Will Angel Networks Be A Safe Harbor For Generally Solicited Deals?

This post was written by Jean Peters, ACA Board Member and Managing Director of Golden Seeds.

If the SEC takes advice it solicited at last fall’s annual government-business forum, accredited investors who are part of an angel group or network may enjoy a “safe harbor” when investing in a company that uses general solicitation to attract funds.

Under Title II of the Jumpstart Our Business Startups Act (JOBS Act), in order to claim the exemption while employing general solicitation, issuers must “take reasonable steps to verify” that all ultimate purchasers meet the accreditation standard.

Creating a safe harbor for organized angel groups comes as part of the number one priority recommendation on exempt securities in the Final Report of the SEC Forum on Small Business Capital Formation. The recommendations were compiled as the culmination of a full day of commentary, presentations and breakout sessions that were attended by more than 250 attorneys, investors, commission staff and other practitioners. I attended the forum on behalf of the ACA, and was part of the panel on exempt securities offerings. Similar breakout groups regarding crowdfunding and regulation of small companies were held concurrently. (For the full report, click here.)

The report’s recommendation addresses concerns over the SEC’s current proposed rule to eliminate the ban on general solicitation, which states that the commission would consider the “particular facts and circumstances of each transaction” in gauging whether an issuer’s attempt to verify the accredited status of all buyers is satisfactory. (For the full proposed rule, click here.)

The proposed rule goes on to list a labyrinth of potential factors that could help determine the reasonableness of verification steps, including: “the nature of the purchaser;” the “amount and type of information” an issuer has about the purchaser; and the “nature of the offering,” including terms such as a minimum investment amount. The rule further elaborates on these factors, but carves out no specific safe harbors. (For the accredited investor definition, click here.)

Given the likelihood that many if not most startups coming to an angel group will concurrently be conducting general solicitation, the amount of information an issuer may require from an angel investor – without a specific safe harbor -- could be prohibitive. As a result, a number of attorneys are advising angels not to participate in generally solicited deals – once they become legal – if no safe harbor exists.

The bar for what constitutes general solicitation is low. Examples the SEC cites include: advertisements in newspapers and magazines, communications on television and radio, seminars whose attendees have been publicly invited, unrestricted websites and other uses of publicly available media. Such activities would apply to almost any startup that has entered a business school competition, or been written about in a newspaper or blog post. Only the stealthiest of startups could be deemed “quiet 506” candidates – those with no hint of general solicitation.

The consequences of failing the “reasonable steps to verify” test could be quite significant – if an unwary, non-accredited investor slipped into the mix of buyers, angel investors who take board seats on the company could face personal liability, and the transaction could be unwound.

This is not the result Congress intended in passing the JOBS Act, and the forum’s final report offers clear and simple alternatives, noting: “The final rule should provide guidance through a non-exclusive list of safe harbors including but not limited to a presumption of accreditation.” Among those safe harbors, the report cites “certification by third parties such as … angel networks, broker-dealers or certain private services.” The report also recommends that the final rule provide that issuers will not lose the exemption if they rely in good faith on information provided by investors.

Angel investors take many risks in investing in the startup economy, including likelihood of an enterprise failing, and extreme illiquidity. One of the most powerful ways to mitigate risk is by forming groups that operate with professional standards, disciplined due diligence, deal screening, term sheets and corporate governance.

Rule makers working on finalize rules ending the ban on general solicitation should take note, and codify the recommendation to make angel networks a true safe harbor for all who sail therein.