We are at a critical point in our country’s development. As we navigate the COVID-19 crisis, we are entering an election year and unemployment numbers soar — people need to understand we still have choices. They need to know that their input matters in deciding the fate of America’s innovation economy, the startups and growing businesses that have helped power some of the biggest technological breakthroughs since the last economic downturn in 2008.
While there is an ongoing debate on whether venture funded startups should accept PPP loans from the Small Business Administration, it is clear that for America’s innovation engine to get a kickstart, small businesses and high growth startups are going to need new sources of funding both now and in the near future. This can happen through changes in the lending market and through better policy which simplifies and expands access to company ownership for a larger class of investors.
A New Proposal From the SEC
Before the pandemic in October of 2019, the SEC was soliciting comments on the Concept Release which included a review of the 20+ year old Accredited Investor definition. A proposal was made to expand the definition, retaining income and net worth thresholds — thereby expanding investor opportunities while keeping protections intact. After this initial period, the SEC voted in December to release a proposal
that if approved, would make these changes official. The agency then opened it up to a 60-day public comment period, but has since extended this comment period through June 1.
Considering the millions of past, current, and future business owners, employees of private companies, and investors who have a stake in the early stage economy, there have been comparatively few comments or outward interest, even when the Office of the Small Business Advocate breaks down the proposed changes in a video.
What it Means to be Accredited
Owning shares in a private company used to be a right reserved for the elite. Under the current rules, the SEC defines an accredited investor as someone who has an individual net worth of $1 million or more (not including the value of said person’s primary residence) or earn more than $200,000 in annual income, et al. These requirements solve half the problem because they MAY help determine which investors have enough of a financial cushion to afford high-risk investments, but they don’t address if an investor is sophisticated enough to make decisions that might tie up 1-10% of their net worth for several years. Based on how many people meet the accredited investor definition requirements and according to reliable sources, the number of people in the U.S. that qualify to invest falls somewhere between 10% and 20% of the adult population. The US has an estimated population of 329,227,746 people.
In August of 2018, an analysis of the unregistered securities market was published by three SEC Department of Economic Risk and Analysis staffers that put the annual average investors of Form D aggregate (company information filings) at 316,288 investors inclusive of duplication (per EDGAR data, page 34) inclusive of duplication. By doing some division, we find that of the 33 to 66 million accredited investors who meet the definition, the percent that invests privately each year lies somewhere between .5% and 3% of the total. That is not inclusive of duplication, nationality, or of investors in companies that haven’t yet filed with the SEC. Hence, low participation levels are not caused by a lack of interest on the part of investors.
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The Importance of Guidelines
The proposed SEC rule change is also important for startups and new investors in the market because having a new, clearer set of guidelines from the SEC would make it easier for company founders to decide how to file when raising capital and for investors, accredited and non-accredited, to know what sort of offerings they may participate in and what to expect. For newly accredited investors, who would be able to invest in private markets for the first time, a simplified process could expand the number of offerings that they participate in. For startups, clearer standards and larger maximums for smaller companies in the “Friends and Family” stage could greatly increase the number of companies reaching later stage capitalization. Raising the limit on regulation CF to 5mil from 1.07mil is huge for startups that have had to compete for senior programming talent with the cash-rich FAANGM (Facebook, Apple, Amazon, Netflix, Google, Microsoft) that market superior benefit and compensation plans to prospective employees.
Now imagine if this rule proposal is approved and the definition of accredited investors changes. This would mean that a slew of potential “mom and pop” investors would now be approved to invest in private markets, including:
- individuals with an entry-level stockbroker’s license or other credentials issued by an accredited educational institution
- “knowledgeable” employees of funds who might not currently meet the SEC’s wealth thresholds
- family offices with at least $5 million in assets under management and their family clients
- “spousal equivalents” who could pool their assets for the purposes of qualifying as accredited investors
Now imagine again how easy it could be for five or six non-accredited investors to form a group to invest 50-100k of capital in a startup company they all believe has potential. Think of how fulfilling it would be for small investors to not only offer capital, but to be able to practice investing in private companies so that they sharpen their acumen for their investing future. That kind of practice can only help newer investors when market conditions recalibrate post COVID-19.
Moreover, these smaller investors would have the opportunity to diversify their investments beyond the NYSE, NASDAQ and the mutual funds of their 401ks, all which have suffered major losses in the recent stock market tumbles. Allocating 5-10% of one’s portfolio into well-vetted, high growth potential companies can help an investor achieve greater portfolio diversification. Venture Capitalists, some of the most visionary market-shapers in our country have invested in early stage for years because of the inherent growth potential and because holding an illiquid asset that is not correlated to the market, or a different asset class, can help to reduce correlation in one’s portfolio. Private investors will tell you that one win often pays for many losses. To quote Ray Dalio,” You want to have some stocks that zig when others zag.”
The Next Steps?
To move the needle forward on this rule change, a change that takes an important step on the path to open private market investing for new investors who have an interest in investing in America’s innovation economy, the next step is an easy one: they can submit their comments to the rule proposal here.
Dagan Bora is the CEO and President of Leyline.io, an early-stage consumer SaaS company that designs software for private market investors.