As many of you know by now, Sen. Chris Dodd (D-CT), Chair of the Senate Banking Committee, introduced the following bill on April 15, 2010 – “Restoring American Financial Stability Act of 2010.” This bill is currently being debated on the Senate floor. The primary purpose of the bill, and the greater bulk of its 1,410 pages, is devoted to promoting financial stability. By Dodd’s own words, the provisions are designed to improve accountability, resiliency and transparency in the financial system. My goal in this post is not to weigh in on all of the provisions geared towards the greater financial system, as I offer no opinion on that aspect, but rather to discuss the two provisions that relate directly to early stage financing:
- Section 412 – Section 412 of the bill directs the SEC to increase the qualifying thresholds for individual accredited investors as the SEC deems appropriate in light of price inflation. This section also directs the SEC to adjust those thresholds going forward not less frequently than once every 5 years to reflect percentage increases in the cost of living. The current accredited investor levels for individuals are $200,000 (or $300,0oo combined with spouse) of income for the past 2 years (and including the current year) or having a net worth of at least $1,000,000. Based on estimates of the inflation percentage, Section 412 could put the income qualifier at $450,000 and the net worth qualifier at $2,300,000.
- Section 926 – in a nutshell, Section 926 requires a 120-day review period for all Rule 506 filings with the SEC. This would be an unprecedented step in the early stage financing process.
Three other points worth mentioning up front. First, a third provision, Section 413, directs the Comptroller General of the U.S. to conduct a study on the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and the results of this study must be submitted within one year. There is no indication what that study will be used for. Second, a fourth provision existed in prior versions of the bill which restored the power of states over Reg D offerings, effectively repealing the federal preemption granted in that area by the National Securities Markets Improvement Act of 1996. This fourth provision appears to have been dropped at this point – thankfully! Lastly, Sen. Jack Reed (D-RI) recently introduced an amendment to the bill requiring funds (venture/hedge/PE) with more than $100M of assets under management to register with the SEC. This amendment mirrors (albeit with a different triggering value – previously it was $30M) an earlier version he attempted to introduce. Under this amendment, funds with less than $100M would have to be either registered and examined by a state regulator or registered with the SEC.
I, personally, do not support either Section 412 or 926 for a variety of reasons. It’s peculiar to me that these provisions have found their way into a bill geared towards financial stability. Neither of these provision, in my opinion, further stabilize our financial system. If anything, they choke a valuable portion of it. To understand this point, just read the National Venture Capital Association’s joint study entitled “Venture Impact: The Economic Importance of Venture Backed Companies to the U.S. Economy“. According to this study:
- 11% of private sector employment is at venture-backed companies;
- Revenues of venture-backed companies total $2.9 Trillion;
- Venture-backed companies as a percent of U.S. GDP – 21%;
- Venture-backed companies as a percent exceed job growth and revenue growth versus the aggregate; and
- Total venture investments from 1970 – 2008 equal $456 Billion in 27,000+ companies.
Clearly, venture-backed companies have an significant impact on the economy. But for a company to reach a venture-backed stage, it needs to raise early stage money and very often that comes from individual accredited investors. Even more so in this economy where institutional early stage investors are few and far between. The accredited investor thresholds are important as angel and venture financing transactions most frequently use Rule 506 of Reg D as the security exemption for such transactions. If Congress increases those thresholds, thus reducing the potential pool of investors, less and less early stage companies will find funding and less and less will ever become venture-backed. In all honesty, I’ve been telling people over the past few years that the SEC ought to reduce the accredited investor threshold. I know plenty of people that could intelligently invest in the early stage space that don’t make that kind of money or have that kind of net worth. Dodd’s view is that the thresholds should be increased due to inflation, and I’d suggest that they should be lowered as today’s worker is far more knowledgeable about finances, economics, technology and the risks of attached thereto.
Section 926 is equally perplexing to me. Why in the world would Congress think it wise to put the early stage financing process under a 120-day review. If it’s not broken, don’t fix it. I could understand if there were evidence that the deals done under Reg D were negatively affecting the economy, but all data points the other direction. I’ve read one or two articles where the North American Securities Administrators Association claimed that a good portion of Rule 506 deals are fraudulent. I think that is an irresponsible statement to make without clear proof. I sense some self-serving comments here by the NASAA – I would assume they’d benefit if the bill passes as written. I am aware of no data that points to a need for a review period in Reg D deals.
Much has been written and debated about this bill already in the public forum and I’ve included some links below:
- “Angels Sing: ‘Frankly Ridiculous’ Restrictions Might ‘Destroy Silicon Valley” – VentureBeat article (3/26/10), contains good quotes from well-known angel investors on the topic;
- “How Dodd’s Reform Plan Hurts Startup Finance” – Business Week (3/19/10);
- Letter from American Bar Association’s Business Law Section (4/23/10) – focuses primarily on Section 926 of the bill and contains good background information and excellent points on why Section 926 should be deleted from the bill;
- Save Reg D website – trying to build a case around deleting Section 926 of the bill;
- Angel Capital Associationwebsite – ignore ACA’s support for the bill as it relies on an earlier version of the bill that was much more palatable. The website, however, has a good laundry list of other articles written on this topic;
- “Barney Franks Says: Don’t Mess with VCs or Angels” – peHUB article (5/11/10);
- “Startups Get Hit By Shrapnel In The Banking Bill” – Fred Wilson’s post on www.avc.com, includes links to other relevant articles and posts.
If you haven’t already done so, sign a petition or write your Congressman about this bill and let them know how you feel. Let me hear your comments if you have any! Thanks.
Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-ups and emerging growth companies. Chris is also founder and owner of MCD Law Partners, LLC, a boutique law firm serving start-ups, early-stage and emerging growth and middle market companies.