Senator Christopher Dodd (D-Conn) recently introduced sweeping legislation that aims to rein in the excesses that led large financial institutions to become “too big to fail.” Somewhat ironically, it also has the potential, as one commentator put it, to make startups “too small to succeed.” In the rush to prevent future problems, we risk taking resources away from our entrepreneurs who are the economic engines that create jobs and help grow GDP.
Two Problems for Entrepreneurs
There are two small and seemingly innocuous provisions buried in the over 1,300 pages of this bill that almost certainly will hurt startups, particularly those at the earliest stages. Both have been opposed by the Angel Capital Association and the National Venture Capital Association. The first (sections 412 and 413) would change the definition of “accredited investor.” The second (section 926) would delegate at least part of the oversight for private placement filings—known as Regulation D—from the federal level to states.
These may be small provisions, but they will have no small effect. According to a study last year by the Kauffman Foundation, so-called “gazelle” firms (ages three to five years) comprise less than 1 percent of all companies, yet generate roughly 10 percent of new jobs in any given year. Even more to the point, remove startups from the job creation totals, and only six years from 1977-2005 saw net positive job creation. In the other 28 years of this span, without startups there would have been net job losses. The jobs attributed to startups reflect both the innovation entrepreneurs bring and the net growth to GDP that’s been heavily documented by both the Kauffman Foundation and NVCA.
“Accredited Investors:” Does the SEC Really Need to Protect Millionaires? Dodd’s bill recommends changing the definition of “accredited investor,”which was set roughly 30 years ago at $1 million in net worth or $200,000 per year in salary for individuals. The idea then was that people who were millionaires had sufficient resources to evaluate investment opportunities and did not need the Securities and Exchange Commission to look out for them. While wealth is not necessarily a proxy for sophistication, at least those prospective investors had the resources to hire lawyers, accountants, and other service providers to help them in their assessment.
The argument behind changing the definition is that, thanks to inflation, $1 million is no longer what it used to be. The mistake in that argument is that the world is not what it used to be, either. Back in the 1980s, there were no on-line resources for investors, few entrepreneurial events, and most people, including myself, didn’t know how to spell “VC.” Today, anyone with a computer can learn more than they can imagine about term sheets, growing entrepreneurial businesses, and venture capital. Checking references: use LinkedIn. Need details on an esoteric technology: you’ll likely find a blog, Wikipedia articles, and links to experts across the globe. In most major cities of the United States, there are a variety of entrepreneurial organizations, and the majority of states have at least one angel group that is a member of the Angel Capital Association. So, $1 million might not be what it used to be for buying a house, but it sure goes a lot farther in making sophisticated investments. The question should be: At what income or net worth level should we as taxpayers be paying regulators to look out for those with fewer resources? It’s probably not millionaires at any level. But while what we have now is not a great solution, if it ain’t broke, don’t fix it.
Adjusting for inflation, the new level would be $2.3M. The legislation would leave the exact figure to the SEC to determine, and worse, allow it to change periodically. A moving target could create legal confusion and make the lawyers guiding these companies even more cautious. What happens if the level increases two years after a financing? Could the company be in trouble because prior investors are no longer “accredited?” Even if they were grandfathered, would they be excluded from participating in new rounds of financing, which often are critical for protecting an investment and generating a return?
The net effect would be to eliminate vast pools of capital from being available to invest in startups. While the exact amount of this reduction is unclear, various studies over the past decade, including the Kauffman Foundation’s Global Entrepreneurship Monitor and a study commissioned by the Small Business Administration, have suggested that a significant amount, and perhaps the majority of “angel” or “informal” investment in startup companies, comes from lower-net-worth individuals who might well fall under the new threshold. Worse, areas other than Silicon Valley, Boston, and New York are most likely to be hit hardest because they have a lower proportion of higher net worth individuals.
Passing the Buck to State Regulators. The second section noted above would delegate regulation of smaller private placements to the states. Imagine the resulting diverse regulatory landscape, with some states being more “friendly” and others more “onerous” to investors. Since regulators rarely see a regulation they don’t like, it is almost a guarantee that not only will the costs of compliance increase, the cost of any financing that crosses state lines will become even more expensive. This might not be a big issue when a company is raising millions of dollars, but it would be particularly expensive and painful for small rounds. There needs to be legal clarity about who is really in charge, and the SEC cannot just pass the buck when it does not want to be involved.
Companies raise money from many locales all the time. Angel groups in New England-including ours-and across the country actively syndicate deals across state lines. Rhode Island, New Hampshire, Vermont, and Maine are within a two-hour drive of my office and our portfolio companies, and many of them have investors from around New England, the country, and even the globe. Investment, simply put, is a matter of interstate commerce and is the jurisdiction of the Federal Government even more so than it ever has been.
Moving Ahead
Given the economic crisis of the past two years, we clearly need changes to our financial regulations to expose unknown risks and avoid undue ones in the public markets. We also need to be careful that those changes don’t have unintended consequences that cause more harm than good. Dodd’s bill has some bright ideas, but needs revisions to remove these sections and protect the entrepreneurs who will help create the jobs and fuel the growth that will get us out of today’s economic mess.
