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In the May issue of Investment Advisor, we noted that Senator Chris Dodd's financial services reform bill (being debated on the floor of the Senate as I write) contains new provisions that would reduce the number of individuals eligible to invest in private ventures. The original draft of the bill would increase the $1 million net worth threshold that defines an "accredited investor," which in turn determines an individual's eligibility to invest in exempted private securities offerings under Regulation D of the 1933 Securities Act. These Reg D offerings enable startup businesses to access "angel" capital and are consequently the critical means of finance for early-stage ventures that could not otherwise bear the prohibitive costs and regulatory burdens of SEC registration.
The angel investor and entrepreneurial community responded vociferously against the proposed legislation, citing the impact that an estimated 77% reduction in the ranks of accredited investors (per a BusinessWeek estimate) would have on angel investment, financing startups, new job creation, and reviving the reliable stalwart of economic growth--the small business sector.
Since our last column, the Angel Capital Association announced on its Web site that Dodd and his Senate Banking Committee have drafted amendments to the initial proposal whereby the threshold for "accredited investor" would stay the same, although the standard for net worth of $1 million would now exclude the investor's primary residence.
The ACA has proclaimed that although "we would have preferred no adjustment to the standard for angel investors, we believe this is a good compromise" adding that the amendments "improve the bill so that it balances the importance of small business capital formation while protecting angels and other types of private investors from securities law violators."
What bunk. The opportunity to make a private investment in a private venture should be every investor's right. The ability to invest in a new business should not be an exclusive privilege bestowed by politicians upon persons of a certain economic class.
No New Investor Protections Needed
Moreover, there are ample investor protections already in place. The SEC's powerful Rule 10b-5 is all about protecting investors, and it applies to private investors just as it applies to the general public. Every state has securities laws on the books that protect private investors from fraud. Indeed, the registration requirements of the 1933 Act also serve that protection purpose. As explained by SEC alumnus Patrick Daugherty of the New York-based law firm of Foley & Lardner, "Regulation D is an exemption from those registration requirements. It's part of our law precisely because there exists a class of investors who can 'fend for themselves,' in the words of the Supreme Court's venerable Ralston Purina holding. Congress, the SEC, and the Supreme Court have believed for 50 years that offerings limited to investors who are 'rich and smart' about finance need not be registered."
Although there is no doubt that the majority of frauds have occurred in highly regulated or visible investment schemes (remember Refco, Enron, and Worldcom?), there is ample history of unscrupulous brokers, dealers, issuers, and promoters abusing Reg D and defrauding investors. The SEC's recent indictment of Provident Royalties LLC for a massive $485 million Ponzi scheme is a good example of how the SEC's limited resources could be effectively allocated away from surfing porn on the Web.
But I have never heard a cogent argument that supports the notion that any individual should be restricted from the opportunity to invest in a startup or new business venture that has appropriately disclosed the risk of failure and loss of all capital that is inherent to venture investment.
What's my point? Private venture investment in startup and early-stage businesses should be entirely exempt from the Reg D accredited investor provisions.
Angel investors know the risks are high and that a significant portion, if not the majority, of their venture investments will fail. There is absolutely no evidence that angels investing in startups played any role whatsoever in the recent financial crisis that has prompted Dodd's proposed reform bill. So, who does this compromise "protect"?
The notion that net worth is an effective indication of an individual investor's sophistication or ability to bear the risk of loss is laughable. The bright-line standard used to ascertain an investor's sophistication is ironically unsophisticated and utterly under-inclusive.
I align with Richard Rahn, chairman of the Institute for Global Economic Growth, that "the rule makes little sense and strongly discriminates against knowledgeable people who are not yet wealthy but are quite capable of making good investment decisions." Rahn refers to this as "financial fascism."
Jeff Joseph is an angel investor, financier, venture catalyst, managing partner at Prescient Capital Partners, and the author of the blog at www.venturepopulist.com. Send Jeff comments, questions, and column suggestions at firstname.lastname@example.org.