Senator Maria Cantwell (D, WA) is an entrepreneur and knowledgeable about startups and how they drive the economy. Here is a letter that she sent to Senator Dodd about the pending bill that could cripple angel investing in the US. Way to go! We all owe her thanks.
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”
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.
Yes, I bought an iPad last Saturday. For those that know me, you will be surprised to know that I even waited in line for almost 2 hours. But I must say, Apple really had its act together. They had the line snake down a service corridor, so that you couldn’t see it when you came in. And then they had coffee at the end of the line. Very civilized. When I got to the front, I was assigned to an Apple employee, who introduced himself, took be in and got me my iPad. He then told me about the accessories that they had in stock, and tested my iPad for me to ensure it worked. I also bought the dock that enable you to charge the iPad while it stands up and the Apple cover. Unfortunately, the you can’t dock the car with the cover on, so I took it off. There seem to be many better covers than the Apple one.
Immediately on leaving, I went to Starbucks to try it out. (OK, maybe to show it off a little.) The screen was brilliant, the package exactly what you’d expect from an Apple product, and the fit and finish terrific. However, the extra size made the touchscreen keyboard very difficult to use, compared to the iPhone. I suppose that I will find a comfortable way to type on it eventually.
It connected to the wifi on the first try. (I wish my Windows laptops did as well.) I then connected it to my exchange server, which also worked on first try. After a brief wait while it downloaded, I had my email, calendar, and contacts. First observation Apple modified their email, calendar, and contacts programs for the iPad to take advantage of the extra screen space. Really nicely done.
Next, I downloaded the Kindle reader. It immediately synced to my Kindle account and downloaded my books, and even synced to the current page in the book I was reading. Really slick.
I searched for apps in the App Store. Some very cool apps made just for the iPad. One of my very favorite is the Netflix app. It allows you to actually stream and watch movies in your queue! And crystal clear picture, no skips, and good sound. I’ve been using it frequently.
The ABC app, NY Times, and BBC are also really good. The apps made for the iPad that take advantage of the platform really show it off well.
One other cool feature is the photo show button on the sleep screen. When you press it, the iPad becomes a picture show while charging. Very cool.
My iPhone apps also work (for the most part) on the iPad. Apple added a “2X” button at the bottom of the screen so that you can double the size of the iPhone screen. Note that it doesn’t double resolution, but that’s not too bad in most apps. Note that iTunes won’t download apps that don’t work on the iPad.
One big problem was getting files onto the iPad. The only way I found was using iTunes clearly sub-optimal. Till a friend (who had been an iPad beta tester) told me about GoodReader. Allows you to use wifi to transfer files. Works well.
Another big gripe from me the iPad has NO CAMERA. Why? I hadn’t thought much about the implications of this, but it not only means that the iPad won’t take pictures, but also can’t use the camera-enabled apps. One of my favorite iPhone apps is WorldCard, which lets you photograph a business card, recognizes it, and then exports it Outlook. I have lots of photo apps on the iPhone and wish they worked on iPad.
Another problem is Apple’s stupid decision not to support Flash. With the fabulous screen and wifi, it is possible to pull up full size web pages, many of which now use flash. They just don’t play/display on the iPad. Note to Apple please support Flash!
Last gripe the only other attachment was a VGA adapter, which can show the iPad screen on a monitor. Why not HDMI, so that you get sound as well as the video?
Not perfect, but a very cool product. I can see the value of the 3G version. Hopefully it will do text messaging as well. And maybe version 2 or 3 will fix some of the shortcomings.
(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 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.
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
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.”
As those who are following this topic know, the Senate Finance Committee moved Dodd’s Financial Reform bill out of committee without any amendments. This unusual move means that the three sections that might cripple angel financing remain in the bill. It becomes more critical than ever that we notify our senators of our adamant opposition to these sections that could have disastrous effects on early stage companies and financing.
At yesterday’s Alliance of Angels monthly meeting, I presented a few slides on the issue (http://drosenassoc.com/AoA Public Policy Issue.pdf) and we asked our members to sign these letters:
We then faxed the signed letters to Senators Cantwell and Murray. (If you are in another state and want the word versions to modify, they are at Word version of Murray letter, Word version of Cantwell letter).
