Don’t Ask Investors to Change. Change Policy.

By: Samer Yousif, VentureWell

There’s been a reckoning in the early-stage investment ecosystem. 

For the first time in history, investors are being forced to recognize and reflect on the lack of diversity within their portfolios and pipelines — and from Silicon Valley to New York City, the startup capital ecosystem is experiencing a reckoning. With the rising momentum of the present moment, many entrepreneurs, ecosystem builders, and even fellow investors are collectively calling on financial stakeholders to commit to meaningful change in their sourcing, screening, and investment practices.

Much of this push for change has been focused on institutional investors and venture capital firms, many of whom have responded with a variety of statements, promises, and initiatives. Very little attention, however, has been paid to angel investors.

Angel investors need to be held accountable.

Angel investors are a critical component of a thriving startup ecosystem. They often write some of the first checks to new ventures and provide critical guidance to early-stage companies and first-time founders. According to the Angel Capital Association’s Angel Funders Report, which surveyed 68 angel groups in 2018, they accounted for $228 MM in investments across 905 companies; they also helped catalyze an additional $1.8B in investments through syndication with other angel groups, individual angels, VC funds, and private equity investors.

While venture capital funds can be easily influenced by the power of public pressure to be more inclusive, angel investors are more private. The diversity of their portfolios is often overlooked and the lack of capital invested in diverse founders by angels mirrors the rest of the industry.

Of the $228MM of angel capital tracked in the survey, 88% was invested in white founders. Black founders represented 3.8% of those investments, mixed race founders represented 1%, and Latinx Founders did not receive enough investment to be tracked in the report. Although female founders increased their percentage of investment from 5% in 2004 to 21% in 2018, that number is still far from parity with male founders. Similarly in the last 5 years, Latinx founders received 1.8% of invested VC capital, Black founders received 1%, and female founders received 9%, reflecting the systemic challenges embedded in our investment ecosystem.

It’s well-documented that diverse teams and companies outperform their homogeneous counterparts by leaps and bounds. However, even with indisputable data at our fingertips, we haven’t seen a corresponding increase in angel capital going to diverse startups. It’s overwhelmingly clear that research alone isn’t going to cut it. Rather, to change behavior, we must change policies in which angel investors and startups operate. By developing evidence-based, culturally competent regulations, policymakers and government officials can reshape incentives and frameworks to catalyze a new generation of investors that’s more diverse than ever before — and, in turn, lay the foundation for a capital-heavy community that can provide a significant increase in investment for diverse founders.

We need more angel investors.

To become an angel investor, an individual must be an Accredited Investor, as defined by the SEC. In short, the individual must have at least $200,000 in annual salary for the past two years ($300,000 for couples), or have $1MM in net worth, excluding their main residence. This Definition for Accredited Investors is problematic, especially for investors of color. While initially created to protect individuals who may not have the financial knowledge or assets to sustain potential losses from angel investing, in practice this policy has effectively shut out many investors of color from this asset class.

Currently, non-accredited investors are mainly only able to invest in public markets. In 2018, two thirds of all securities offered were in private markets and eligible only to the wealthy–those investment opportunities were inaccessible to 88% of Americans. Unsurprisingly, many of those excluded Americans are investors of color. According to the last American Angel report, approximately 1.3% of surveyed angel investors identified as Black; 2.3% identified as Latinx.

Additionally, the length of time it takes a company to reach an IPO has increased from 4 years in 1996 to 11 years in 2019. As a result, the number of public companies in the U.S. has halved from 1997–2017. As companies decide to remain private longer, a majority of Americans, including those that have the financial knowledge and wealth to invest in this asset class, are systematically excluded from these wealth creation opportunities. The SEC has even acknowledged that the current Accredited Investor definition is disproportionately depriving minorities and people in lower cost of living areas of the chance to invest in the private markets.

Changing the Accredited Investor Definition.

