How Dodd's Reform Plan Hurts Startup FinanceScott Shane
Tucked into Senator Christopher Dodd's (D-Conn.) massive proposal to fix the U.S. financial system are a few changes that would affect how new businesses are financed. While investors in new businesses aren't the target of the senator's financial reform plan, the proposed bill would cause some collateral damage to the way that informal investors finance companies if it became law.
New Criteria for Accredited Investors
Senator Dodd proposes adjusting for inflation the income and net worth requirements for a person to be considered an "accredited investor" by the Securities & Exchange Commission. This benign-sounding change would dramatically reduce the number of accredited informal investors financing companies in the U.S. today.
Currently, a person must have a net worth of $1 million or an annual income of $200,000 if single or $300,000 if married (and filing jointly) to be an accredited investor. The senator's proposed bill doesn't say what inflation adjustment will be used to convert these numbers, established in 1982, to today's dollars. But if we use the Bureau of Labor Statistics inflation calculator to adjust these figures on the basis of the consumer price index, then the annual income requirements for accredited investor status would become $449,000 if the investor were single and $674,000 if the investor were married, while the net worth requirement would become $2.25 million.
Even under current metrics, there aren't that many accredited informal investors. In 2004, sociologist and business demographer Paul Reynolds conducted a representative survey of the informal investing activity of the U.S.adult population.Updating Reynolds' estimate of the share of the adult population who are accredited investors to the 2008 adult population as reported in the Statistical Abstract of the United States, there were 5 million to 7.2 million American adults who were accredited investors in 2008.
Reynolds' survey found that 10.5% of accredited investors had made an informal investment in the previous three years. So we are talking about 528,000 to 756,000 accredited investors who made a friends-and-family or angel investment in the previous three years.
Adjusting the income and net worth requirements for accredited investing to those proposed in the Dodd bill would reduce the number of accredited informal investors to 121,000 to 174,000 people. (Applying the inflation-adjusted income requirements to 2007 IRS tax return data—the latest available—the number of accredited investors on the basis of the change in the single filer income requirement would drop 77%, from 4.5 million individual filers who earned $200,000 or more to 1.04 million individual filers who earned $500,000 or more.) That's a massive drop in the number of accredited informal investors.
Why Being an Accredited Investor Helps
While the same people who made informal investments as accredited investors under the current net worth and income requirements could make those same investments as unaccredited investors if Senator Dodd's inflation adjustment became law, that the investors would no longer be accredited would have two adverse effects on startup finance.
First, some of the most successful startup companies transition from informal investment to institutional investment as they grow and demand more capital. While only a small number of companies that obtain an informal investment subsequently obtain venture capital financing—perhaps several hundred to a little more than 1,000 per year—these companies are disproportionate creators of wealth and jobs. (The National Venture Capital Assn. reports that approximately 10% of sales and employment in this country are accounted for by the less than 1% of startups that received venture capital backing.)
Venture capitalists prefer to invest in startups backed by accredited informal investors rather than unaccredited ones. Venture capitalists typically invest their money through a sale of securities under Regulation D of the Securities Act of 1933. Rule 506 of Regulation D provides for an exemption from registration if all of the investors are accredited and requires additional disclosure requirements if any of the investors are unaccredited.
In terms of complying with securities laws, it is cheapest and easiest for venture capitalists to focus their investments in companies that have received money only from accredited investors. Therefore, the dramatic decline in the number of accredited informal investors that would occur if Senator Dodd's bill became law would mean a massive reduction in the number of startups receiving their initial capital in a way that makes them attractive to follow-on investment by venture capitalists. Such a reduction would make it more difficult for many entrepreneurs to obtain venture capital financing.
Second, if the level of income and net worth required for accredited investor status were increased, many currently accredited informal investors would no longer be able to invest as part of an organized angel group, thus lowering their investment performance. (To facilitate compliance with securities laws, angel groups generally require their members to be accredited investors.) According to Rob Wiltbank of Willamette University, who analyzed this question using his data on angel group members, only 40% would meet the new net worth requirements.
The inability to invest as part of a group is likely to lower angel investor performance because of the myriad advantages that group investing provides. First, group investors get better access to deal flow because entrepreneurs can more easily identify angel groups than individual angels. Second, group investors can make use of each other's expertise to make better investments. Third, groups benefit from scale economies in due diligence and investment management and can better standardize investment processes. Fourth, groups can pool resources and make larger investments than individuals can make alone, and allow investors to better diversify their investments across ventures, industries, and technologies.
The Problem of State Regulation
Senator Dodd's bill would also permit the states to impose their own set of regulations on securities offerings, something that is currently prohibited. Different state regulations on securities offerings could pose several problems for startup finance.
First, the kind of informal investing in high-potential startups by accredited investors tends to take place in areas around major cities. Many of these cities are located in places where investors live in different states. For instance, companies located around our nation's capital could easily raise money from investors in Maryland and Virginia, while those in New York City could easily raise money in New Jersey, New York, and Connecticut. If different states imposed different securities regulations, making accredited informal investments in affected cities would become more difficult and costly.
Second, entrepreneurs sometimes raise money from investors located in a different state from where the startup is located. Angelsoft, a provider of investment tracking software for angel groups, found that 26% of the investors in the average angel deal undertaken by a group using its software were located in a different state from the startup. Thus, the proposed legislation would likely require one-quarter of entrepreneurs raising money from angel groups to comply with more than one state's regulations on securities offerings.
Third, many angel groups now co-invest, with some of that co-investment occurring across state borders. Cross-state co-investment by angel groups (or individual accredited informal investors) would become much more complicated if the states were permitted to impose their own regulations governing investments in startups.
In short, there's nothing wrong with Senator Dodd's efforts to reform our financial system. However, his bill needs to take more precise aim at the sources of our current problems to avoid adversely affecting our system of financing startups through informal investments.