I urge you do send them as well.
On my last post, I referenced Scott Shane’s data. For those that haven’t read his book, The Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live By (http://www.amazon.com/Illusions-Entrepreneurship-Costly-Entrepreneurs-Investors/dp/0300158564/ref=sr_1_1?ie=UTF8&s=books&qid=1269045575&sr=8-1) it’s an important book for angel investors.
He has now published an article in Business Week that gives more detail on his insights and calculations of the impact of Dodd’s unintentional assault on angel investing (http://www.businessweek.com/smallbiz/content/mar2010/sb20100318_367600.htm).
Bills of the magnitude and length of Dodd’s financial reform bill achieve many important reforms, but it cannot be allowed to pass in its current form and cripple something that is both vital and working, like angel investing.
This open letter was sent to Senators Murray and Cantwell, Secretary Locke, and Representative Inslee. Please feel free to forward this to any other Senators or Representatives.
I chair the Alliance of Angels in Seattle. We are a not-for-profit group of over 60 individual and small institutions that invest in early stage startups in the Pacific Northwest and are one of the most active angel groups in country. In the last 3 years (2007-2009), we have invested $7.3M, $16M, and 17.5M in 44, 36, and 29 companies respectively. In almost all cases, we were the primary source of financing for these 109 new companies. The Alliance of Angels has been widely recognized for the benefits it provides to the community, to startups, and for potential economic development these startups bring with their new and innovative products and services.
I believe that Sections Sec 412 and 413 (pages 380-381) and Sec 926 (pages 816-819) of Senator Dodd’s Financial Reform Bill will have a significant negative impact on Angel investing, and might even cause groups like ours to no longer be able to function. While I applaud many of the goals of Senator Dodd’s bill that lead to better visibility and accountability, the three sections cited will have many unintended and disastrous consequences. This cannot be allowed to proceed.
Section 926, entitled “Authority of State Regulators Over Regulation D Offerings” (pages 816-819) is the most problematic. Today, startup companies can raise money from “accredited investors” like the Alliance of Angels simply and easily. As a result, we have funded over 100 new, innovative, and high-growth companies. Senator Dodd’s bill will force these startups to have to make a filing with the SEC and the SEC will have 120 days to review the filing. And then, if the review doesn’t happen, the individual states could then apply regulation. Section 926 will replace an accepted and working system with one riddled with uncertainty and delay. For a startup, a 120+ day delay in financing is often a death sentence. From an investor point of view, many Angel investors, recognizing the increased risk of failure from this added costly and burdensome regulation, might make the difference between continuing support of the entire early-stage investment asset class.
Furthermore, an added layer of state regulation over angel financing that currently works well will put a chill on angles syndicating deals across state lines. At this time such regulation is as unwise as it is unneeded. At the Alliance of Angels, we consider deals from across the Northwest (Washington, Oregon, Idaho, and Montana). If there is additional cost or restriction or time required, co-investment by angels in other state will be chilled. We need more angel investment, not less.
Lastly, Section 412 of the bill will change the definition of an “accredited investor,” adjusting this for inflation. Currently, and accredited investor must have net worth over $1 million or income over $200,000 ($300,000 for a couple) in the current year. People with this net worth or income are sophisticated financial investors. Do they need additional regulation to protect themselves from investing in startup companies?
According to Scott Shane, if you use a database on wealth from the IRS and calculate inflation based on information from the Bureau of Labor Statistics, the new thresholds for accredited investors would be $2.2 million in net worth, $450K in individual income ($775K in salaries for married couples). I believe that this will cripple groups like the Alliance of Angels and would cause a significant drop off in angel financing for startups.
In summary, “it’s not broke, so don’t fix it!” Angel investing in the United States has sufficient safeguards and does not need these provisions in Senator Dodd’s bill to make it safer. Instead, it will put a chill on the entire angel investing process, injecting uncertainty, excess costs and more risk. Please take whatever actions you can to make sure these provisions are eliminated from the bill.
Setting a strategic course and vision for a startup is one of the most potent weapons to get your company on the right path, become capital efficient (because you will spend your resources wisely to reach your goal), and then get to a premium exit valuation. Yet, many startups don’t spend sufficient time early on setting their strategic course. This post offers some simple tips in doing this.
