Now that our US Senators are ready to roll-up their sleeves and mud wrestle their way to financial reform (debate has now commenced), now is a good time to pause and take stock of what the ultimate bill could mean for investment and technology. If you’re suffering from financial reform overload and words like Blankfein, Dodd, and collateralized debt obligations induce nausea, please avert your eyes. But for those who are still paying attention, the outcome of Capitol Hill’s latest circus could have major ramifications on Silicon Valley’s investors and by extension the whole community of start-ups. As The Funded’s Adeo Ressi puts it, if the tide turns against angel investors and VCs, “basically funding as we know it, in all stages, is done.”
Before we explore this worst case scenario, let’s skip to the portions of Senator Chris Dodd’s bill that pertain to angel investors and their proposed amendments.
I. Accredited Investor Threshold
Section 412 calls for the financial threshold to be adjusted for inflation from its current level of $1 million in assets or $200,000 in income ($300,000 for a couple). That adjustment would raise the bar to roughly $2 million in assets or over $400,000 in salary. For those unaware, an accredited investor is someone who can make high-risk investments, like start-ups, without extra protection or hand-holding from the government. If you’re not an accredited investor, but you still want to invest in a start-up, you have to register with the Securities and Exchange Commission for a Regulation D Offering. Regulation D is unattractive because filing takes both time and money— the process may cost $25,000 or more when you add-up lawyer fees, etc. All of a sudden investing in best friend Ronnie’s new Foursquare doesn’t sound like a good idea.
The Commission shall, by rule— (1) increase the financial threshold for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, by calculating an amount that is greater than the amount in effect on the date of enactment of this Act of $200,000 income for a natural person (or $300,000 for a couple) and $1,000,000 in assets, as the Commission determines is appropriate and in the public interest, in light of price inflation since those figures were determined; and (2) adjust that threshold not less frequently than once every 5 years, to reflect the percentage increase in the cost of living.
Because the road to Regulation D is unsavory, more than doubling the requirement would automatically eliminate many angel investors from the market. Over the past several years, the majority of upper-middle class homeowners were able to qualify as accredited investors because their home value could be calculated for their net worth. While it’s possible to fudge your net worth— a $2 million bar is obviously harder to clear. After a small uproar in the angel community, Chris Dodd has expressed support for amending the section to the original rule, with the exception, that a house can no longer be part of one’s net worth (according to Angel Capital Association). That may still knock out some investors, but it’s a relatively fair compromise when you consider the alternative.
II. Regulation D
Under Section 926 in the original bill, the SEC is required to review every offering, with up to 120 days to review the deal— regardless of whether it involves accredited investors or not. If the SEC fails to complete its review in that window, it’s then up to the state and that state’s rules to decide.
Commission shall review any filings made relating to any security issued under Commission rules or regulations under section 4(2), other than one designated as a non-covered security under subparagraph (A)(iv), not later than 120 days of the filing with the Commission….
If the Commission fails to review a filing required under clause (i), the security shall no longer be a covered security, except that— ‘‘(I) the failure of the Commission to review a filing shall not result in the loss of status as a covered security if a State securities commissioner (or equivalent State officer) has determined that there has been a good faith and reasonable attempt by the issuer to comply with all applicable terms, conditions, and requirements of the filing; and ‘‘(II) upon review of the filing, the State securities commissioner (or equivalent State officer) determines that any failure to comply with the applicable filing terms, conditions, and requirements are insignificant to the offering as a whole….
The potential fallout is obvious: major delays for start-ups who need to deploy capital immediately, the significant upfront costs associated with an SEC filing, and the possible headache of new state rules. Thankfully, Dodd has come to his senses once again here, agreeing to offer an amendment that “deletes all previous language and disqualifies individuals who have been determined to be “bad actors” by Federal and State authorities from using Regulation D 506 private offerings,” according to the Angel Capital Association. That will effectively keep the status quo with the exception of new rules pertaining to “bad actors” (referring to those that have a record of applicable fed or state violations).
III. Is Armageddon Still Possible?
With all of Senator Dodd’s concessions, that brings us back to roughly square one. Well, not quite. It’s a given that the financial reform bill will not pass in its current form, thanks to all the cooks in the kitchen (for better or for worse). But there’s no guarantee that the amendments will see the green light either. Many in the angel investing and VC community are optimistic, but then again, few expected sections 412 and 926 to be stapled on to the 1,300-page monstrosity. The fact that the anti-angel language was originally included is a reflection of the volatile and often toxic political environment. The American public is still angry and (understandably) demanding reform. In response, lawmakers— some trying to prove something (or win midterm elections) others with decent intentions— are taking a sledgehammer to the financial sector. While the grandiose financial institutions, like Goldman Sachs, may have the largest targets on their backs, others have gotten swept up in the tsunami.
As The Funded’s Ressi explains:
Momentum is not on our side, this issue is a fly on the ass of an elephant…I can tell you what I believe the two likely outcomes are, one is bad, one is not as bad, so the bad one is…the state regulators and other interested parties change it [the bill] back and it passes as is and the legislation in Europe passes pretty much as is, and basically funding as we know it, in all stages, is done. So it has to change, so there will be a massive amount of “do we do that?”, different vehicles— there will be a massive amount of innovation. Option two is that hopefully it will be reformed, the reforms talked about today are compromises, they’re not what they should be but they’re better than what it was. (See video above)
Whatever happens in Washington will also have broader implications for the global investing community, because any reform will heavily influence Europe. The European Union is already working on new restrictions for angel investing/VCs through the Alternative Investment Fund Managers Directive.
I would say Las Vegas odds are in favor of a positive outcome for angel investors but that’s not an easy bet.