They’re at it again!

The SEC just announced some new rules, based largely on the requirements of the JOBS Act. These rules, on their surface, seem really great. They acknowledge the rise in angel investing by allow companies to seek out angels nationally via “general solicitation.” Unlike Crowdfunding, which allows companies to seek investment from the general public, these rules apply ONLY to accredited investors, who are deemed to be sophisticated and able to assume the large risks associated with angel investing.

This is a reasonable thing to do, since the early-stage investment asset class is virtually free of fraud and the investors don’t need protection from themselves.

But the SEC, in granting the permission to do general solicitation for accredited investors, proposed a set of rules that will all but kill angel investing in the US. I am not alone in this opinion. See: http://www.angelcapitalassociation.org/data/File/pdf/Release-New_SEC_Rules_Could_Kill_Angel_Investing_Final.pdf

If passed, any company that uses the new provision must file onerous forms with the SEC, will incur substantial legal fees, must investigate all of its investors to ensure that they meet the federal accredited investor standard, and face still sanctions if they don’t do everything correctly.

What problem is the SEC trying to fix? We don’t have fraud. It works now and the JOBS Act was put in place to ensure that more angel investing, not less, would occur, so that more startups would get going, grow, and create lots of the right kind of jobs.

This cannot stand! Write to your representatives in DC, the SEC, and express your outrage.

Angel Syndication – Regulatory and Legal Framework

Frequent readers of my blog know that I am active in public policy on behalf of angels. They also know that I am a nerd and about as far from a lawyer as you can get. So, they should take this post in that spirit.

When angels purchase stock in a startup, they must certify to the issuer that they are an accredited investor (an SEC term; if you want to understand this google it). The issuer must only speak to accredited investors and must not do any public announcement or advertise to the general public. (This is why angel groups may only have accredited investors as members or in the room when companies present.)

But the market has changed.

  • Companies now need much less money to get going because of things like open source software, better tools, Amazon Web Services, etc. Very often, a company can be created for a few $100,000s, where a generation ago it cost $10’s of millions.
  • Angels now fund an amount comparable to VCs – about $20B annually in the US. But this is spread over many more companies.
  • There has been an explosion of angel groups (angels working together in a concerted way), that operate in much more professional and disciplined manner. And these groups have gotten larger, with more members.
  • VCs have moved upstream – to later and later stage deals. A generation ago, this was called mezzanine investing. Angels must fill the gap created and now often put over $1M in companies (over several rounds). Often VCs don’t enter the picture at all.
  • Exits are now primarily via acquisition, rather than IPO. Acquisition exits are more likely to be smaller – in the $10s of millions. Therefore, companies must be much more capital efficient. Rather than take in tens of millions in investment, they must consume only a few million, if they are going to give the entrepreneurs and investors a good return.

As a result, angels often must find much larger sources of capital to fund their companies. On an increasing basis, they turn to other angel groups to work together to form a syndicate to do the funding. This works because angel groups (under the auspices of their trade organization, the Angel Capital Association, www.angelcapitalassociation.org) use common frameworks that have allowed the different groups to trust each other’s analysis (due diligence) and valuations.

Naturally, these groups use the internet and internet-enabled tools to find each other and share deals. Under the current regulatory framework (Rule 506), this is strictly not legal. The JOBS Act (see previous posts) attempted to change the regulatory framework to allow angels and angel groups to operate in the 21st Century using the Internet; Congress required the SEC to publish new rules to make that so. The ACA and other groups are working with the SEC to ensure that these rules make sense and are operational. To date, it has not been so.

The SEC is of the opinion that, if a company uses “General Solicitation,” then it no longer has “safe harbor” that is granted under current rules. Simply put, today if an investor says he or she is accredited and fills out a simple form during the investment process, then the company cannot later be faulted. Under the new rules proposed by the SEC, the issuer (the startup company selling the shares) is responsible for ensuring that each investor is in fact an accredited investor. This means that even if the investor says they are, fills in a form, or has invested in other startups, the company must verify that they are accredited. If they don’t do so, they risk rescission – at some later time, the whole deal can be unwound. This is incredibly drastic. It would be like selling someone your house, them taking title, and after they’ve lived in it saying that they weren’t a qualified buyer and you had to pay them their money back. Of course, once the startup has spent the money, this means bankruptcy so that the investor loses all of their money.

