Lower the Accreditation Thresholds


By: Robert Fisher, CEO of Fisher Tanner Associates. He is a member of Ohio Tech AngelsX-Squared Angels, and the Angel Capital Association.

Editor’s Note:  The opinions in this post are from the author and do not necessarily reflect those of the Angel Capital Association.

Funding small companies through the issuance of private securities has proven to be among the most productive and efficient means of spurring innovation and job creation. A new recommendation from an advisory committee seeking to redefine who is qualified to invest in small companies puts undue focus on predicting levels of theoretical risk to unprotected investors. Such a redefinition is apt to constrain capital and damage the large and flourishing market for small company funding in place today. This blog reviews the issue and proposes a more balanced risk/benefit approach with the objective of increasing the capital available for new private investment while minimally affecting risk levels for investors or adding friction to today’s funding process.

For those of you who have not yet had the opportunity to pour over the scintillating new page burner a recommendation on the Accredited Investor Definition approved by the Investor Advisory Committee to the SEC – allow me to provide a distillation. The definition of an “Accredited Investor” (“AI”) is used to determine the eligibility of investors to participate in the private securities market by buying shares in private companies, including startups. Since 1982 this has been defined for individuals by meeting an income threshold ($200K/yr individual or $300K/yr for joint tax filings) or a net worth threshold ($1MM excluding value of primary residence). The objective was to define a class of (AI) individuals able to “fend for themselves,” meaning they are able to sustain a loss and not cry too much about it. The flaws and shortcomings of using income/wealth measures to qualify eligible investors are well documented in the recommendation which revisits the definition and suggests approaches to improving it, including among other things:

  • Regulating the levels of investment permitted based on the percentage of income or net worth or removing factors, such as retirement accounts, from the calculation of net worth
  • Allowing investors who are financially sophisticated, even if they do not meet financial thresholds, to make investments, with several potential measures including a test

A Bigger Picture

The recommendation follows a mandate specified by the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) to review the AI definition. I submit that a broader and more useful charter must include a true cost-benefit analysis to determine the desirability of private security offerings we affectionately refer to as “506 offerings.”

  • The recommendation is not a cost-benefit analysis. Such analysis would seek to measure the benefits that accrue and weigh them against the risks (quantified by their estimated cost).
  • It is important to carefully distinguish among types of private offerings when attempting to generalize about real-world instances of unsustainable losses. If new blanket regulation is designed for the netherworld of speculative deals, projects solicited in nursing homes, etc., it risks doing enormous damage to the burgeoning angel community where investments resulting in unsustainable losses remain de minimis.
  • The recommendation seems to largely ignore the benefit side of the equation. The word “risk” appears 20 times in the 11-page write-up. The word “loss” appears 11 times. But the word “job” appears only once (and only when referring to the JOBS Act). Dodd-Frank asked the SEC to study the issue “for the protection of investors, in the public interest, and in light of the economy.” How does one evaluate risk vs reward if only the former is measured?
  • Per the Kauffman Foundation, the majority of net new jobs in the U.S. come from companies less than five years old. Accredited angel investors account for over 90 percent of the equity funding of these startups. In recent years angel investing has proven to be among the most powerful engines of new job growth in the U.S.

Adjusting for Inflation

Let’s give credit where due. The recommendation does not simply recommend increasing the income and net worth thresholds to reflect inflation since current levels were set in 1982.

From the recommendation:

A common perception would be that one million dollars represented real wealth in 1982. That isn’t necessarily the case in 2014.

I wholeheartedly agree and call your attention to another passage excerpted from the recommendation that I include among my personal favorites:

First, we do not know with any certainty whether the Commission found exactly the right level when it set those thresholds originally.

Angel investors provide an instructive example to the sensitivity that investable capital has to these threshold levels. The angel capital industry we enjoy today was considerably smaller when those thresholds were set in 1982. While angel investing was happening then, few people knew or used the term “angel investor.”  In fact, by 1996 there were only about 10 angel groups in the United States. Today there are over 400, according to the Angel Capital Association. Total investments by angel investors, in groups or individually, in 2013 were estimated at $24.8 billion, and nearly 71,000 entrepreneurial ventures received angel funding.

The explosive growth of angel investing as a premier source of small company funding and new job creation is greatly due to investors’ wealth finally growing into the levels required by the ultra-high thresholds set in 1982. This fortuitous outcome would not have occurred if the original thresholds had been indexed to inflation.

I concur with this part of the recommendation which seems to suggest that there is no rationale for treating the original threshold as if it were a gold standard to which we must return.

Levels of Investment: Regulating Investor Judgment

Let’s all take a deep breath and briefly revisit the committee's mission. Small, privately-held companies fail for numerous reasons, some foreseeable some not. Among the most commonly seen in post mortem reviews among angel world investments: running out of funding, inability to scale, inability to manage people, competitive assault, inflexible CEO, market shift, fatally flawed business model. The most financially sophisticated among us will (in their humbler moments) confess these flaws are often near impossible to foresee.

Nothing in the proposed recommendation can (or should) attempt to ensure good judgment or omniscience by individuals in selecting investable companies. Rather – the focus of the recommendation is evaluating whether they can bear the economic risks of such investments. So while we rely on investors to exercise sound judgment in the selection of investments, can we not also rely them to invest only what they can afford and not compromise their retirement savings in the process? Transitioning from verifying whether an investor has the means to whether they have the judgment soon gets dicey. Perhaps there was a reason the original accreditation tests were purely financial.

Benefits: A Better Course of Action

A more comprehensive approach would focus on the benefits which considerably outweigh the risk for those engaged in angel investing. Lowering the thresholds will allow more individuals to participate as angel investors. One can reasonably deduce that a lower income threshold (e.g., $150K/yr individual, $225K/yr joint) and net worth threshold (e.g., $500K excluding primary residence) will further accelerate growth of this successful funding and job creation vehicle without undue risk of unsustainable losses which are apt to remain extremely rare in the angel world.

With regard to other forms of qualification, the recommendation notes:

The chief benefit of a definition based on income or net worth is that it is relatively simple and straightforward to implement.

While acknowledging the failure of the financial threshold tests as a measure of investment sophistication, the other approaches proffered in the recommendation add complexity, overhead, and potential for countless new loopholes which will ultimately render them counter-productive. Most importantly, as noted in the prior section, we should eschew the business of regulating investor judgment. A superior “do no harm” strategy is to lower the thresholds, watch the investments grow, and not create new impediments.

Conclusion

As noted, the Dodd-Frank mandate called for a re-examination of the AI definition and that is precisely what the recommendation does. But if we were to alter today’s private securities investment environment with no consideration of the impact on the benefits side of the equation, we risk damaging a market that has helped tens of thousands of companies gain a foothold in recent years.  Lowering the thresholds removes additional barriers to private sector growth, creating jobs and opportunities, and still maintains ample protections in accord with the intent of our beloved 506 offerings.

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