David Verrill is Chairman of the Angel Capital Association and also leads the Hub Angels Investment Group in Boston. He wrote an Op-Ed in the Wall Street Journal today on the SEC General Solicitation Rules.
Last week's SEC ruling on General Solicitation sounds an alarm to angel investors in the US on several grounds. But first, a quick summary of the ruling. Rule 506b keeps regulations as they are for those companies who only privately solicit funds from self-certified qualified investors. No harm there, and thanks to the SEC for maintaining the status quo for what has been historically the best way for startups to raise money from accredited angel investors.
The problem is with the new 506c rule, which puts the issuer (CEO of a startup, hedge fund manager, venture capitalist) on the hook to take “reasonable steps” above and beyond the self-certification questionnaire to verify accreditation of an investor if the issuer generally solicits that investor. The definition of what constitutes being generally solicited is extremely broad, including anything public, such as an event or appearing on a Web site. Herein lies rub #1. Much of the
deal flow for my angel group comes from events and activities that could well be considered a "public" forum. Think about the accelerators (TechStars Demo Day), business plan contests (MIT $100k, MassChallenge events), or even the portals (Gust) that all have mechanisms of communicating with their various audiences that makes them likely subject to the 506c requirements. These critical members of the startup ecosystem are very important sources of quality deal flow for angels (and
VCs). In order to avoid any question of whether or not 506 b or c would apply, an issuer might play it safe and file under 506c because the penalties are severe (like offering your investors their money back, or being banned from raising more capital for a year) if you file for 506b but are shown to have generally solicited. What would you do as a startup CEO?
For 506c filings the SEC provided a complicated set of principles about what constitutes “reasonable steps”, although it did provide a non-exclusive list of methods that would satisfy the requirement, such as two years of federal tax documents to the issuer – or, have a third party (lawyer, accountant, broker, investment advisor) verify accreditation, and recertify on a regular basis (as frequently as every 3 months). Herein lies rub #2. Angels invest their own money, when and
where they want. We avoid brokers, and have no investment advisor intermediaries – we know the startup space better than any investment advisor. The dozen or so angels I talked with this week said they would never give their tax returns to a startup CEO, broker, lawyer or investment advisor. While providing more detailed financial information for an investment in say, a hedge fund, is common practice and perceived as a cost of doing business (and some would argue for good reason given the
fraud in that particular asset class), this is certainly NOT common practice in angel investing – we don’t need them, don’t want to pay for them, and don’t want to introduce unnecessary third parties into an ecosystem where there is virtually no fraud. We want every penny going to the startup – not some unnecessary third party.
The US General Accounting Office (GAO) has been given the responsibility by Congress to review the rules of accreditation. Today you are considered a sophisticated and accredited investor if your annual income for the past two years has been $200,000 or more (or $300,000 if filing jointly with your spouse), or your net worth is more than $1 million (not including your primary residence). Last week the GAO thankfully did not recommend increasing these hurdles – investors like the
consistency of regulation, if the hurdles were increased significantly then huge numbers of angels would stop investing. The GAO did not do angels any favors though in recommending the SEC consider adding additional criteria to the wealth and income levels –like the use of investment advisors. Will an investment advisor provide any value added to the 270,000 active angel investors in the US?
The SEC (and GAO) has done a great job of soliciting inquiries from organizations and individuals far and wide. But frankly, they have not paid attention to how the startup ecosystem works, and who the drivers are. In 2012 angels are estimated to have invested nearly $23 billion in more than 67,000 startup companies – constituting almost 90% of the outside capital to get those companies started. That is 20 times the number of companies that VCs invested their $27 billion in last year,
with very little of that going to true startups. The startup companies that angels funded last year created nearly 275,000 jobs – and over the last 20 years companies less than five years old have provided nearly all of the net new jobs in the United States. Hedge funds raised more than a trillion dollars in 2012 - a huge part of the alternative investment economy to be sure, but did they directly create any jobs?
Angels are the lifeblood of startup companies in the US. Angels invest on every Main Street in the US, not just Wall Street. Angels are primary job creators in our economy. Angels provide expertise, mentorship and a whole host of other benefits besides their money. Angels tend to plow profits back into the startup ecosystem. Angels invest their own money, not those of a pension fund. There is almost no fraud in the angel world.
The SEC needs to recognize the power of angels, and the value chain of funding a company from startup to successful exit. The SEC needs to protect angels with safe harbors against 506c. The SEC needs to continue preserving the self-certification of accreditation in 506b. And the SEC needs to maintain the current levels of income and wealth for accreditation without onerous and unnecessary requirements – including third parties. Only these actions will allow the Jumpstart Our Business
Startups (JOBS) Act to achieve its intended goals – to make it easier for companies to gain funding, and create more high paying jobs.