# Tuesday, 27 April 2010

We all remember back in September 2008 when the exotic credit default swaps and collateralized debt obligation bonds filled with subprime mortgages nearly took down the financial industry. Hedge funds also were blamed for running up the price of oil in 2007-8. Due to all of this, governments around the world are calling for financial reform.

The EU is planning on regulating the “riskier” end of the financial system. Its proposed Alternative Investment Fund Managers Directive will bring more transparency and reporting-targeting things that pose a “systemic risk” to the financial system. Sounds like a great idea, right? The problem is of course is unintended consequences.

If the Alternative Investment Fund Managers Directive is passed under its current form, Venture Capital firms will be required to disclose a lot more information. Traditionally VC firms are private for a reason and this will radically change the VC business in Europe. In addition, it will add a new cost, as much as €100,000 annually per VC firm. The AIFMD will also regulate a VC firm like a bank and force them to hold greater capital requirements. This is counter to the industry trend as VC funds themselves are getting smaller, not bigger (a consequence of being so much cheaper to start a business in 2010 then it was in 2000, or 1990.) The proposal in its current form will also require VCs in the EU to only invest in EU countries! (That is crazy!) VCs will also be required to use external custodians and independent valuation agents.

Most of the financial press skipped over that last point or just mentioned how it will increase costs. While costly, it can change the very nature of a negotiation between the entrepreneur and the VC. Let’s say that you are a startup and asking for $10 million of investment at a $40 million post-money valuation. The VC is interested to invest but thinks that you are valued closer to $20 million. What happens next is usually a give and take and a negotiation that results in an agreed upon valuation and investment structure. I have taken Venture Capital a number of times and have worked at companies that have as well, and this is the point in the process where things get creative. A lot of times, the conversation turns from an initial me vs you to a win win structure. But now, the VC firm by law will be required to get an external valuation of your company! The negotiation will never take place, increasing the me v you mentality, thus driving up valuations, and reducing the number of start ups that get funded.

European start-ups beware. Move to Silicon Valley. Thankfully the European start-up I work for took Venture Capital from an American firm.