment. I look forward to hearing about your ideas and positive developments going forward.

So, as I mentioned, I have been here since Tuesday. This is the last stop on a whirlwind tour of the Bay Area. Yesterday, I visited the Runway, a very impressive start-up incubator located in downtown San Francisco. Just around the corner from the Runway, I participated in a roundtable on crowdfunding and start-up access to capital hosted by the new “Start-Up Legal Garage” at UC Hastings College of the Law. This innovative clinical program helps train young lawyers to provide legal advice that can help start-ups get off on the right foot. In visiting all of these places, it struck me how committed this region of the country is to innovation — new ideas — new products — disrupting old models.

So today’s conference is an excellent opportunity to talk about both innovation and regulation. How does the Securities and Exchange Commission support innovation? Innovation isn’t explicitly part of our mission. But I think that the Commission does, in fact, support innovation — through facilitating capital formation. A major driver of innovation in this country has been the existence of a dependable foundation of capital formation rules that — while not perfect — have allowed companies that need funding to obtain capital to grow and prosper. A key question the Commission is always grappling with is — how do we continue to facilitate innovation as business models are disrupted, financial markets change, and technology evolves? How do we ensure that our rules keep pace with all of this innovation?

Today, I want to talk about a few areas at the Commission where I see the possibility of new options for capital formation. Just as companies continue to innovate, we as a Commission need to grow, keep pace and stay out on the edge of such change. We need to be forward looking and creative so that we can best carry out our mission. In order to facilitate capital formation, our rules must reflect and accommodate the quickly evolving marketplace.

As you well know, the Bay Area has historically been the capitol for venture capital, and it remains so today. As of January 2nd, there were over 1,700 venture capital funds within our San Francisco office’s regulatory footprint. We know this from data collected on Form ADV, which is the form investment advisers use to report information to the Commission.[3] That is almost three times as many venture capital funds as our next closest regional office. Clearly, venture capital is continuing to thrive in this area of the country.

Venture financing has typically been through private investments in smaller issuers. There have been — and continue to be - amazing innovations hatched right here in the Bay Area. Many of these success stories are attributable, in part, to backing from various venture capital and private equity firms. Twitter, Tesla, and Google have all received funding from private funds from this area. The list of great companies that were initially funded through venture capital is a very long one.

As a Commission, we of course want to facilitate investment in these types of innovative companies and make venture funds’ deployment of capital work as smoothly as possible. At the end of the day, we all care about the same things — facilitating capital formation, creating more and better jobs, and nurturing new companies. There is no better place in the world to form a start-up and follow your dream than in the United States — and we need to keep it that way.

But the Commission is also focused on new capital-raising methods. Venture capital might not be an option for every company, for a variety of reasons. So, we need to make sure our securities laws are flexible enough for a wide variety of companies and funding needs. Our securities laws in this area should aspire to provide a variety of funding options that can accommodate companies at different stages in their cycles. I want to discuss some of these options, in addition to venture, that may be available to smaller and newer companies. I want to particularly highlight some of the new options that the Commission is considering.

Despite the fact that venture financing contributes a substantial amount of capital to smaller businesses, is there more that can be done? As I mentioned, venture funding may not be available for every company. There are a limited number of VC firms. Perhaps your start-up focuses on an industry or sector that is not attractive to venture at the moment, for whatever reason. Maybe your company is in a stage of development that is not appealing to venture. Or, it could simply be that you don’t like the strings that come attached with venture capital, such as surrendering some management control.

