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As a lawyer who works with startups, I have mixed feelings about some new national legislation.
With great fanfare, Congress recently passed the Dodd-Frank Financial Reform Act (HR 4173). Although most of RAFSA addressed the banking system and Wall Street, it also made some important changes to the regulations governing venture capital and angel investing. Of critical importance to the entrepreneurial community are some changes to the SEC’s Regulation D.
Regulation D is important because if you sell your shares, units, warrants options or whatever only to investors meeting these standards (known as “accredited investors”), the securities law requirements are dramatically easier to meet. If you let even one non-accredited investor into your deal, you need to comply with much more restrictive state and federal laws that can result in very substantial legal and other professional fees, and that’s if you do it right. If you have a non-accredited investor in your deal and you fail to touch all the bases, you open your company up to claims and remedies that can literally destroy your balance sheet, and stop any further investors in their tracks.
Early versions of RAFSA would have limited accredited investor status only to people with incomes of $450,000 a year and/or $2.3 million in net worth. Thankfully, the final version enacted made much less drastic changes. This is a good thing, because if the pool of eligible private investors had been purged of anyone who makes more than $200,000 but less than $450,000, there would be a lot less money around for start-ups. So we should all be smiling now – especially anyone who retained their status as an “accredited” and therefore government certified intelligent investor. Right?
Not so fast. Here is the catch. If you make more than $200,000, you still pass the test – for now. But for those of you who might not earn that much, but hope to qualify based on a net worth of more than $1 million, you can no longer include the value of your principal residence! At least until recently, equity in a principal residence has been a major component of the net worth of many accredited investors. Under the new rules, owning your own house, even if it’s debt free, counts for naught. This is a strange move.
Let’s say you have a pension paying you $100,000 a year for life, $999,999 in cash and marketable securities, and you own a $1 million house, debt free. You flunk the test, even though you might consider yourself both sophisticated and fully capable of providing for yourself even if you lost your whole investment in a startup. But, if you have amassed $500,000 in your 401K (which is pretty much unavailable to you save for extreme circumstances), and if you just borrowed $500,000 against your $700,000 McMansion and invested it all in options on futures on pork-belly indexes, you’re a veritable Warren Buffet – even if you have no current income. This clearly makes little or no sense at all – but it’s the law now, so we’ll have to deal with it.
Since 1982 Reg D has operated on the assumption that people who make $200,000 a year and/or have more than $1 million of net worth are smart enough to make their own decisions and handle the consequences when it comes to investing in private companies. If you read the New York Times, you might have learned last week that startups, not bailout programs, create something like 2/3 of all net new jobs in this country. That’s why anything affecting their ability to raise money is important not just to the startups and their investors, but also to those of us who would like to see a sustainable recovery.
On the whole, I am happy and relieved that RAFSA did not make radical changes to Reg D, which is such a vital tool for entrepreneurs and investors. But it troubles me greatly that the architects of RAFSA, who condescendingly don’t want you to look at the equity in your home as real wealth, are the very same guys who, in some people’s estimation, played a pivotal role in pumping up the real estate bubble with easy money and lax underwriting standards at Fannie Mae and Freddie Mac. Why this sudden abundance of caution? I’ll let you draw your own conclusions.
Oh, there’s definitely something going on in the ‘Land of the Free’-
Corporate campaign limits go out the window but here we have more restrictions on who can invest and borrow.
Government and corporations are lobbying for their own special secured part of the internet.
Pretty soon you will need a license to blog, like in Saudi Arabia.
As a business attorney who has lived and breathed the world of Regulation D private placements for the last 14 years and has seen firsthand the good, the bad, and the ugly of these deals, I agree with the author that overall, these recent changes to Regulation D were quite modest when compared to what had been proposed earlier and what the state securities agencies would like to see happen to Regulation D. The net worth and annual income categories of the “accredited investor” definition had gone largely unchanged since 1982, so it is tough to argue with a straight… Read more »
It seems to me that a tiered aproarch would work to meet the accredited standard. Those that make less than the minimum would be limited to their investment as a percentage of their net worth and or income. Why shouldn’t any investor be allowed to invest? Anybody could have bought Enron.
Mark, point well taken. Mere net worth and high income are no substitute for critical evaluation skills. We cannot truly know what would happen in the absence of the securities laws and regulations that we have today, but I think it’s fair to say that many of the safeguards are designed to protect groups and persons who are not very likely to invest in these types of deals anyway. Of course, the regulatory scheme would not exist had there not been abuses in the earlier part of the last century, but it’s a fair question to ask whether all of… Read more »