In December 2019, The SEC proposed amendments to the Accredited Investor Definition to include “those with the knowledge and expertise to participate in our private capital markets”. The SEC was accepting public comments on the proposed amendments and is now considering how to reform their Definition. At a high-level, the proposed changes are included below (a deeper dive can be found here):

  • Knowledgeable Employee Qualification — Confirms that investment employees of a fund or its fund manager qualify as Accredited Investors.
  • Joint net-worth and spousal equivalents — Allows for the wealth and income threshold to be met by spousal equivalents, including cohabitants and same-sex couples.
  • Licensed Financial Professionals — Allows individuals with certain investment-related certifications or credentials to automatically qualify as Accredited Investors. Although not finalized yet, FINRA Certified individuals (Series 7, 65, and 82) are likely to be included.
  • Registered Investment Advisors — Investment advisors that are registered with the SEC are Accredited Investors.
  • Rural Business Investment Companies (RBIC) — Any entity that has the status of being a RBIC would automatically qualify as an Accredited Investor.
  • Qualified Entities — This broadens the types of entities that can qualify as Accredited Investors to include Family Offices, LLCs, and other entities with at least $5 million in assets. Additionally, any entity whose owners are all Accredited Investors, is also considered an Accredited Investor.

It should be noted that the SEC has not proposed to change the net worth or income threshold for the Accredited Investor Definition. Although the SEC seems to be taking steps in the right direction, it hasn’t gone far enough. The above changes are modest improvements on this policy, but not reevaluating the wealth threshold is an oversight.

Communities of color have been deprived of wealth creation opportunities for centuries, as evidenced by the average Black Families’ net worth estimated at 10% of the average White Families’ wealth in the U.S. As a consequence of these disparities, investors of color may not have the same net worth of their white counterparts but they may still have the knowledge, interest, and opportunity required to invest in this asset class. In acknowledging this disparity, the SEC should reexamine their wealth threshold to a more accessible level. Additionally, the existing Definition disadvantages individuals living in lower cost of living areas. An individual making $200,000 living in San Francisco would need to make about $109,000 to maintain the same standard of living if they were in Houston.

Some recommend that the SEC remove the Accredited Investor definition altogether. While enticing, this option would essentially make the asset class open to all Americans and remove many of the necessary protections for less experienced or risk-tolerant individuals. Rather, there should be a more inclusive middle ground. It isn’t clear yet what an inclusive and responsible Accredited Investor Definition should be. But it is clear that the new Definition must include the interests and needs of communities of color.

That includes better incentives for angel investors.

California, Massachusetts, and New York continue to lead the U.S. in venture capital investments, in terms of deals and dollar amount. As early-stage capital continues to flow through those states’ economies, other states have created strategies to attract some of those investments. One tool that has gained popularity among many states is the Angel Tax Credit. An Angel Tax Credit (ATC) is used by states to incentivize investment in early-stage, high-growth potential startups within their state by providing tax breaks for qualified investments.

There is currently a patchwork of different angel investor tax credits across the U.S., with 29 states implementing different ATC policies, with varying caps on the tax credits per investor, and regulations regarding carry-over and refunds. Each of these initiatives have been implemented to varying degrees of success.

Minnesota has taken a unique approach to their ATC policy. In 2010, they introduced a 25% angel investor tax credit for angel investments in Qualified Businesses, which is administered by the Minnesota Department Employment and Economic Development (DEED). Both the angel investor and startup must be pre-qualified by the DEED for the investment to be eligible for the ATC. Additionally, investors are required to make a minimum investment of $10,000 in any given deal for it to be eligible. In the first two years after launching this initiative, Minnesota was able to significantly increase the amount of capital invested in startups within the state. Between 2010–2012, $71.7 million in angel investment (52 percent of the total Qualified Investments during that period) was attributable to the ATC, and 48% of investors reported that they would not have made their Qualifying Investment had the ATC not existed.

