Little Known Dodd-Frank Rule Change May Hurt Startups

**This post originally appeared on "The Hill" on March 3, 2015.**

By: Chris McCannell, director of APCO Worldwide’s Washington DC financial service practice and government relations. He has over 15 years of Capitol Hill experience working for Members of Congress on the Financial Service Committee and the tax writing Ways and Means Committee. He and his colleagues have been ACA’s registered lobbyist for the past two and a half years. Chris is an active participant in ACA’s programming including national events like this week’s Leadership Workshop.

The conversation around implementation and rulemaking of the Dodd-Frank Financial Reform legislation, which became law in 2010, has been focused on issues such as margin requirements for derivatives, bans on proprietary trading (the Volcker Rule) and other bank centric capital standards. Lost in the debate is a little known part of the legislation which requires the United States Securities and Exchange Commission (SEC) to revisit the definition of an accredited investor. A change in this industry wide definition could have drastic impact on capital formation, start-up growth, and ultimately American jobs.

Investing in start-up companies is risky. In order to limit exposure and ensure that investors have the ability to tolerate financial risks, policy makers set a minimum requirement of $200,000 of annual income or $1 million in net worth (excluding a primary residence) in order to invest in non-public offerings.  Dodd-Frank requires that the SEC revisit this definition of accredited investors every four years, with some advocates pushing for the minimums to be raised to reflect inflation.

An adjustment in the definition of an accredited investor would greatly impact capital formation and job creation for today and tomorrow’s start-up companies. Currently start-up entrepreneurs raise capital by first exhausting their own personal savings, turning to family and friends before involving outside investors.  The first  outside investors are typically angel investors, accredited individual investors who come together to research investment opportunities, mentor entrepreneurs and ultimately invest in start up companies. Angel investors are spread throughout the United States investing their own money to nurture early stage start-up companies. In 2013 angel investors invested an estimated $25 billion in 71,000 companies in the United States. Angel investors bring 90 percent of the early stage equity raised by start-ups. Their investment in successful companies are often followed with subsequent rounds of investment by venture capital, private equity and potential public offerings.

The SEC itself and Government Accounting Office found that a change in the accredited investor definition to reflect inflation which some advocates are supporting to $450,000 in income or $2.5 million in net worth would eliminate 60 percent  of the households that currently qualify as accredited investors. The Angel Capital Association, the trade group representing 12,000 accredited investors has conducted a survey which confirms this, also finding that the impact would be higher in the country’s interior.

Proponents of change in the accredited investor definition argue higher limits will eliminate investor fraud.  Anecdotal stories of grandmothers being swindled out of their life savings in nursing homes abound, but a change in the definition of what constitutes an accredited investor would not lessen the opportunities for fraud. In the most famous example perpetrated by Ponzi artist Bernard Madoff, his customers were by and large very high net worth individuals, sophisticated financial institutions and foundations, all accredited investors who were taken advantage of by a fraudulent salesman. In the angel investing community fraud is virtually unknown and next to impossible to perpetrate. Entrepreneurs make their pitch to angel investors who research companies, analyze economic potential and invest capital after due diligence. Angel investors have direct contact and knowledge of the entrepreneurs and companies they are investing in.

Changes in definition of wealth will also incentivize currently accredited individuals who become unaccredited through new rules to direct their capital to other investments such as real estate, public stock offerings and high risk bonds instead of start-up companies, starving our entrepreneurs from capital and our country from much needed jobs.  From 1980 to 2005 the Kauffman Foundation research showed that firms less than five years old accounted for all net job growth in the United States. The large majority of these jobs come from innovative high growth firms, the kind of companies angels fund.

Instead of a one size fits all approach, the SEC should look to adding specific sophistication criteria through a detailed questionnaire to ensure that an accredited investor has the financial experience and knowledge in addition to asset requirements to invest in early stage start-up companies. This approach could help maintain the pool of capital needed for job creating start-ups.