In July of 2010, President Obama signed into law the Dodd-Frank legislation. The law reached 848 pages and attempted to correct problems that its authors believed were causes of the financial meltdown late in the last decade. One little known provision of the law required the Securities and Exchange Commission (“SEC”) to review the definition of “accredited investor” every four years.
In late 2015 the Investor Advisory Committee (“IAC”) of the SEC published a series of recommendations regarding suggested changes in the accredited investor definition. We need to understand what is at stake here. Many of the securities laws exemptions that early stage companies rely on are first navigated by ensuring that an “issuer”, a company that is raising money, is doing so with accredited investors. Accreditation is the initial gate that investors must get through to be able to provide capital to an emerging company.
In the judgement of many commentators the IAC’s recommendations, if implemented, would significantly reduce the number of persons who would be eligible to invest in the kind of private offerings that early stage tech companies usually avail themselves of to raise capital. These recommendations therefore caused a large number of comments to the SEC.
After reviewing the IAC recommendations and the comments generated by those recommendations, the SEC last week released its thoughts on how it might approach the issue of revising the accredited investor definition. Because of the centrality of this definition, any changes that limit the number of persons who can invest in the private offerings that finance early stage companies pose a major threat to the supply of capital for these companies.
For many years the standard for defining an accredited investor has been:
- An individual with an income of $200,000 or more the last 2 years (and expects that income this year)
- A married couple with an income of $300,000 or more the last 2 years (and expects that income this year)
- Or an individual or married couple that has a net worth of $1 million exclusive of the value of the primary residence
The idea behind these standards is that such persons will have sufficient “sophistication” to understand the risks of investing in the private offerings that are critical elements of the early stage financing landscape. Another bedrock idea is that people of such means can withstand the loss of capital which is possible with this type of investing. How big would the effects of such a change in the accredited investor standard be? Table 4.2 on page 48 of the link below is from the SEC Staff Report on the accredited investor definition in December 2015.
It shows the portion of U.S. households that qualified to invest in private offerings in 1983 and who would have qualified to invest in these offerings based on inflation adjustments to the definition. The adjustments would decrease the number of U.S. households qualified to invest in private offerings by ~50%, from 7-8% to less than 4%. That would dry up a lot of the capital that early stage companies use for the earliest stages of the growth process. The effect on early stage capital formation would be serious if not catastrophic.
Note that this table only addresses the number of U.S. households that qualify to consider investments in early stage tech companies. Many of these households don’t feel comfortable enough with private offerings to participate so cutting the number of eligible households by half should be done only for excellent reasons. That begs the question – why is it necessary to do anything at all? Almost everyone who participates in this type of private offering understands the risks of these type of investments. I’ve been in this space for 23 years and the stories of investors being misled about the nature of these investments are few and far between. Maybe a time to leave well enough alone?
We’ll look at the proposals the SEC is considering in the next installment of this series.