Since I am a professional angel investor, many people now see me through that lens a finance guy. People who have known me for some time would think that laughable. “Dan is a techie or a strategist,” would be a much more common refrain. Good angels must help their startups with more than just money startups need the benefit of the experience their professional angels can bring to bear.
The first step in setting a vision for you company is simple sit back in a quiet room and think about what you define as success. Write down all of the statements that come to mind. If there are several co-founders involved, do this as a team activity (or maybe do it individually and then come together and merge your visions). While anything is acceptable, specific statements are most helpful. Examples might be:
- Newco achieves $100M in revenue.
- Newco is recognized as the market leader in the emerging XXX category.
- Newco is acquired by XXX for $300M.
- Newco revolutionizes solar energy production with its latest generation of solar cells.
- Newco’s proprietary algae system creates the first commercially viable alternative to petroleum for gasoline.
- Newco buys Microsoft.
Several statements are probably better than one.
With these in hand, think about the date at which you hope to achieve those goals. Then comes the fun part.
Write the front page Wall St. Journal article that appears about your company on that day. Remember several things.
- The headline is important; it must reflect the story.
- Newspaper stories are written as an inverted pyramid structure. The most important information goes at the top of the story and the details follow.
- The total article must set out why the achievement is important in both a business and strategic sense. Why it is a milestone?
This will be fun, but it is often more challenging than it appears to be at the surface. Try it and post your feedback.
For extra credit, put together the time line of headlines/articles that get you there.
If done well, it will point out with a degree of precision where you are heading, what it will take to get there and if there are differences among the founders, or other key stakeholders.
In a previous posting/rant, I talked about Angel Groups that gouge entrepreneurs (http://blog.drosenassoc.com/?p=13). Some charge over $10,000 for the right to present and that steams me. However, I have not directed my wrath at another group that gouges entrepreneurs even more brokers and small investment bankers. Note to entrepreneurs: Do Not Use a Broker (or small investment bank)!
Such firms typically charge an entrepreneur between 5-10% of the amount raised, in addition to expenses, legal fees, and a retainer. No angel I know wants to see the money they invest in a startup flow out the back door in this way. You do not need to pay to find angels and get them to invest in your company. If you have a good idea and a good business, approach us directly. The staff at the Alliance of Angels gives you far better feedback, based on angels who actually invest, than you will get from a broker. And it’s free!
The Northwest Entrepreneur Network (NWEN) and Washington Technology Industry Alliance (WTIA) offer seminars, networking events, and classes on how to raise money. They are low cost and valuable.
But.. no angel I know likes deals where there are brokers involved. We like to meet with and get to know the entrepreneur, help them get their company going, and build to a success. None of want or need someone in the middle.
Senator Dodd decided to take on an overhaul of banking regulations. In his massive 1300+ page bill (http://banking.senate.gov/public/_files/ChairmansMark31510AYO10306_xmlFinancialReformLegislationBill.pdf), he has slipped in an attack on angel investing. It would impose burdensome and unnecessary new legal and regulatory requirements on startup companies raising angel financing. A recent post by Joe Wallin and Bill Carlton on TechFlash (http://www.techflash.com/seattle/2010/03/congress_attack_on_angel_financing.html) outlines the issues.
The Alliance of Angels, through it national trade association, the Angel Capital Association, has been lobbying against similar proposals for the last two years. Sen. Dodd’s bill is by far the most serious threat to angel investing in quite some time.
The change in definition of accredited investor will cause many smaller angels to no longer be accredited. Particularly when angels work in groups like the AoA, the amount they invest in a deal might be small. Limited the capital capacity of a group like ours to help “protect our members” is both silly and dangerous.
But as Joe and Bill point out, the most troublesome part of the proposed legislation is inserting a new level of regulation. Many speculate that Sarbanes-Oxley killed the IPO market for small companies by imposing a new layer of regulation and cost on small companies. Sen. Dodd’s proposal to have the SEC and state regulators involved in angel financing is misguided. Very few startups can afford a 120 filing hurdle – they will run out of cash and go under. This is just absurd.
We urge everyone to write both of our Senators and your congress person to have these provisions removed and save angel investing.
Please act now!