Despite these incentives, diverse founders continue to be under-funded.

As a part of the Minnesota Angel Tax Credit legislation, 50% of the tax credit was set-aside for diverse founders (women, people of color, and those living outside of the Twin Cities region). Unfortunately, that mandate wasn’t met. From 2010 to 2012, only 1% of the $138.9MM of capital and accompanying ATC went to founders of color and minority-owned businesses.

Those disparities continue today. In 2019, the Minnesota ATC was reauthorized for $10MM, with a target of 50% of tax credits allocated toward diverse founders. Again, that target was not met. Of the $39.9MM Qualified Investments in 2019, diverse founders received 14%.

Of the three categories of diverse founders listed above, founders of color fared the worst. They received 4.5% of the Qualified Investments made in 2019, a total of $1.8MM. This is in a state that is about 21% people of color.

Minnesota had good intentions in their attempt to incentivize investments in diverse founders, however, the execution has left much to be desired. Good intentions need to be supported with targeted interventions to ensure that this public subsidy of investments actually reaches its intended beneficiaries.

First, we must increase the incentive to invest in diverse founders.

Although Minnesota had set aside half of the $10MM in ATC funding for diverse founders in 2019, only 14% of the total qualified investments went to those groups. The body governing the disbursement of these loans should have a stronger mandate to achieve the targeted investment goals. In an effort to increase their reach, DEED decreased the minimum threshold for Qualified Investment to $7,500 for diverse founders, down from $10,000 for non-diverse founders, but that wasn’t enough. To overcome systemic barriers, policymakers need to double down on their investments in those communities. Potential strategies include increasing the amount of the tax credit for Qualified Investments in diverse founders, extending the number of years the credit can be carried over, and/or making those tax credits refundable to investors.

We must increase awareness of these initiatives

In 2019, only 7 Qualified Businesses led by founders of color received an ATC-eligible investment; similarly, 11 Qualified Businesses led by female founders also received investment. There is a need to engage a broader group of diverse founders in this program in order to increase awareness of the tax credit, provide assistance with their qualification applications, and educate entrepreneurs on how to leverage the ATC to incentivize investments.

We need to actively engage more female investors and investors of color.

It is well-documented that implicit bias has a strong negative impact on the decision making of investors, a majority of whom are white and male, in regards to making investments in diverse founders. Additionally, investor networks are often inaccessible to diverse founders, adding another barrier to their access of capital.

Conversely, female investors and investors of color are more likely to have networks that are accessible to those same founders, more likely to pattern match with those founders, and more likely to fairly vet the investment opportunity. This is evidenced by angel networks like Golden Seeds37 Angels, and the Black Angel Tech Fund.

Investor networks and angel funds like Portfolia and Pipeline Angels are actively disrupting the angel investment ecosystem by recruiting and training a new generation of female investors and investors of color who are committed to funding diverse founders. By intentionally engaging such organizations and nurturing the development of additional organizations, policy makers and administrators of ATC can increase the amount of capital being invested in under-resourced founders.

We need to hold our policymakers accountable.

As outrage continues to grow within the investor, startup, and tech communities, we have to use all levers of influence to change the ecosystem. Especially public policy. Developing evidence-based, long-term policies and regulations that change the framework in which investors and startups operate is integral to building a more equitable ecosystem.

As a community of innovators, investors, and ecosystem builders, we need to bring a holistic and analytical approach to the various systemic barriers that are severely inhibiting our collective potential and develop creative, ambitious policy solutions. We’re living in a once in a lifetime moment; let’s capture it.

About Samer Yousif - Samer works on VentureWell’s global programs, most frequently with the U.S. Department of State’s Global Innovation through Science and Technology (GIST) initiative. Prior to joining VentureWell, he spearheaded the North America outreach strategy for a global competition while at Ashoka. Samer has a Masters of Global Policy Studies with an emphasis on international entrepreneurship from the University of Texas at Austin.