Category: Angel Investing

Quebec City Conference on Public Policy on Venture Capital

Last week, I was invited to attend and speak at the Quebec City Conference Public Policy Forum on Venture Capital and Innovation (http://www.quebeccityconference.com/eng/about/about-ppf.php ). It was a presage to the main conference on Innovation. The participants and speakers were all excellent, with the majority non-US, which gave the event a perspective not usually seen in similar events. While I could write at length about each topic (e.g. getting innovation out of universities, supporting industries during times of transitions, and international models), I will focus on some of the insights about the VC model itself.

Starting with a well-tread topic – VC returns, which are negative in the last 10 years, Thomas Hellman of UBC, did some cool analysis of the Thomson/Reuters data which analyzed the returns from US VC funds from inception through 9/3/08, and plotted the ROIs against the percentile of those ROIs. Stunningly it showed that the top 1% of funds had 41% of the total returns, the top 5% had 70%, the top 10% had 84%, and the top 25% had 104%. Several key thoughts follow from this:

  1. 75% of the funds lost money.
  2. If you aren’t in the top 10%, you probably won’t do too well.
  3. LPs are deserting the asset class, if they aren’t already in a top decile fund.

So what does this mean? Clearly the VC industry will continue to contract as the funds that haven’t performed well can’t find LPs. This has been discussed at length elsewhere. At the conference, in the networking sessions, and afterward, I learned more. But, with LPs abandoning any but the most established VC funds, should governments sustain them? Or is the VC model broken? (Those that follow my blog, know that I suggested this a long time ago, http://blog.drosenassoc.com/?p=7).

And.. if you assume that the VC industry will collapse back to the top decile+ of funds, what does that mean to funding early-stage startups? That was one of the major topics of the conference. It was also the reason that angel investing got so much attention! (And, of course, why I was there.)

As I’ve blogged before, it is evident to both governments and policy makers that “high-growth startups,” primarily in tech, healthcare, and cleantech, can propel the economy. Many of the government speakers and participants acknowledged this and are struggling with how to make this happen in their geography.

Many of the policy makers that were present (and many of the VCs from outside the US) seem to believe that angels and angel groups must play a key role, both in financing and helping startups. But what does that mean? The conference participants adopted my term “professional angels” to distinguish between those that make occasional angel investments and those “professional angels” that (a) primarily do angel investing, (b) develop and maintain a portfolio, (c) invest with an experienced discipline, primarily in groups, and (d) help their companies and often serve on boards. A great deal of discussion was how to encourage Professional Angels to invest more and pick up some of the load from the VCs who will disappear.

A number of government incentives were discussed, including tax credits, capital gains holidays, etc. It seems that Canada is well ahead of the US in considering these. Hellman presented the results from some of the BC programs that have worked. When his study is published, I’ll include a reference.

What was also striking was how much the government officials in Canada and elsewhere are looking at the Angel group model in Seattle and wondering how they can duplicate what we have done. As we in Seattle realize that the model needs to be local (we couldn’t just copy the model from the Bay Area), it won’t be simple to extend it to other geographies.

 

Angel Investing is Vibrant and Getting More So

Not much surprises me these days, particularly during this mud-slinging political campaign season.

However, Marcelo Calbucci’s Tech Flash post (http://www.techflash.com/seattle/2010/10/have_we_killed_the_angel_investor.html) did. How my posts could be so misunderstood by someone I respect baffles me, especially when that misunderstanding is posted to a widely read blog.

My previous post on Angels forming LLCs for their investments IS entrepreneur friendly, and based on national best practices. Any entrepreneur who has a successful venture with 50 angel investors knows the pain (including excessive legal fees) for getting signatures on every shareholder issue. If a large number of these angel investors are in an LLC, you only need one signature – much more efficient and much less costly. This is the practice in many places, including some of the largest angel groups in the Bay Area and East Coast. It is not widely done in Seattle. And it is not a way to get better terms in seed and A round investments; there really is no relationship between the two.