The good news is that the Commission is currently considering several new options that will promote and enhance capital formation and help U.S. companies remain at the forefront of innovation. For example, Regulation A+ could potentially be an interesting new fundraising option for both small and medium-sized businesses. This provision was part of the JOBS Act passed by Congress in 2012 and would expand upon the Commission’s current, but little used, Regulation A exemption. Reg A+ would enable companies to offer up to $50 million in a 12-month period without registering its securities with the Commission, as opposed to the current $5 million limit. It also would allow small businesses to raise money from the public with a streamlined approach to oversight by the Commission. Reg A+ is a creative example of reimagining a capital formation option that was essentially broken.[4]

We are still in the process of finalizing the new Reg A+, so I can’t really speak too much about it. Although it is not clear how effective Reg A+ will be once the final rules are adopted, I am pleased to see us retrofitting an archaic rule to adapt to a changing marketplace. Changes in technology, in the demands of investors, in our financial markets, and in the needs of small and large companies are clearly disrupting our regulatory paradigm. We are quite appropriately assessing what is working with our rules and what is not. We should be continually examining our securities laws to look for other opportunities to do the same. As a Commission, we need to be as dynamic and nimble as are the companies seeking to obtain capital and the investors who want to invest their capital.

Another new form of capital raising that could plug a gap in the capital formation process is financing through crowdfunding. I suspect most of you are familiar with the concept of crowdfunding — but, in essence, crowdfunding allows small companies to harness the power of a community of small investors via the internet, to fund themselves quickly and efficiently. Crowdfunding offers the possibility of small businesses raising equity more directly, and potentially more efficiently, than our current options allow, including providing an alternative to bank lending. In that sense, it certainly has the capability of disrupting the current capital formation model. As we all search for ways to allocate capital as effectively and as efficiently as possible, crowdfunding may play an important role.[5]

At the same time, equity crowdfunding is a challenging concept for many reasons. It is a new regime. It does not fit neatly into our 80-year old securities law framework, which is focused on operating companies with some history. With crowdfunding, we are in many ways writing new rules and creating new markets out of whole cloth.

The excitement over this new form of raising capital needs to be balanced by consideration of potential risks — both to issuers and investors. It will only work if investors have confidence in the new internet marketplace. And the risk of losses to investors — including complete and total loss — is potentially elevated by the nature of the underlying companies. Some argue that the investors most likely to fund these newer and smaller companies may be the least equipped and suitable for these types of investments. They will generally be non-accredited investors who may be dabbling in an area that has caught their eye. Or perhaps a friend has recommended an idea to them. These are unlikely to be seasoned angel investors.

In addition, equity crowdfunding may be reduced to a temporary fad if fraud or questions of credibility become part of the mix, or if investors’ rights are not preserved through subsequent tranches of financing. For the crowdfunding market to be successful over the long-run, it needs to be a place that is fair, effective, and where both investors and companies understand the risks. In this area, our securities laws matter more than ever. Investor protection and capital formation must go hand in hand.

As the Commission thinks through innovative and new ideas about capital formation, we also need to think about new and innovative ways to fulfill our investor protection mission. Crowdfunding offers the perfect opportunity to do that. And we should be creative. One idea that I would like to get your thoughts on is whether we can make crowdfunding work better by pooling each class of crowdfunding investors into a fund vehicle. If done right, this could potentially solve the problem of hundreds or thousands of small investors on a company’s register, while also ensuring that crowdfunding investors could effectively exercise their governance rights. I know other jurisdictions are experimenting with this idea. I’d like to hear your thoughts about what benefits and risks such pooling might present here in the United States.

Adopting a final crowdfunding rule will be a challenge, but I am eager to work on it. I hope that the panel following my talk will be able to get into this issue a little bit. I would welcome your feedback and thoughts on how to help crowdfunding work as I continue to grapple with it myself.

The final capital formation option that I want to discuss is the idea of regional exchanges. Some view regional exchanges as a possible way to help to increase secondary market liquidity for smaller companies. In 2011, the state legislature of Hawaii authorized a working group to examine whether a locally focused, Hawaii-based stock exchange would be beneficial to support investment in local companies. Other states have undertaken similar examinations. Local or regional exchanges could be a beneficial method for connecting local enterprises to local investors and providing more secondary market liquidity. An exchange focused on venture or smaller issuers may also hold promise. My fellow Commissioner, Dan Gallagher, has discussed the possibility of venture exchanges as well.[6] There are a number of questions that need to be addressed, and I support the Commission staff issuing a Concept Release to get everyone’s best thoughts in this area.

