The SEC could change the requirements for investing in startups, and that's not good | TechCrunch (2024)

As strange as it may seem, only a small percentage of Americans can legally invest in most startups today. Under long-standing rules governing who qualifies as a so-called “accredited investor,” only quite wealthy individuals (those make at least $200,000 in annual income or have $1 million in assets, excluding their home) can buy shares in a fast-growing, privately held company.

This “accredited investor” definition is extremely important for the startup ecosystem, since the most common legal arrangement that startups use to raise funds limits participation almost exclusively to accredited investors.

Granted, the landscape of investor participation in funding startups may be changing thanks to the JOBS Act. What’s being referred to as “regulation crowdfunding” is set to go live in May, allowing startups to accept not just monetary donations, but securities-backed investments, from online supporters, regardless of their income.

Nonetheless, as many industry experts have argued, the regulatory requirements for both issuers and investors participating in this new form of crowdfunding may limit its full potential. Because regulation crowdfunding will be costly and restrictive for most issuers, many entrepreneurs may opt to instead rely on traditional accredited investors to raise capital, whether in the form of venture capital or angel investments.

Thus, despite some new opportunities in non-accredited investor financing, the fact that the Securities and Exchange Commission (SEC) is considering adjusting the financial threshold for accredited investors is alarming. Increasing the income requirement to inflation would substantially diminish the already limited pool of people eligible to fund startups. Today, around 10 percent of U.S. households qualify as accredited investors. If adjusted for inflation, that figure would shrink to less than 4 percent, according to the SEC’s own analysis.

Data from the Angel Capital Association shows why increasing the accredited investor thresholds would be so damaging to the startup economy. The ACA estimates that some 25 percent of its more than 12,000 members would lose accredited investor statusand that this loss would be even more significant in areas outside of New York, Boston and California, where venture capital is already much harder to come by. One third of ACA members in these other regions would no longer qualify, amplifying the barriers startups outside the coasts already face in securing adequate seed funding from existing VCs and angel networks.

As angel investing has become an increasingly important source of capital, particularly for emerging startup ecosystems, whyis the SEC now considering altering these eligibility requirements?

For starters, the Dodd-Frank Act mandated a review of the current definition. And, considering the threshold hasn’t changed since it was originally established in 1983, it’s perfectly understandable to revisit the definition to make sure it’s still accomplishing its original goals of protecting people without sufficient financial foundations to take on the economic risks of private investments.

Since 1983, our financial institutions and our economy at large have dramatically changed, so a review of the definition is certainly warranted. Back then, fewer than 2 percent of U.S. households qualified as accredited investors, and the tech sector represented only a small percentage of the economy.Yet, assessing what’s transpired in the startup and investment world since 1983 doesn’t suggest the definition needs changing — at least not in any way that would further limit who can invest.

By maintaining the accredited investor qualifications for so long, the SEC has functionally enabled more investors to participate in supporting the startup economy, facilitating a thriving angel investor community that continues to grow each year. And this has all happened in an era in which the availability of information about business investments, and the opportunities to make those investments, have exponentially increased.

These are indeed different times to be an entrepreneur or an investor, which is why the SEC staff’s recommendation (detailed in its study released in late December) to adjust the accredited investor definition for inflation is misguided. Though far more people can pursue these admittedly extremely risky investments than could in 1983, there is no evidence that the present definition has harmed individuals who would be excluded under an inflation-adjusted threshold. Any increase should be justified based on the goals of the definition, and there is no evidence that the current definition is failing to adequately protect investors.

The SEC’s report does acknowledge inflation-adjusted caps would “shrink the accredited investor pool considerably” and proposes additional income-based conditions to mitigate the effect. These proposals include maintaining the current threshold, subject to limitations, for investors whose incomes fall between the current and proposed inflation-adjusted threshold, as well as allowing households with existing minimum investments to qualify.

SEC staff estimate this additional criteria would actually expand the pool of eligible accredited investors from the current 10 percent to 11 percent of U.S. households. While this higher percentage is certainly appealing, it’s not entirely convincing. It would place new limitations on existing accredited investors, effectively creating a second tier of accredited investor. And the minimum investment qualification covers people whose net worth doesn’t meet the inflation-adjusted threshold, but nonetheless have substantial assets invested, likely leaving limited remaining capital to participate in private offerings.

If the SEC is ultimately willing to expand the pool of accredited investors, why modify the minimum income threshold in the first place? Instead of creating new, conditional income- and net worth-based criteria in order to qualify, expanding the pool of eligible investors would be better accomplished by adding qualitative measures for investor sophistication.

In fact, in its study, SEC staff also recognizes that income alone may not be the best way to determine who should be permitted to invest in risky startups. In addition to adjusting the threshold to inflation, the study further recommends the agency consider creating new ways to qualify as an accredited investor, including obtaining certain professional credentials, demonstrating investment experience or even passing a kind of accredited investor exam.

These are welcomed suggestions, but if they come only as a concession for an increased financial threshold, then they’re ultimately insufficient. