It’s no secret that the availability of capital is critical for early stage startups. While entrepreneurs may find some initial financial support by tapping into the generosity of friends and family, once those pockets dry up, they often turn to angel investors—individuals who put their own money into what they see as promising ventures. While a small cadre of wildly successful angel investors have made millions from betting early on companies like Google and Twitter, thousands more across the United States are investing in early-stage startups in dozens of industries every day.
According to the Angel Capital Association (ACA), angels provide 90% of outside equity raised by startups. And in 2013, this group invested $25 billion in 71,000 companies. That’s impressive. But this number could drastically change depending on if and how the Securities and Exchange Commission acts after their review of the accredited investor definition, a status most angels depend on to pursue these private investments.
Whether the Commission should revise the definition of accredited investor was one of the topics at issue during the SEC’s Government-Business Forum on Small Business Capital Formation held last Thursday at its DC headquarters. The Dodd-Frank Act—the 2,300 page financial regulation bill—mandates, among other things, that the SEC undertake a comprehensive review every four years of what some consider an outdated definition.
By current SEC standards that were originally adopted in 1983, an individual is qualified as an accredited investor if she makes over $200,000 in annual income, her household has made over $300,000 in income, or she’s worth at least $1 million in assets, excluding her house. While this income level far surpasses the median household income in the United States, over 7 million individuals or nearly 4 million households still qualify, for now.
One proposal on the table at the SEC suggests adjusting these thresholds for inflation, which means you’d need to make around half a million dollars in order to invest your own money in a startup. According to numbers analyzed by the ACA, raising the income bar for inflation would disqualify nearly 60% of the accredited investor population. A decision like this could significantly reduce the pool of capital available for early stage startups.
This possibility is alarming. So it wasn’t surprising to hear many of the participants from the business community at the SEC’s forum express outright opposition to raising this threshold, not only because it would eliminate existing investors, but also because an income threshold to begin with misses the point. The entire reason for defining this class of people is to protect them from making poor investment choices.
Yet income is hardly an indicator of financial sophistication in undertaking risky investments, especially in the world of novel startups and high tech. By today’s standards it would be illegal for a bio-chemistry PhD making $190,000 a year to invest equity in a biotech startup on a site like Angel List. And if adjusted for inflation, someone making even twice that amount would still be prohibited from investing.
Voices in the startup and investment communities have suggested an alternative set of criteria which could include years of experience, licenses issued by a qualifying test, or relevant degrees to measure investor sophistication rather than only relying on an income threshold that offers virtually no insight on an individual’s understanding of capital markets.
Whatever the ultimate criteria, there’s clear opportunity for the SEC to expand participation in the startup economy, and facilitate capital formation, by allowing those with both interest and knowledge in innovative new companies to support the entrepreneurs building them.
At the end of the forum, attendees gathered to submit recommendations to the SEC as they review the definition. We hope the Commission takes these recommendations seriously. If not, they could end up significantly stifling a community that’s been an enormous asset for the startup economy, instead of expanding opportunity in it.
And whether anybody can invest equity in startups through crowdfunding—well, that’s another question the SEC will have to consider, but rules to regulate the equity crowdfunding market have only been proposed thus far. As far as we can tell, the SEC first wants to figure out who’s accredited. Visit engine.is/jobsact to learn more about the crowdfunding part of the JOBS Act and why we think that’s important, too.