It is a way for Angels to preserve their rights in the face of a VC round that follows. VC’s typically don’t like to have to get 50 signatures, so they reserve certain rights to “major investors” in their term sheets. This typically either washes away or severely limits the investor rights of Angels, once VCs have entered the deal. It is definitely in the interest of the entrepreneurs, Angels, and the company to make sure that a broader base of investors has a say in the future of the company; the trust from shareholders (the owners of the company) that they will be treated in an open and democratic way is the basis of our entire equity system.

Angels who work together to learn best practices make for a much stronger ecosystem. That is why I spend so much of my personal time trying to learn from other angel groups, both locally and nationally, about what works and doesn’t work. My colleague Angels do likewise. We run a bunch of educational events locally to share our knowledge and insights and encourage other Angels to strike deals that are balanced between return and being entrepreneur friendly. It is why I spent so much time crafting a “Series A Angel Term Sheet,” (http://drosenassoc.com/Draft%20Term%20Sheet%20for%20Alliance%20of%20Angels.pdf) that is now being widely used, not just in Seattle, but around the world. It simplifies the process of bringing in early money for startups, while lowering the costs. All of these activities lower the barrier for entrepreneurs raising money, not as you assert, making it more difficult.

Angel groups are a fabulous way for an entrepreneur to raise money. It is much more efficient to present once to 60 active angels than to set up 60 individual meetings. I don’t know one entrepreneur who would argue with that proposition. And, through the Angel Capital Association (a Kauffman Foundation spinout), we are now sharing best practices, participating in educational events, making sure that public policy encourages early-stage investment (e.g. http://blog.drosenassoc.com/?p=41), making sure that as many Angels as possible enter the ecosystem, and encouraging each other in bleak economic times.

As part of this socialization, it is evident that Seattle IS progressive. We have funded as many or more early stage deals at a slightly higher price than our peers in the Bay Area and Boston. Your assertion that entrepreneurs in the Bay Area are getting their deals funded without a financial projection or a solid plan is an urban myth that is not supported by fact; it encourages behavior that neither helps entrepreneurs or investors. We do help the “the next great idea from two guys who are just finishing their computer science degree at The University of Washington” in part by helping them understand what it means to create a great business. In my 25 years of experience, I have not seen a success where throwing money at people without a great business concept created a great business. It is the marriage of great technology, great people, and a great plan that makes the breakout companies. Yes, this takes some discipline and hard work. Saying that the best model is angels willing to throw money at entrepreneurs who are not committed to a disciplined approach is not only wrong, it does a great disservice to the entrepreneurs willing to quit a high-paying job to risk everything to build a great company.

And during the last year, I’ve spoken at events throughout North America without reimbursement. Like you, Marcello, for me this is a passion, not a business. But most Angels need a return on their investment, if they are going to continue to invest. We need more maturity in the process, not less.

We all want to see more intelligent, high-net-worth individuals in Seattle become Angel investors. They way to do this is NOT by telling them that they should “invest and pray”. It is by showing them how to be successful angel investors, how to lead deals without as much pain as in the current process, and by making it easy to pull the trigger on their first few investments. One way that other communities (e.g. Bellingham) have used is the deal-specific LLC that started this conversation.

Success will come by finding more ways for entrepreneurs and Angels to communicate and understand common goals and then achieve extraordinary results. And success will build more success.

Investor Relations for Private Companies

One of the questions I am asked by first-time startup CEOs: what is an appropriate level of communication with my investors?

This is both a difficult and profound question. It is simple to say that more is better than less. It is also simple to say that any good investor would rather have you spend your time executing your plan than spend your time chatting with investors.

So.. my simple rule of thumb is that you should treat your investors (and the money that they have invested in your company) with respect. And you should recognize that their support, encouragement, and trust that came with that money are incredibly valuable commodities that will continue to pay dividends over time. Let me give rules of thumb for great investor relations by private companies and some issues that need to be considered.