It is not clear to me what problem the SEC is trying to fix. The angel investment industry is remarkably free of fraud and does a fabulous job policing itself. We tend to co-invest with members of our network and group. And we diligence the companies we invest in to ensure that they are solid prospects. We know many will fail, but that is the risk we knowingly take. We don’t need the SEC to protect us from bad (or good) decisions.

The SEC’s stand is so obviously bad and stupid on so many levels. It will make doing any form of solicitation a non-starter and put the industry back to the early 20th Century when the current securities laws were written.

Comments welcome.

Angel Deal Syndication

As the VC market has (in general) moved upstream to later and later-stage deals, angel investors have filled the breach by not only investing at the seed stage, but also carrying deals through to exit. As a result, an increasing number of angels are joining groups (like the Alliance of Angels). As these groups reach their capital capacity in a deal, the angels are reaching out to other groups with great deals for participation (it is generally called “syndication”). In a companion piece, I will discuss the regulatory framework changes needed to make this easier, but in this post, I want to address the logic and rationale for syndication of angel deals.

I look at the world as follows:

So, what does this mean? In the lower left quadrant, there are groups/geographies that have lots of capital, but very few deals. They want to invest, but find very few local deals that merit that investment. These groups want to syndicate deals to see more good deals. Many areas in the country fit this category. Groups in these geographies often try to stimulate deal flow through either governmental programs or incubators.

Areas and groups in the upper right quadrant have lots of good deals, but not sufficient capital to fund them. They want to syndicate their deals so that their good deals can be fully funded.

The upper right quadrant have high deal flow and lots of capital. This might be typical of Silicon Valley. Groups here generally can fill their rounds, and so might not need to syndicate unless they want some specific expertise from people or groups in other areas.

If you are stuck in the upper left quadrant with low deal flow and low capital, you are probably not in a good situation to form an angel group or do much formal angel investment.

Hope this simple framework is helpful. Comments welcome as always.

 

Pantanal Magic Photo Book Available

My first photo book, Pantanal Magic, is now available for pre-order. Cost will be $100 per book and 100% of the proceeds will go the Seattle Humane Society (www.SeattleHumane.org) and Washington State University College of Veterinary Medicine (http://www.vetmed.wsu.edu/). To see a preview of the book, go to www.rosen-photo.com and click on the Pantanal Magic Book link. Hope you enjoy.

General Solicitation

Once again, through inadvertent action, the federal government is about to threaten Angel Investing. This all started as a way to increase investment in startups, when congress passed, and the Obama signed the JOBS Act (see: http://blog.drosenassoc.com/?p=97). Title II of the JOBS Act allows “General Solicitation and Advertising” of private placements (like Angel deals). One would think this is good for two principal reasons: (1) it roughly brings current practice into compliance, since many angel groups post their deals on a web site (like Gust, which is used by many angel groups) or run events where companies present to their members and others; and (2) more and more angel deals are funded by many angel groups (usually called syndication), so there is an implicit solicitation. We liked this idea. It allows our companies to reach a broader audience of only accredited investors. All good, right?

Well, not so much. The legislation also asks that the SEC use “reasonable steps to verify” that they are accredited. Even with that, it seems pretty straightforward. The reasonable steps to verify have been around a long time (under Rule 506B). Every time angels (or other accredited investors) make an investment, the deal documents come with a short form that you fill out how you qualify as an accredited investor. The SEC has given “safe harbor” using this mechanism.

But the SEC is considering that this long-accepted method will not be acceptable if an issuer (a startup company raising money using Regulation D) uses the new General Solicitation rule (Rule 506C). Instead, the SEC originally proposed that investors would have to give the issuer copies of their tax returns. The Angel Capital Association (ACA) wrote a very strident response that this would severely diminish angel investing, since few angels would turn over their tax returns to a startup. And, of course, the startup would have to find a way to preserve these records and keep them confidential – a real mess, given that most startups don’t even have permanent offices.

The ACA Public Policy Committee fought hard to ensure that existing “quiet offerings” (Rule 506B). Therefore, if you don’t take advantage of the General Solicitation (“noisy offerings”), you still can take advantage of the existing rules.

If you do use a noisy offering, then you will need to follow new rules, which have not yet been written. But the preliminary rules (and discussions with SEC) show that the SEC is unlikely to allow “self certification” for these offerings. Therefore, one of two outcomes now looks likely: (1) issuers (or their attorneys) will have to collect a lot of information about their investors and investors will have to share a lot of personal information; or (2) new third-party certifiers will emerge to do this.