These exchanges could allow small companies to exclusively trade their shares. Disclosure and other rules might be somewhat relaxed. Perhaps such an exchange could provide a new runway for growth for smaller companies, while also providing the essential, material disclosures that investors need. We need to understand why such exchanges have not worked in the recent past, and what, if anything, could be done differently.

I want to leave you with a few final thoughts on capital formation. I mentioned some new options that the Commission is considering to promote capital formation — Reg A+, crowdfunding, and regional exchanges. I also mentioned the tried and true pathway of venture capital. And there are other potential options that I will have to save for another time.

Some of these options for growth will succeed and some may be lightly used. That’s ok and it’s expected. The important point is that we are all engaged in thinking about how to best fund companies given our dramatically evolving financial marketplace. In the end, I hope that we have added a few more options to the palette.

I tend to think of each capital formation option as presenting a different method of growing with different strings attached. Any time an entrepreneur is seeking financing, there will be strings attached to receiving the money. For example, I already mentioned venture capital — some may not want to accept the strings attached with venture capital financing, such as involvement by the investor in management. Others may not want the strings attached that come with being a public company, such as quarterly reporting. The capital formation process and the securities laws should be flexible enough so that businesses have a variety of options that can hopefully suit their unique needs while still protecting investors.

Many of you in the audience are on the forefront of innovation. Given your backgrounds and experience, you have a deep appreciation and understanding of what it takes to adapt to changing landscapes. It’s in many ways what makes you successful.

I hope that the Commission can follow your lead and channel some of that innovative and disruptive spirit. Our regulatory system is 80-years old. I think there is a recognition that we need to evolve in the areas of both capital formation and investor protection to adapt to today’s rapidly changing marketplace.

But many aspects of our securities laws have held up remarkably well. The basics are strong and simple: clear disclosure to investors, good corporate governance, eliminating conflicts of interest, straightforward approaches to fees and costs, transparent public trading markets, being a good fiduciary when managing others’ money, and so on. Time and time again, these basics have led to some of the strongest, most productive companies in the world. I think it’s no accident that the American approach to capital markets, including SEC oversight, has been emulated by many. I know that regulation can feel uncomfortable, especially for those who might do the right thing on their own. And we at the Commission should always be innovating to make it work better. But the basics are needed and have benefited market participants. Time after time, we’ve learned that markets do not effectively regulate themselves and when basic rules aren’t followed, the results are detrimental for everyone.

I wear a lot of hats as an SEC commissioner and there are countless areas to focus on. But, please know that fair and effective capital formation is something that I care deeply about. There is nothing more important for our country and our economy than making sure that businesses obtain the capital they need to grow and create jobs within a marketplace that is safe for investors. I urge all of you — whether you are a business owner, an academic, an entrepreneur, an attorney, a fund, or just someone interested in capital formation — to help us as we continue to explore and discover new options for accessing capital. Only with your input and help can we make sure our options are dynamic and responsive to the marketplace.

I look forward to continuing to work with all of you on these very challenging but exciting projects. Thank you very much for your time this evening, and I hope you enjoy the rest of the conference.

[3] These numbers are based on Investment Adviser Registration Depository (“IARD”) data as of January 2, 2015.

[4] For background on Reg A+, see Proposed Rule Amendments for Small and Additional Issues Exemptions Under Section 3(b) of the Securities Act, Dec. 18, 2013, available at

[5] See Commissioner Kara M. Stein, Remarks before Los Angeles County Bar Association 47th Annual Securities Regulation Seminar, Oct. 24, 2014, available at

[6] See Commissioner Daniel M. Gallagher, Remarks at FIA Futures and Options Expo, Nov. 6, 2013, available at

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