Ten Simple rules for great IR for private companies:

  1. Get the bad news out fast and first. Even if the news in embarrassing (like we are running out of cash sooner than we anticipated, or our customers found a flaw in our product), share it first and fast. Be very candid about the failings as well as the successes.
  2. Don’t bury bad news at the end of a report.
  3. Don’t wait to issue the report until you have good news to share.
  4. Don’t forget to share your passion for your business – that’s generally what made your investors invest!
  5. But don’t allow your passion to obscure the operational facts, like the numbers are not what we anticipated.
  6. Communicate frequently, but not too frequently. These communications should never be less than once a quarter. But remember that your investors are not your employees, so you don’t need to send daily/weekly updates with operational trivia. This just defeats the purpose of making sure that your investors know the state of the business by burying them in the minutia.
  7. Communications can written or in person or a combination. Face-to-face quarterly meetings are a great idea for a company that is growing and needs support and help from its investors. They are especially good for a company that needs to show its product. But they take some time to prepare.
  8. Communications can be short, but never skipped. For example, a simple note to all of your investors that “we have had to revamp our product plans and details will follow within 30 days” is an OK message. As is, “we have received an acquisition offer, but the terms require us to keep the details confidential, so we will let you know as soon as the deal is consummated.” Don’t surprise them!
  9. Your investors are smart, so treat them accordingly. Be very realistic and forthright about the impact of any misses/changes. Early stage investors know the risks. Tell them if the board insisted you take a salary cut or that you have had to lay off key people. These things happen. Sometimes the impact will be that their investment will never realize the potential you had hoped for, but that you will work for the best possible outcome.
  10. And, lastly, NEVER have the communication of the change of your company status come via a package of documents from your lawyers! Even in the case of good news (which is rare), you owe it to your investors to be the one who communicates FIRST. Even if it’s an email (or cover letter in the legal package) that says, “we have had to do X, because of Y, and the result is that your shares have to be changed in the following way. You will be receiving a package by FedEx to implement that change. I will be holding an emergency investor meeting tomorrow at 9am to explain these changes. Those who can’t be there can phone in.”

Even with these simple rules in hand, there are a number of issues that you need to consider.

  • Can I share proprietary information with my investors? This is a tough question. Seek counsel from your lawyer. In general, most startups do share proprietary information, but make sure your investors know it is proprietary. Make sure that they know they can’t redistribute or share it further. Only give info in writing that is less sensitive.
  • Know your investors. Ask them if they have investments in competitive companies. If they do, it doesn’t disqualify them from investing in your company, but make sure that they know they can’t share the info you give them.

Simply put.. if you treat your investors well, they will be there to support you when you need them. Not just in this company but in future ones.

Merger of Angel-backed Companies

Most startups first create a feature. If they are smart, it will be a unique feature that fits a demonstrable customer need in the market and they can have many customers adopt their technology. If the company is really good, they will transform this feature into a product. If that works, they might get to create a series of related product and make a product line. Rarely will the startup create a full-fledged company.

It is when a startup grows its business to the Company stage that it can get exceptional value (<$100M). In general this takes experience and skills that aren’t usually found either in a startup or on their board.

Most angel-backed startups have trouble making it beyond the feature or product stage. In the past, many startups counted on VC funding to grow to the product line and company stage. This is now exceedingly rare, given both the number of angel-backed startups and the limited activity of VCs (see some of my previous posts).

So what does that mean? One outcome is that we move our angel-backed startups to profitability and they grow organically. This can lead to an acquisition, but more often than not, exits are rarer than we would like. (I will be doing a post on this soon.)

I predict that we will begin to see a wave of mergers between successful angel-backed companies. This makes perfect sense.

When two companies are in alignment and have products/features that can satisfy a broader set of customer needs, builds revenue and a customer base that exceeds critical mass, and gives the combination the chance to get to the company stage – creating a lot more value than the two companies separately.

Film, Angels, and Entrepreneurs

Last week I was invited to speak at an event at Victory Studios in Seattle that was sponsored by the new Seattle chapter of the Institute for International Film Financing (IIFF). I told them I thought they had the wrong person, but they explained that in LA and San Francisco there had been some great interactions between tech angels and the film community – we had a lot to teach each other. I agreed to speak, but was concerned that I really knew nothing about the film business.

I love film (as well as theatre). I’ve loved movies for as long as I can remember and (from my previous posts) you know that I found the new 3D/IMAX experience entertainment-altering. I’ve also blogged about setting up my home theatre to watch movies and loving Netflix on the iPad. I enjoy the output of the film industry, but really have no knowledge about film as a business, nor have I ever given it much thought.