Is this really so bad? YES – this is bad. First and foremost, we all rely on the “safe harbor” on the Reg D investments. At this point, the rules don’t give this safe harbor for any particular mode of validating accreditation. This means that deals can be challenged and unwound. Very bad. Secondly, even using third party validation, will cause the costs of these deals to increase. Instead of money going to hire engineers and sales people, it will be used on deal overhead. Very bad. And lastly, most angels HATE extra paperwork. If the validation requires that you hunt through and list all of your deals for the last 5 years (it would take me hours to do this!) And, I would be generally unwilling to provide my tax returns to anyone. In the end, it would just mean a lot of extra paperwork and time. I would probably avoid any deal that used a noisy offering.

I think that the SEC (and the legislators who supported the JOBS Act) really needs to recognize that the angel investing arena has self-regulated very well and the current system has worked well. Extending the current process for noisy offerings makes a ton of sense. It is the right way forward.

After all, “if it ain’t broke, don’t fix it!”

Angel Investing and Job Creation

As you know, I chair the Public Policy Committee of the Angel Capital Association (http://www.angelcapitalassociation.org/). In that regard, I’ve spent a bunch of time in Washington, DC, meeting with legislators and executive branch people. I thought it would be useful to post a simplified version of the story we tell.

It still surprises me, being so immersed in Angel Investing, that there is so little understanding of what we do. Many confuse what we do with banking. Others confuse us with venture capitalists. And yet others confuse us with friends and family. The ACA Public Policy agenda, when stripped to its essence, is comprised of the following four items:

1) Educational. Angel investing (and therefore angel investors) are the wellspring of our economy; we are the true job creators. We are not Wall Street; we are Main Street. We invest our own money (not other peoples’ money) in virtually every community in the country to start high-growth, high-potential startups that transform the economy to the 21st Century. We do this knowing that (statistically) over half will fail and we will lose our money. When we back the winner, we plow the returns back into more startups. We are not looking for government protection. But encouragement will make a difference in the rate and amount we invest in these high-growth companies.

2) Do no harm. Sometimes there are unintended consequences of legislative actions. One good example of this were several provisions in the original draft of the Dodd-Frank Financial Reform act that would have eliminated over 70% of the eligible angels and made Reg D filings difficult or impossible. This would have severely hampered Angel Investing and curbed the companies we support. We take aggressive, but prudent, actions to ensure that such actions are understood and not taken.

2) Cap Gains. Reauthorizing the Section 1202 zero capital gains for Qualified Small Business, first through the extenders bill (making it retroactive to 1/1/12) and in place till the Congress has time to make it permanent. We need some structural changes (e.g. 2 year rather than 5 year holding period; LLCs as well as C corps; and changing the roll-over period to 1 year from 60 days) that we will work with staff to explain. And.. this needs to be permanent so that we can use it as an incentive; we look at lots of companies and the timing can’t be accurately predicted, so our members (and all angel investors) need to be able to plan on this or they won’t use it. When angels get an exit, they re-invest their proceeds in new deals; this is the flywheel upon which angel investing is based. If a substantial proportion of the proceeds are absorbed by taxes, the entire asset class looks much less attractive. And remember that Angels (unlike VCs who invest other people’s money and only make a return when they invest) don’t have to invest in these deals.

3) Angel Tax Credit. Other countries and lots of states have enacted an angel tax credit that has spurred investment in high-growth startups. Typically this is 25% in the year of investment. Zach has some wonderful data from WI. These tax credits do a great job in stimulating new investment.

More will follow.

At the Clinton Global Initiative – CGI America

I recently participated in the Clinton Global Initiative that was held in Chicago on June 7th and 8th. It really was a fascinating event in many respects. The agenda can be found at: http://www.cgiamerica.org/2012/agenda/. The basic thread was what specifically can be done to put America back to work. There were a slew of great speakers and breakouts. I was invited to help guide the Entrepreneurship sessions.

Dan Rosen & President Bill Clinton

It is impressive to see what former President Clinton can get companies and individuals to do – there were specific commitments to create programs, hire returning veterans, and great discussions and commentary about what has gone wrong and what can be done.

