Archive for January, 2016

Accredited Investor Definition – SEC Proposal Two – Higher Net Worth and Income Requirements

As covered before in a previous post, the net worth and income requirements that define an accredited investor have remained the same for more than three decades. During that time the dollar figures for those two standards have not been adjusted for inflation. As a reminder the standards are:

• An individual with an income of $200,000 or more the last 2 years (and expects that income this year)
• A married couple with an income of $300,000 or more the last 2 years (and expects that income this year)
• Or an individual or married couple that has a net worth of $1 million exclusive of the value of the primary residence

Experts calculate the rate on inflation since these standards were set in multiple ways. Should the SEC decide to adjust for inflation even the lesser impact method would change the thresholds above to:

• • An individual with an income of ~$430,000 or more the last 2 years (and expects that income this year)
  • A married couple with an income of ~$528,000 or more the last 2 years (and expects that income this year)
  • Or an individual or married couple that has a net worth of~ $2.1 million exclusive of the value of the primary residence

According to an SEC study published in July of 2013,  Regulation D financing was used in 40,000 financings by non-financial isuers averaging a bit under $2 million each in the four years 2009-12. The total financing under this rule (the bulk of which went to meet the needs of U.S. small business) approached $80 billion over those four years. From the comparison above it is apparent that the number of individuals and families that could meet the definition of “accredited investor” would fall materially.

The SEC should be very careful in considering higher qualification minimums. The ~$80 billion mentioned above is only one part of the private offering market in the U.S. As discussed earlier in my “Heart of the Matter” post, the number of eligible households in the U.S. would shrink by more than 50%. The withdrawal of this much capital via regulation would create a huge headwind for early stage companies seeking to raise capital. Many worthy companies would not be started and others would die on the vine.

The articial capital shortage that such increases in the accredited investor income and net worth levels would cause also needs to be assessed with regard to one question. Why? It’s true that a higher percentage of households are now defined as accredited investors. Many of them don’t particpate in private offerings where this definition matters. Any of you who have tried to raise capital from qualified investors who made their money outside of tech have observed that phenomenon up close and personal.

People who make these type investments into early stage tech companies self-select into this group. They have available capital. They usually understand the early stage tech environment. They are aware of and educated about the risk they are taking. And most important, they are willing to take this type of risk. When all those things are true, why shouldn’t these investors be able to take risks that they are comfortable taking? My verdict is that the current income and net worth standards should stay in place.

Accredited Investor Definition – SEC Proposal One – Same Standards with Investment Limitations

In my previous post on the SEC’s consideration of changing the accredited investor definition I laid out the overall stakes of any changes. Let’s turn now to the specific recommendations the SEC is considering. The first recommendation is:

“Leave the current income and net worth standards in place and use investment limitations to protect investors”

Investment limitations would likely be based on either percentages of net worth or percentages of income. In either case the practical difficulties of proving compliance are likely to be more challenging than people are ready to assume liability for in completing an investment round.

Think about it from the issuer’s point of view. The company issuing securities to raise capital has two key objectives in raising a round of investment:

• It wants to raise as much capital as it needs on the most favorable terms possible,and
• It wants to avoid any legal problems created by ineligible investors, failure to properly conduct the round, etc.

Investment limitations would make the second of these objectives much more difficult to achieve. At the end of the day the consequences of failing to comply with the law in raising capital will fall most sharply on the issuer, the company that is raising capital. This will have predictable effects.

The attorneys and CPAs advising the company will advise their clients conservatively to ensure that potential investors are properly qualified. Such conservative advice will no doubt include ways of verifying the eligibility of your potential investor. Let’s use a simple example to shed light on what this would mean.

Let’s suppose that you have an angel investor (“Investor X”) prepared to write a $50,000 check for your company. Whether the standard you must meet is an investment limitation based on income or net worth you’ve got vexing problems. Your conversation with Investor X will need to go something like “I’d really love to get a clear and complete picture of your financial situation so I can verify your compliance. Can I have”:

• Copies of your tax returns for the last two years
• Copies of your bank statements
• Copies of your brokerage statements
• A personal financial statement that reveals and values other assets that you own

I’ve talked to several investors about these type of requirements. First, they are a large shift away from the “self-certification” regime that was used in this situation for many years. An investor could say “I’m qualified to invest” and that was something the issuer could rely on to meet its obligations. That option would not be good enough to verify eligibility based on limitations based on income or net worth.

Most investors I’ve canvassed on this question have a simple answer – “I’m not giving that kind of information to a company that I’m trying to invest in”. There are startups trying to become the secure third party repository and verification provider in these situations but investors still have concerns about putting this type of information in anyone’s hands.

Even if an issuer can obtain this kind of information, the headaches are not over. Would an income limitation apply to your income as of this moment, over some period of years or would it allow the recognition of future income that is guaranteed? As of what date would net worth be calculated? What if a potential investor’s net worth changed in a material way immediately prior to or after the investment is made?

I don’t think companies raising capital are going to sign up for these type of administrative hassles. Therefore, my verdict on this proposed change is “NO”. I advocate leaving the current income and net worth standards in place without qualification.