I found myself at a film studio, sitting among a panel of film experts, including experienced producers, speaking to an audience of established and aspiring film makers, producers, and directors. As I listened to them speak, I realized why I was there. There really were a ton of similarities!

Listening to a producer discuss how the director and stars had a strong desire to create the vision exactly the way they wanted it, without regard to the budget, sounded like a conversation I had just had with the CTO/founder of a tech startup who had delayed shipping on schedule to get it exactly right. A discussion about the need to consider marketing budgets in film production sounds so eerily similar to that of a web company that had only budgeted sufficient money to launch their product, but not enough for distribution. And there was a long discussion about using social networks to enhance views that could have been a web startup as well as a movie.

The similarities do abound. Is a short film marketable? (Is a single feature company marketable?) Can a director be a producer as well? (Can a tech founder be a CEO?) Etc.

But for me, the biggest learning experience is how the movie industry has paralleled the tech industry. It used to cost many $M to produce a film, just like it used to cost $20+M to build a software company. You can now produce a film for several $100k’s. The technology has made it easier to do the filming, do the editing, etc. Even distribution is changing markedly. For example, you can distribute a film entirely on line, using services like YouTube and Netflix.

However, I also realize that, while I have some expertise in startup deal structure and terms, this might not apply to film ventures. I haven’t yet taken the time to review the kind of deal structure, partnership arrangements, rights, etc of a film deal. Nor have I looked at the business/revenue models that apply to film. I sense that most film investors do so more on gut, instinct, and passion than the smart tech investor.

The main difference is that most tech (or medical) startups create a product that doesn’t have to be a “hit” to succeed. If you get it wrong, or your timing is wrong, you still have the opportunity to fix the situation. This makes investing in a single film very different than investing in other startups. Most of our tech startups are more like investing in a studio than a film. This might dissuade a tech angel from film.

Comments from experienced film investors very welcome.

Success!!

All of the work on the Dodd bill by angels and their supporters in the Senate has paid off. Today, a bipartisan amendment sponsored by Senators Kit Bond (R-MO) and Senate Banking Committee Chairman Christopher Dodd (D-CT) and co-sponsored by Senators Mark Warner (D-VA), Scott Brown (R-MA), Maria Cantwell (D-WA) and Mark Begich (D-AK) was adopted by voice vote as part of the financial reform bill being debated in the Senate. See the following announcement:

http://banking.senate.gov/public/index.cfm?FuseAction=Newsroom.PressReleases&ContentRecord_id=a8a93650-936c-1e68-27b0-a38401ac9619

Thanks to all of the angel investor groups who contacted their Senators, and thanks to those Senators who recognized the importance of our mission and got the entire Senate to support our cause.

Modumetal – the ACA Innovative Company of the Year

Greetings from San Francisco, where I am attending the Angel Capital Association (ACA) annual meeting. This afternoon, the ACA introduced a new award named after Luis Villalobos, one of the nations’ most prominent angels and founder of the Tech Coast Angels, who unexpectedly died last Fall. I was asked to introduce Christina Lomasney, the Modumetal CEO. Here are my remarks and the ACA press release:

Thanks, Richard [Sudek, the chair of the TCA and outgoing ACA board member].

It was just one short year ago in Atlanta that Luis and I decided to walk back from dinner and discuss our shared passions for Angel investing and innovative companies.

It is my distinct pleasure to introduce Christina Lomasney and Modumetal – both of whom embody my discussion with Luis and a great example of Peter’s [Diamandis, Chairman of the X Prize Foundation, who had just spoken] exponential company.

In more than 25 years of investing in and starting companies, it is rare to see an idea that can create and industry and change the world. Modumetal is such a company.

Christina has inspired the Alliance of Angels and other local angels with her vision to invest more than $4.9M. And inspired her employees to achieve great things with limited resources. And inspired large customers to bet on this early stage startup. Modumetal is a great example of why we angels do what we do – investing in innovative startups and helping them change the world.

Join me in recognizing the 2010 Luis Villalobos Award winner – Modumetal and Christina Lomasney.