Several highlight comments:

  • Bill Clinton talked about the need for “creative cooperation” instead of the partisanship that is choking our political process.
  • He also talked about transforming our society to one that is sustainable, citing Costa Rica which has 26% national parks, is 51% forested, and has 92% of its energy (going to 100%) from renewables. He saw this model as a challenge model for the US.
  • Fareed Zakaria had a memorable quote, when saying he didn’t have a PowerPoint: “People who use PowerPoint rarely have power and never have a point.”
  • He then discussed the impact of two concurrent revolutions – globalization and technology – and how they are a “pincer movement” on American employment, where the American worker is stuck in a bad place, because we have had a divergence of capital and labor.
  • He cited that most countries have a cabinet level position to enhance tourism (“every tourist is a walking stimulus program”), where the US has a cabinet level position to prohibit tourism.
  • Rahm Emanuel, the new mayor of Chicago, cited the need for cities like Chicago to stop looking to Washington, DC or Springfield (the Illinois state capital) for help or answers; “the reinforcements aren’t coming.” He talked about programs he has done locally to help the city and employment in public-private partnerships and how he has gotten the cooperation of the unions.
  • He also made some interesting global comments about the economy. Apple, one of our most successful companies by any measure has over $100B in revenue, but only employs 40k people in the US. But, Foxcon, which make many of its products, employs over 1M people, primarily in China, to build Apple’s products.
  • Clinton: “I was just in Silicon Valley meeting with business leaders. I was told that, if we had the workers with the right skills, we would hire 3M people.” This was a segway to discussion about education.
  • I was really impressed by Ai-jen Poo, Director, National Domestic Workers Alliance. He spoke eloquently about the need to change both models and training in financial education. Paraphrased: “today the role models in disadvantaged communities are drug dealers and rap stars. They are successful and rich. We need new role models that bring financial dignity and literacy. Today, in these communities, you have liquor stores, pawn brokers, payday loans, and drug dealers. If you could raise the average credit score from 500 to 650, then you would transform them to convenience stores, credit unions and banks, and thriving businesses. This requires making “smart” sexy. And teaching and giving financial literacy and financial dignity.” Truly inspiring.
  • Clinton (in his second keynote) talked about Lincoln. In the teeth of the Civil War, he did the following:
    • Created the transcontinental railroad;
    • Created the National Science Foundation;
    • Chartered the land-grant universities
    • Others…
    • And wrote the Emancipation Proclamation.

    He was clearly in the “Future Business.” This is what we need now!

  • Kasim Reed, Mayor, City of Atlanta, said: “Being a mayor is where hope meets the street. It is a question of will – doing the right thing even when the cost is high.”
  • Another passionate and brilliant speaker was Neil deGrasse Tyson, Astrophysicist and Director, Hayden Planetarium, American Museum of Natural History. He said (paraphrase): “Getting students to study the hard STEM topics is more a question of inspiration than knowledge. We need to inspire our youth.”

The only downside for me was the seeming confusion between lending and equity. There was much discussion about helping small business and a lot of confusion about loans as investment. We angels have our work cut out for us.

Northwest ACA Regional Meeting

The Northwest ACA Regional meeting was held in Seattle on May 1-2. About 80 active angels from around the Northwest attended, from WA, OR, ID, BC, and Montana. A few guests from CA and even New Zealand were also there. Sponsored by the AoA (www.allianceofangels.com) and hosted by K&L Gates (http://www.klgates.com/), most attendees seemed to find the meeting both informative and enjoyable.

Among the topic were:

Looking at this list, we covered a lot of territory. I was impressed by the engagement of the entire group and the vast knowledge that the angels in the room represented. Anecdotal conversations lead me to believe that the event was overwhelmingly successful.

JOBS Act – What does it mean for angels

I have been asked repeatedly over the last several weeks: “What does the JOBS Act mean for Angels?” In this and other future blog postings, I will give my perspective.

First, what is the JOBS Act? It stands for Jumpstart Our Business Startups Act; it has nothing to do with earlier jobs stimulus efforts other than sharing an acronym. It is a regulatory reform act and does not have any tax elements. The full text can be found at: http://www.govtrack.us/congress/bills/112/hr3606/text (There are other pending legislations that address how to stimulate early-stage company investment through tax incentives.)

Broadly speaking, the JOBS Act is intended to provide more capital to startups that fuel the growth of our economy. It does the following:

  1. Removes some of the most onerous provisions of Sarbanes-Oxley Bill from emerging growth companies. The argument is that, while large, publicly traded companies needed the extra oversight and transparency, it was never intended to cripple the ability of high-growth startups from tapping the public markets.
  2. Brings the Securities Act of 1933 into the 21st century by recognizing that markets and communications have changed.
  3. Potentially allows for the revitalization of Reg A filings as a way for smaller companies to raise money from public markets.
  4. Enables “Crowdfunding” – a way that very early stage startups can get many small investors to stake their company early in the lifecycle of the company.

