To Grow, We Must Let a Thousand Checkbooks Bloom


By: George Bittlingmayer, professor of finance at the University of Kansas and member of Mid-America Angels

This blog post originally appeared as a column in RealClearMarkets 

The startup scene in Kansas City has grown by leaps and bounds in recent years, mirroring the upswing in cities nationwide. In fact, the big, welcome news of the last decade is that tech innovation hubs have expanded beyond Silicon Valley to cities from Austin to Pittsburgh and Boulder to Nashville. Unfortunately, those new, thriving ecosystems of entrepreneurs, incubators and early-stage investors may soon hit a headwind blowing in from Washington, D.C.

Angel investors, the first and often crucial providers of funding for high-growth startups, provided $24.8 billion in growth capital last year, not too far behind the $29.6 billion that came from venture capital. While the overall amounts are similar, angel investors play a distinct role, typically funding businesses earlier and with smaller amounts per company.

While there are a few "super angels" who individually investment millions per year in a large number of companies, most angel investors are middle-class professionals - entrepreneurs, attorneys, consultants, engineers and middle managers - who each invest comparatively modest amounts. Refined in the U.S., this arrangement channels grassroots talent and capital to productive uses in ways that are the envy of the world.

Under Dodd-Frank, the US Securities and Exchange Commission is obligated to tinker with this system, and it may be optimistic to expect that the agency will leave well enough alone. All investors in "unregistered" offerings, and thus all angel investors, must qualify as "accredited investors." According to SEC rules from 1982, this means having an annual income in excess of $200,000 or net assets in excess of $1 million. Fortunately, those limits have not been adjusted for inflation, allowing the investor base for startups to broaden. However, Dodd-Frank requires the SEC to review this definition after July 21 of this year "to determine whether the requirements of the definition should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy." The SEC has invited public comment but revealed little of its thinking.

Public comments and pending proposals focus on the income and net asset hurdles, and whether other criteria, such as expertise, should be added to those dollar hurdles or substituted for them. One proposed change seems obvious but is potentially catastrophic. The North American Securities Administrators Association (which represents state and provincial securities regulators), the AARP and the Consumer Federation of America argue that the income and net worth limits should be adjusted for inflation. The AARP would limit accredited investor status to those with at least $400,000 in income or net assets in excess of $2.5 million, a rough doubling in one fell swoop. Implementation would likely result in the loss of at least few billion of the annual $25 billion in angel funding. A recent survey by the Angel Capital Association found that 25% of the members polled would be excluded under inflation-adjusted criteria.

Higher dollar limits might make sense if fraud were a problem or if middle-class retirement savings were at risk. However, actual experience provides no evidence, systematic or anecdotal, that angel investing is plagued by fraud or catastrophic losses. Unlike the case of AAA-rated mortgage-backed securities in 2006, startup investments are known to be risky. Also, the growth of angel investing has meant that education, support and guidance are available from angel groups and law firms specializing in startup finance. Angel investing is not the Wild West, if it ever was.

Rather than restricting the number of angels, it makes more sense to expand their ranks, which the SEC is free to do. Last fall, New Jersey congressman Scott Garrett pressed SEC chair Mary Jo White on whether the funding and efficient functioning of non-public markets like angel investing would be improved if the SEC allowed individuals with formal certification (say a CPA, CFA or a business degree) to qualify as accredited investors, regardless of income or net worth. In February the Angel Capital Association proposed that current income and net asset thresholds be maintained and that, in addition, investors be allowed to attain accredited status independent of income or net worth based on experience or certification.

As we can attest from the Great Recession, the American and global financial systems can and do malfunction. Even venture capital has come in for its share of criticism for its high fees and poor performance. One bright spot has been angel capital, which has more participants than ever before thanks in part to income and wealth limits that have effectively decreased over time. Consistent with the intent and assumptions of the JOBS Act and with the judgment of thousands voting with their checkbooks, less will be more. Lower hurdles on participation will strengthen thriving startup scenes in Kansas City and across the land.

George Bittlingmayer is a professor of finance at the University of Kansas. 

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