Here is the ACA Press Release:

For Immediate Release

Contact:

Marianne Hudson
ACA/ACEF
913-894-4700 x1 (or 816-668-2248)

mhudson@angelcapitalassociation.org

Contact:
Erich Mische
Modumetal
877-632-4242
erich.mische@modumetal.com

Modumetal Named 2010 Luis Villalobos Award Recipient

National Award Recognizes Most Innovative Idea Financed by ACA Angel Group

San Francisco, CA, May 6, 2010 – The Angel Capital Association (ACA) named Modumetal of Seattle, WA, as inaugural winner of the Luis Villalobos Award.

The national award, which was established in 2010 to honor the late Mr. Villalobos, founder of Tech Coast Angels and a true “leading light” in the angel field, recognizes the most ingenious and innovative idea recently financed by one of the member angel groups of the Angel Capital Association.

Christina Lomasney, Modumetal co-founder, president, and CEO was presented the award at the 2010 ACA Summit in San Francisco, CA. The Summit was attended by 400 angel group leaders and investors from the United States, Canada, and 23 other countries.

“Luis was an innovator and a ferocious learner and tireless entrepreneur supporter,” said Richard Sudek, chairman of Tech Coast Angels and chair of the Luis Villalobos Award committee. “He started one of the early angel groups, and was intrigued and excited about innovative technology, science, and new ways of doing things. It made so much sense for ACA to honor Luis with this award which recognizes entrepreneurs who make very unique contributions that are disruptive or game changing.”

Modumetal is creating a new class of ultra-high performance nano-laminated materials.

“The leadership and support that Mr. Villalobos represented in helping entrepreneurs to realize their visions for the world echoes clearly today for Modumetal in his stories, his example, and in his own perseverance in realizing the Tech Coast Angels.” Lomasney said. “The Modumetal team is grateful for Luis’ inspiration and is honored to be the first to receive the Luis Villalobos Award for innovation.”

The Modumetal by Design™ process uses electricity instead of heat to grow metal from the ground up, in nano-scale layers. Modumetal, a revolutionary nano-laminated alloy system, is stronger and lighter than steel, can run longer and hotter than nickel-alloys, is more corrosion resistant, and costs less than stainless.

Alliance of Angels (AoA) of Seattle, WA co-led a multimillion-dollar Series A investment round in Modumetal. The syndicated round included significant investment from AoA members as well as from co-lead investor Second Avenue Partners and the Washington Research Foundation of Seattle.

“Between the people, the product, and their approach, I think Modumetal is one of the most creative and innovative companies in my twenty-five years of investing,” said Dan Rosen, Alliance of Angel chair.

Modumetal’s nano-laminate alloys have the potential to create an entire multi-billion industry that will transform transportation, aerospace, energy, and defense industries.

“This is exactly the sort of deal that Luis would have loved,” Rosen said. “Modumetal has inspired its employees to achieve great things, its investors to believe they can change the world, and its customers to work with this small startup to implement this striking innovation and change the way things are done.”

—

The Angel Capital Association
(ACA) is a trade association that supports angel investment groups in North America. ACA was founded by angel investment groups located in the United States and Canada to help maximize the success of group based angel investors. (www.angelcapitalassociation.org)

Modumetal of Seattle, WA, is realizing the commercial potential of a unique class of nano-laminated materials. The Company is creating materials that will change design and manufacturing of metals by redefining structural, corrosion, and high temperature performance. Modumetal is made by a “green” electrochemical manufacturing approach, which reduces the carbon footprint of conventional metals manufacturing at the same time that it revolutionizes materials performance. (www.modumetal.com).

Rescue of Angel Financing Imminent

by Dan Rosen, Joe Wallin and William Carleton

As we have previously blogged, Senator Dodd’s financial reform bill has posed a grave threat to angel investment and startup communities nationwide by virtue of two provisions in the bill that would have upended Regulation D. These “reforms” were ostensibly to address the problem of unscrupulous brokers, dealers, and promoters who have abused Reg D to defraud investors. The problem was, the provisions in Sen. Dodd’s bill were unnecessarily broad. Fraud is uncommon in angel investment transactions, and there were other ways to reform Reg D without gutting the rule that is working well to make startup and angel financing safe and efficient.

Here’s a quick refresher on the two problematic provisions in Sen. Dodd’s bill, problematic for startups and angels. The first provision would have adjusted the threshold at which angels qualify as “accredited investors,” sending two-thirds of active angel investors in the United States to the sidelines, ineligible to participate in getting startups off the ground. The second provision would have required companies to wait 120 days for the SEC to determine if they qualify for a securities law exemption that is self-executing (meaning, no waiting) today.