Much of the attention to the JOBS Act has been focused on the Crowdfunding part, so I’ll address this in this posting. However, the largest impact is likely to be from the other provisions, which will modernize and simplify the operations of Angel financings, small IPOs, etc. I’ll address those in future postings.

Crowdfunding (Title III of the JOBS Act)

In the past, startups were typically initially financed by “friends and family.” There are legendary stories of entrepreneurs mortgaging their homes to start their businesses, and then reaching out to their family, friends, and associates to get the company off the ground. As the original Senate bill said, the decline in home values has caused much of this source of early-stage capital to dry up.

Crowdfunding has precedence. People have contributed small amount of money (via the net) to charities, arts, etc. The music and theatre industries have tapped their fan base to ask for money for new works.

The difference with these precedents and Crowdfunding is the purchase of equity, which has been highly regulated. In the US, only accredited investors (a person with over $200k of annual income or over $1M in net worth; see http://www.sec.gov/answers/accred.htm for the full definition) could invest in highly-speculative private shares. The accredited investors were thought to be sophisticated investors, who could do appropriate diligence on the company and assess the risks. In general, Angels and VCs are the primary investors in this category.

There is still a raging debate on the advisability of allowing less sophisticated investors to enter this asset class. On one hand, the optimists say “why should only the very wealthy be allowed to buy early shares in a company like Facebook?” On the other hand, the pessimists would say, “this is a recipe for fraud; charismatic fraudsters will prey on the unsophisticated investors getting them to invest an amount of money that they can’t afford to lose in companies that don’t really exist.”

The devil will be (to some degree) in the details. The Act calls for a 270 day period for the SEC to write the rules. It also includes some safeguards:

  • A company may only raise $1M in a year from Crowdfunding;
  • No investor may invest more than $10,000 (or $2,000 if the investor has an income of less than $100k);
  • The investment can only be through a registered broker or funding portal;
  • A degree of public transparency by publishing the terms of the deal, the basis of the price, cap table, etc. that Angels would typically study;
  • Take steps to prohibit “bad actors” from issuing securities using Crowdfunding to help prevent fraud.

This is an experiment that marries the internet, social networking, and modern communications with selling private securities. It could work, it could fizzle, or it could be a great vehicle that tests the innovative spirit of fraudsters. If it works, it could cause thousands of flowers to bloom – startups in all parts of the US will have access to capital. If not, we can hope that the SEC regulations will limit the amount of fraud.

Impact on Angels

The simple answer is none of us know exactly. But there are certain things I believe to be absolutely true.

First and foremost, Crowdfunding will only INCREASE the need for angel financing. Very few of our high growth companies will get by on just Crowdfunding. If this is a successful experiment, then more companies will need follow-on financing from Angels.

But, the question is “will angels be willing to invest in a company with potentially hundreds of new, unsophisticated shareholders?” Will the cap table be screwed up? Any good, sophisticated angel knows that valuation is a key to success. My biggest fear is the following scenario:

  • Company X at the concept stage has a charismatic CEO with a great vision. He posts a plan and video on a funding portal asking for $1M with a $20M post for common stock at $1 per share. (We all know that it is possible to write a business plan the justifies this!)
  • The company then spends the money and makes progress toward a product. It now seeks angel financing for $2M.
  • We assess the company, like its prospects, and agree that it is a worthy investment, but assess the appropriate pre-money valuation to be $2M (not $20M) for preferred stock.
  • The previous Crowdfunding investor now see their shares valued at less than 10 cents on the dollar. They are very angry.
  • This is widely reported in the press and the entire asset class takes a hit.

We have a lot of work to do on Crowdfunding.

Signing the JOBS (Jumpstart Our Business Startups) at the White House

It was much cooler than I thought – being in the Rose Garden at the White House for the signing of the JOBS Act. I was just a few feet from Obama. Surprised at how many people I knew there, including Tom Alberg (Madrona), Joe Schocken (Broadmark), Steve Case (former AOL), Sen. Scott Brown (R-MA), Bill Carleton (McNaul Ebel), etc. Pictures are below.

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