As a rule I live by, “if it ain’t broke, don’t fix it!” The new SEC rules violate that basic principle (see: http://www.startuplawblog.com/ or my previous posts). There is virtually no fraud in the Angel Investing asset class, but the SEC has decided to impose (without a Congressional mandate) stringent new rules that will cripple angel investing.

Let me use an analogy. Let’s say that you are a wine connoisseur. You buy a superb bottle of wine each month from a new small winery, knowing full-well that it will be expensive. But you really like supporting small, unknown vineyards and hope that the wine will mature into on that is exceptional in 5-10 years. You have been doing this for years and find that it is worthwhile.

All of sudden you are told by the federal government that before you are allowed to buy a new wine from any small, new vineyard that has announced their new wine, that winery must verify that you can afford to buy this wine.

The winemaker must verify that the purchaser is allowed to buy this expensive new wine or lose the license to sell wine at all. The winemaker says: “I’m just a wine maker and don’t have any ability to check or store financial records.” So she asks his distributor, who says: “I can do that for you, but it will be time-consuming and expensive.” The winemaker is befuddled, since she knows that, unless she can sell his wine in a timely fashion, her business will flounder, so she agrees to pay the distributor, even though the winemaker has always sold directly. She learns that if she never announced that she had a new winery to customers or was a large, established winery these rules would not apply.

So the distributer calls you and says, “give me your financial records, so that I can verify that you can afford to buy this wine.” You really want to buy the wine, since you have done hours or days of research finding the winemaker and studying how she makes great wine. Getting the financial information together is another time-consuming task that has nothing to do with studying wine. You decide it’s just not worth it, so don’t buy the wine.

But being forced to do this EVERY time raises the complexity and difficulty of finding new winemakers. So you decide that buying from only large vineyards is good enough, since you won’t have to go through the hassle. It’s not as much fun, you aren’t supporting the new winemakers that move the industry, but it is less difficult.

This is a direct analogy of what the SEC is imposing on entrepreneurs, startups, and their angel investors. We are being told that we must add to the complexity, cost, and hassle of doing these risky, early-stage deals (where over half fail anyway), while assuming additional risk that the company will have violated a cumbersome and costly regulatory process. If they have made a mistake, then they can’t raise money for a year, which we all know is a death sentence of a startup.

Please contact the SEC, your Congressional Delegation, any anyone else who will listen and spread the word.

I am being asked, why is the SEC proposed ruling such a big issue?

Unless you read the entire ruling and get to talk either directly or indirectly to SEC staff, it doesn’t seem like a big issue. 

Simply put, the proposed SEC ruling is (a) trying to fix a problem that doesn’t exist; (b) will increase risk in our early-stage deals by adding a dimension of regulatory risk that isn’t there now; (c) will increase the cost and time for getting deals done; and (d) violates the Congressional intent of the JOBS Act, which recognized that using angel investment to create more jobs in startup companies was good for the US.

Their proposed ruling is setting new policy by bureaucrats in an area where the policy should be set by legislators

There are several issues here:

1. What constitutes a general solicitation?  One reason I welcomed the JOBS Act provision on general solicitation was that Angel groups hit that boundary many times.  My angel group, the AoA, was ultra-conservative. For example, we didn’t give our 2 page startup summary sheets to guests, who had not yet given us the accredited investor forms.  Other groups, like Zino Society, did big events (Zillionaire Forum) that are attended by many people who aren’t accredited.  While I think this is a great idea, since it exposes new people to startups and helps fund them, are the companies that present there using general solicitation?  When a company posts its plan to Gust (as the AoA requires), are we generally soliciting?  We live in a connected world, with social media being the norm, so the new rules should take that into account. But, the boundaries are murky and, if the proposed rules are adopted, the consequences of a mistake are draconian.
2. When the JOBS Act passed (and remember I was an insider), Congressional intent was to help angels fund more companies.  The new SEC rules not only won’t achieve that intent, but will make it harder, because of the uncertainty.  I will likely avoid investing in any deal that uses general solicitation. If the startup company makes a mistake, I will lose my investment quickly, since they will have spent my money (as I want them to) and not be able to return it when the deal is rescinded. Even if the deal is not rescinded, they will be prohibited from raising money under Reg D for one year; that is a death sentence for a startup.
3. The old rules provided a safe harbor to the companies (the investors were accredited if they said they were).  The new rules do not provide safe harbor.  The companies must verify that each investor is accredited and not a “bad actor.”  That responsibility is on the company and their board.  To get that degree of certainty, our advisors are saying that each issuer must do a background check with a third party, which will cost several thousand dollars per investor.
4. I most certainly won’t give personal financial records of any type to a startup. Perhaps a third party verification industry of broker/dealers will emerge that will do so, but that will add cost and complexity. Furthermore, that will likely mean I will have to fill out additional myriad forms for each investment, attaching my tax returns, bank accounts, etc. each time. Again, I find myself asking “what problem are you trying to solve?” Public market equities don’t require me to jump through any hoops. Seems simpler.
5. If you think you are not using general solicitation, but later it is determined that you did (e.g. presented at a public event, did a post on a social network, talked to a reporter, or potentially even told a customer who asked how you could ship your product), the impact is draconian.  You have 30 days to file an amended form D, allow your existing investors to rescind, and potentially face a one-year ban on fundraising. 
6. Today, if you use Reg D, 506b (quiet), you can file after you raise the money (15 days).  If you do use 506c, then you must file an Advance Form D 15 days BEFORE the first time you generally solicit.  So, that would mean that you will need to file before you speak to your first investor and then file (an amended Form D) when you reach final terms.  And the Form D is posted to a web site that can be reviewed by the State Security Administrators.  We believe that this is the reason for this whole process – they want to do away with Federal preemption of Reg D filings.  They can then require a company to jump through myriad state hoops, as they have done in Alabama.
7. The SEC is making the Reg D forms much more complex.  You can read that to mean that legal fees will be substantially higher.  This will make smaller deals (which we have been advocating) more problematic.

For a more thorough treatment of these issues, see: http://www.startuplawblog.com/

Hope this helps.

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.

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 21^st 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 20^th Century when the current securities laws were written.

Comments welcome.

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.