Well, whatever the outcome for the overall financial regulatory reform legislation now being debated in the US Senate, it appears that the startup and angel investing community can breathe a huge sigh of relief this week.

That’s because it now appears that Reg D will survive largely intact.

In fact, Reg D may be amended in a way that will improve it.

The below table compares what had been proposed with amendments now making their way to the Senate floor. We believe the amendments to save angel investing and startup financing will be sponsored by Sen. Dodd himself. The sound policy represented by these amendments was achieved largely through the efforts of the Angel Capital Association, under the leadership of its Executive Director, Marianne Hudson, supported by the ACA members’ contacts with Senators and their staffs.

Original Proposal New Proposal
Adjust Accredited Investor Thresholds

As originally proposed, would have adjusted the accredited investor financial thresholds for inflation since the thresholds were first set. This would have eliminated approximately 2/3rds of angel investors currently active. In addition, the first proposal would have required an adjustment every 5 years.

 Adjust Accredited Investor Thresholds

As now proposed, the net worth standard for an accredited investor will stay at $1,000,000, which is where it is now, with one important change:  net worth will exclude the value of a person’s primary residence.

In addition, the bill would require the SEC to review the accredited investor definition to determine if it should be adjusted. The first review would be within 6 months, and thereafter reviews would be not less than frequently than every 4 years. Significantly, the new language also requires the SEC to consider the economic impact of any change, arguably leaving the door open for a future decrease in the accredited investor thresholds.
SEC Review of Filings

As proposed in the bill approved by committee, would have required the SEC to review all accredited investor offerings within 120 days of the filing with the SEC. If the SEC did not undertake that review in time, states would have been free to impose their own rules.

 Disqualifications for “Bad Actors”


Directs the SEC to issue rules for the disqualification of offerings and sales of securities involving individuals who are “bad actors.” “Bad actors” are persons with a prior record of violations of certain federal or state laws.

To date, the legislative process has worked better than we imagined it could. The language of the amendments saves angel investing, keeps costs for startups where they are now (still not low enough!), and gives state regulators the green light they need to pursue the fraudulent broker dealers and scam artists who have abused Reg D. (No responsible member of the start-up ecosystem would want fraud to take cover under Reg D; that favors no one and, as members of the startup and angel investing community, we hate bad behavior as much as any group of citizens.) The angel investing community was able to focus the attention of the Senate Banking Committee on preserving what works well now, while meeting the direct problem that concerned state securities regulators. All of this was supported, in the background, by Senators and their staffs who “got it.” We also believe that Congressional staffers who tweet could see the groundswell of rising consciousness on the issue among entrepreneurs. Architects of this effective social media effort included Matt LeVeck and Irene Tamaru.

The new reforms are not law yet, so we must remain vigilant. The sections could be further amended on the floor of the Senate, putting harmful provisions back in the bill or changing the provisions once again. If the bill is passed by the Senate, it would yet need to go through a reconciliation process with the House; and other action by the House could effect changes. So we’re not letting our guard down yet. But we are saying, it’s time to tell your representatives that you thank them for listening, and that you’re keeping watch on how this finishes.

“Save Angel Investing” Amendment to Senator Dodd’s Restoring American Financial Stability Act of 2010

(With thanks to Bill Carleton and Joe Wallin)

High-growth startups are a cornerstone of our economy. Studies have shown that these startups account for much of the job growth in the US and are critical for America’s competitiveness. Angels who finance these companies often become actively involved and help the companies thrive. Angel investment in startups provides the primary and the best source of early-stage capital needed for startup tech companies and other innovative new businesses in America. Such investment is encouraged in many states and other countries.

Section 926

Section 926 of the Dodd bill would impose new, unwarranted and devastating restrictions on the “Reg D” process by which Angels (and Angel Groups) support America’s startup innovation economy. Moreover, as we explain below, these restrictions are wholly unnecessary: more-effective, more precisely-tailored reforms are available to fix the abuses of Regulation D that occur outside the Angel investing arena.

