Dave Neal – VC

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.

The Heart of the Matter – Changes In The Definition of “Accredited Investor” Under Securities Law

In July of 2010, President Obama signed into law the Dodd-Frank legislation. The law reached 848 pages and attempted to correct problems that its authors believed were causes of the financial meltdown late in the last decade. One little known provision of the law required the Securities and Exchange Commission (“SEC”) to review the definition of “accredited investor” every four years.

In late 2015 the Investor Advisory Committee (“IAC”) of the SEC published a series of recommendations regarding suggested changes in the accredited investor definition. We need to understand what is at stake here. Many of the securities laws exemptions that early stage companies rely on are first navigated by ensuring that an “issuer”, a company that is raising money, is doing so with accredited investors. Accreditation is the initial gate that investors must get through to be able to provide capital to an emerging company.

In the judgement of many commentators the IAC’s recommendations, if implemented, would significantly reduce the number of persons who would be eligible to invest in the kind of private offerings that early stage tech companies usually avail themselves of to raise capital. These recommendations therefore caused a large number of comments to the SEC.

After reviewing the IAC recommendations and the comments generated by those recommendations, the SEC last week released its thoughts on how it might approach the issue of revising the accredited investor definition. Because of the centrality of this definition, any changes that limit the number of persons who can invest in the private offerings that finance early stage companies pose a major threat to the supply of capital for these companies.

For many years the standard for defining an accredited investor has been:

• 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

The idea behind these standards is that such persons will have sufficient “sophistication” to understand the risks of investing in the private offerings that are critical elements of the early stage financing landscape.  Another bedrock idea is that people of such means can withstand the loss of capital which is possible with this type of investing. How big would the effects of such a change in the accredited investor standard be? Table 4.2 on page 48 of the link below is from the SEC Staff Report on the accredited investor definition in December 2015.

http://www.sec.gov/corpfin/reportspubs/special-studies/review-definition-of-accredited-investor-12-18-2015.pdf

It shows the portion of U.S. households that qualified to invest in private offerings in 1983 and who would have qualified to invest in these offerings based on inflation adjustments to the definition. The adjustments would decrease the number of U.S. households qualified to invest in private offerings by ~50%, from 7-8% to less than 4%. That would dry up a lot of the capital that early stage companies use for the earliest stages of the growth process. The effect on early stage capital formation would be serious if not catastrophic.

Note that this table only addresses the number of U.S. households that qualify to consider investments in early stage tech companies. Many of these households don’t feel comfortable enough with private offerings to participate so cutting the number of eligible households by half should be done only for excellent reasons. That begs the question – why is it necessary to do anything at all? Almost everyone who participates in this type of private offering understands the risks of these type of investments. I’ve been in this space for 23 years and the stories of investors being misled about the nature of these investments are few and far between. Maybe a time to leave well enough alone?

We’ll look at the proposals the SEC is considering in the next installment of this series.