The War on Reg D – Redux
There’s been a LOT of complaining recently about the terms which negatively impact the $26B annual world of “Angel” investing, which have been slipped into Senator Chris Dodd’s Financial Reform bill (“FINREG”). The Wall Street Journal railed about it under the banner “Angels Out of America“:
- Regulation D, also known as “Reg D” among securities types (along with Rules 504, and 505, and 506) is an area of US Securities law in which the SEC exempts certain qualified securities offerings – those made into very small start-up companies by private investors – from the requirements of “registration” for public offerings, with State and Federal Securities regulators.
- Under Reg D and the associated Rules, a start-up company can take investments from individuals without involving the investment banks, filing for an initial public offering (IPO). and complying with Sarbanes-Oxley (SOX) requirements – among other horrors.
- A key aspect of these Federal legal codes, is the concept of an “Accredited investor” being involved in these “exempt” (from public registration) investments. Accredited investors have to date been able to factor in their primary residence into the net worth calculation, a central tenant of Reg D.
That is about to change, to the detriment of many individuals hoping to start a company, hire people, and build something.
Thanks, Senator Dodd – such a nice going-away present – and so appropriate for you.
The idea behind the logic of Regulation D is that the Government needs to protect people who don’t have the net worth, therefore the sophistication to make such worldly deals. Common sense, right? OK, maybe not – this whole area of law has never been tested, or put under any sort of scientific or logical scrutiny — as it arose out of securities law problems which occurred mostly, 75 to one hundred years ago, which haven’t yet been re-thought to fit our modern entrepreneurial economy.
Back to the present day of “The Dodd bill”
As a result of the “War on Reg D” terms slipped into the Dodd bill, Angel investors became devils recently, writing and calling their senators and congressmen/women. What in the world is Congress thinking, the reasoning went – killing off new venture formation, in THIS economic climate? In other words, you guys HAVE to be kidding us??
Nothing to fear, though — the Cavalry did arrive. During May, after the Angel Capital Association pushed back, enlisting help from the start-up legal community, negotiators from both sides arrived at a re-negotiated set of terms for what has been called “The War on Reg D” – the attempt by State Securities Regulators, through their organization NASAA, to put the whammy on start-up investing by regular citizens. The Government needs to jump in there and protect them from themselves, right?
Reportedly, the NASAA’s logic is that we need to tighten up Reg D in this way, in order to protect Aunt Sally and Uncle Bill from predatory Broker-Dealer thugs, Guido and his brother, who may sell them unsavory investment products which will clean out their investment accounts. Yet, there has yet to be a documented instance of abuse of Reg D by startup companies. The NASAA seems to be living in the past, or trying to modify law which doesn’t even APPLY.
But don’t worry, entrepreneurs… the lawyers got together, and… they’ve fixed most of the bad language in the Dodd bill. There is only this one little thing. This one, material term lingering.
And that is, that Angel investors can no longer factor in their home equity in the net worth calculation for Reg D. If they do, and it slips by, then they will be eligible to recover at least 200% of their invested capital from the entrepreneurs involved – and the introducing “finders”, “agents”, or “brokers” – should the venture fail – per existing US law.
What’s the big deal – just removing the primary residency requirement is nothing, right?
Removing the primary residency from the calculation of net worth for Regulation D eligibility does sound very innocuous. That’s probably why some of those involved in re-negotiating the Dodd bill seem to be patting themselves on the back, and heaving a sigh of relief.
The problem is, it’s going to wipe out (by my calculation) at least 50% of the $26B average angel investment in the US. Those investment dollars go into 57,000 new small to medium (SMB) businesses/ventures, and create (on the average) about 200,000 new jobs per year.
The amount of investment by Angels has been tracking equal to venture capital for several years now, but goes into a lot more start-up ventures.
I have been researching the distribution of income and wealth (holdings) in the US, and have a $100 bet on with a top-drawer start-up lawyer – Mr William Carleton of Seattle, about this; so i could be wrong (i really dislike being on the other side of the trade, with someone like William). William feels this change may reduce the number of Angel investors by 20%. Let’s say it follows anywhere in that zone: 20% to 50%. Is that something that makes sense to do, in this economic environment? What is the upside?
I feel Mr Carleton’s estimate is too low, because I’ve developed a feel for this from 30 years spent in Silicon Valley companies – large corporations, start-ups, and consultancies; from my past involvement as a member of the Keiretsu Forum; and from my personal friends and business acquaintances — that most members of Angel groups in states like California and Massachusetts (where 75-80% of Venture Capital and Angel investment occurs), have a lot of their net worth tied up in their primary residence. I’m also working out an analytic model to estimate the number from macro and micro-economic data.
Angel investment closely mirrors Venture Capital investment, as far as $ per region around the US. It is heavily concentrated in California, where 60% of the money goes to work (40% Bay Area, 20% LA). And real estate holdings tie up a lot of net worth in CA; as they do in MA – the #2 VC hotbed in the US.
We may be losing our freedom and individual rights under this tiny portion of the FINREG bill – and what else is in it?
Super Angels like Ron Conway make for really compelling reading, and help many start-ups – more than his share! Thank you, Ron. But the vast majority of Angels are business people that have had some degree of success, and genuinely want to help others doing similar things, but aren’t “flat out wealthy”. There aren’t that many of them left that still make over $200 to 300k per year (depending upon marital status) for the past two tax years, or hold more than $1M in hard cash which will now be required. About 50%, on a good day. It’s likely less after the financial calamity of 2008 to present (not to mention 2000 to 2008).
But the Securities’ lawyer logic is, in bargaining away our rights, “the standard for Reg D hasn’t been changed since 1982, and we must keep pace with inflation, and protect Aunt Sally from the vultures”. They have also imbedded into this bill, the right for the SEC to periodically review the thresholds for Accredited investors. So, without an act of Congress like this one, in the future more and more Angels can be squeezed out of the right to invest in startups – just by an SEC action. That is BAD for new venture formation.
I have doing been primary research on this, and can make a good case, but it may come down to seeing the reported numbers from the experts, like the center for venture research at the Univ of New Hampshire, after the law goes into effect next year, since it is hard to prove as a numerical fact, until “after the fact”. But i have a pretty compelling set of facts and rationale pulled together.
This same Congress, in the midst of the worst recession since… the great depression, has seen fit to dramatically increase the tax on “carried interest”; that is, the profit on venture capital investments. Now wait a minute – last time i checked, the venture capitalists were HUGE supporters of getting Barack Obama and the Democrats into power. So I will leave it at that!
But honestly, doubling taxes on capital formation and startups? In the middle of an economic calamity?? I can’t even write about it.
The bigger question
The bigger question is: what are we doing killing the Goose that lays the Golden Egg every year, in this economy?
And further – do we have representation in our Government today – or a semi-permanent “ruling class” that issues these edicts?
What do you think?
Steve Bell is a serial tech entrepreneur, a Series 7, a Series 63, and an Angel investor. He runs a video blog on start-up venture formation at StartupTrek.net