We do not believe that it is the intent of Sen. Dodd or Section 926 of his bill to do so, but a consequence of the current language in the bill would be to seriously impede angel investments.

Today’s process (Reg D) requires that startup companies funded by “accredited investors” (sophisticated business Angels who understand the risks in such investments) can invest without undergoing the expense, complexity and delay of a registration process. Instead, within a few days after the first sale, startup that has received the investment files a simple “Form D” notice filing with the SEC and with each state in which an investing Angel resides. This system has worked well for over 15 years, as shown by the growth of early-stage companies. Remarkably, there are virtually no examples of fraud or abuse in such angel investments.

On reflection, it makes sense that Reg D should work so well for startups and Angel investing. First and foremost, the startups in which Angels invest are not in the business of selling or trading securities. They do not engage broker dealers to do so, and they do not sell to the general public. Instead, these startups are placing securities directly in the hands of sophisticated Angels in order to obtain needed capital to get a new business off the ground. If the startups and the Angels are successful in what they set out to do, they will create jobs in the process and possibly returns on investment. Angels know the risks, going in.

In this vital process, the way that innovation in America is financed at the grass roots, no one is making a living or taking a profit from the process of selling securities. Startups are “incidental” issuers only, and all participants in startup “grass roots financing” (including entrepreneurs, Angel investors, and lawyers) have every reason to self-police. In the rare instances of securities fraud, the Reg D exemption notice filings serve a critical record-making function, just as they should: investors who feel cheated can sue to show how a Reg D exemption was claimed and filed falsely. If there was fraud, those investors are going to have recourse, personally, from the officers, directors and others associated with the rare problem startup. And you can bet the persons in those rare, fraudulent startups will not be supported again by the Angel community, nor should they be.

Section 926 wants to toss out this process that has worked so well and start over with a 120 day review period for all Reg D filings. For most early-stage startups, time equates to life or death and the regulatory review process proposed in Section 926 will kill many promising companies. For those of us willing to spend the time, expertise, and money to start potential high-growth companies, the changes that would be imposed by Section 926 seem unnecessary and counter-intuitive.

Section 926 also wants the SEC to define by rule a class of securities that are too small in size and scope to merit eligibility for the uniform, federal Reg D notice exemption system. But it is exactly the small, “seed” (getting a startup off the ground) financing that most needs the benefit of Reg D!

From discussions with Joe Borg (Director, Alabama Securities Commission, and Member, NASAA Board of Directors) and others, we have come to understand that the States, as a part of financial system reform, have been plagued with certain disreputable promoters, brokers, dealers and investment advisors (“bad actors”) defrauding investors by abusing Reg D filings. The State regulators have the authority to prosecute, but feel they are hamstrung by being able to do so only after the fact when the money is already gone. The primary intent of Section 926 is to give the States the ability to regulate these “bad actors” before they are allowed to take in funds under fraudulent terms. Angel investors and groups share this concern and would like to suggest a solution to the State Regulators’ problem that does not restrain Angel investors (or Angel groups) from creating high-growth startups.

There is a valid need to regulate promoters, brokers, dealers, and investment professionals that raise money for others. Attached you will find a suggested amendment to Section 926 that achieves the following:

Address the concerns of State Securities Administrators by:

  • Eliminating federal preemption of state authority with respect to exempt offerings that that involve brokers, dealers, or investment advisers.
  • Instructing the SEC to amend Rule 506 of Regulation D, to incorporate by reference the disqualifications already in Regulation D that pertain to Rule 505, so that “bad actors” can’t abuse Regulation D.
  • Clarifying that existing state jurisdiction to investigate and bring enforcement actions with respect to fraud or deceit, or unlawful conduct, applies not only to broker-dealers, but also to investment advisers.
  • Disallowing the use of Rule 506 for offerings that are not “all accredited investor” offerings (current rules allow 506 offering with up to 35 non-accredited investors if certain information requirements are met).

Address the concerns of startups and angel investors by:

  • Eliminating the 120 day SEC wait/review period in the current version of the bill.
  • Eliminating the authority given to the SEC under the current proposed bill to establish, by rule making, a class of securities offering that would be too small to merit federal exemption, leaving in place the current, national, uniform notice-filing system for startups.
  • Clarifying that a security is a covered security with respect to a transaction that is exempt from registration under Rule 506, including with respect to groups of purchasers comprised solely of accredited investors.

We believe that this meets the needs of the State Regulators to clean up the industry without the chilling effect that an elimination of Reg D would impose on funding startups by accredited angel investor.

Furthermore, by eliminating the “bad actors,” we will enhance the ability to get new startups going – investors will feel more secure in knowing that they are not investing in scams. This is a true win-win.

Section 412

Also of concern in Senator Dodd’s bill is Section 412, which would change the definition of an “accredited investor.” It is hard to argue that an individual with a net worth of greater than $1,000,000 is not a sophisticated investor. Section 412 would index that $1M back to 1982 and make the new definition $2.25M, eliminating 77% of the potential accredited investors (see Shane’s article in Business Week (http://www.businessweek.com/smallbiz/content/mar2010/sb20100318_367600.htm).

Section 412, in our view, is nothing more than a poorly conceived tool to limit the scope of broker dealers and investment advisers abusing regulation D. The tool is poorly conceived, because it is so indirect. In the process of eliminating three quarters of the population from which the fraudulent broker-dealers might operate, it also would devastate the single most important source for start up financing in America. And it would also prevent knowledgeable and sophisticated angel investors with high net worth (but not high enough) from receiving the returns that their richer brethren receive; this is neither fair nor democratic and, once again, not in the spirit of the Dodd bill.

As part of saving angel investing, if we make the protective changes to Section 926, we believe that we no longer need the protections suggested in Section 412 – there should not be an indexing of the definition of accredited.

___________________

Amendment to S. ____
“Restoring American Financial Stability Act of 2010”
Offered by ____________

Page 816, strike line 3 through page 819 line 4 and insert the following:

 

 SEC. 926. AMENDMENTS OF RULE 506 UNDER REGULATION D ;  AUTHORITY OF STATE REGULATORS OVER REGULATION D 
 OFFERINGS INVOLVING BROKERS, DEALERS, AND 
 INVESTMENT ADVISERS. 

Section 18(b)(4) and Section 18(c)(1) of the Securities Act of 1933 (15 U.S.C. Sections 77r(b)(4) and 77r(c)(1), respectively) are amended —

(1)    by inserting, following subparagraph (D) of said Section 18(b)(4), a new subparagraph (E), as follows:

“(E)    Rule 506 under Regulation D, provided that all purchasers with respect to such transaction are accredited investors, as such term is defined in the rules of the Commission under the Securities Act of 1933, or are persons, entities or groups composed solely of accredited investors purchasing securities solely for the beneficial interest of said accredited investors.”

(2)    by redesignating paragraph (1) of said Section 18(c) , “Fraud Authority,” as subparagraph (1)(A) thereof, and restating it as follows:

“(A)    The securities commission (or any agency or office performing like functions) of any State shall retain jurisdiction under the laws of such State to investigate and bring enforcement actions with respect to fraud or deceit, or unlawful conduct by, a broker, dealer, or person associated with a broker or dealer, or an investment adviser, or persons associated with an investment adviser, in connection with securities or securities transactions.”

(3)    by inserting, following such redesignated and restated subparagraph (A) of said paragraph (1) of Section 18(c), a new subparagraph (B), as follows:

“(B)    A security is not a covered security with respect to a transaction that is exempt from registration under this subchapter if the offering of such security involves the payment of any commission based on funds raised by the issuer in connection with such offering, or otherwise involving a broker, dealer, person associated with a broker or dealer, or involving an investment adviser who has a financial interest, direct or indirect, in the offering of such securities, or a person associated with such an investment adviser.”

(4)    by inserting, following subparagraph (D) of said Section 18(c)(2), a new subparagraph (E), as follows:

“(E)    AVAILABILITY OF PREEMPTION CONTINGENT ON LACK OF DISQUALIFICATIONS. The Commission shall amend, by rule, Rule 506 under Regulation D, to disqualify securities issued in reliance on said rule as covered securities under Section 18(b) of the Securities Act of 1933, for reasons which are comparable to the disqualifications currently set forth at subparagraph (b)(2)(iii) of Rule 505 of Regulation D.”

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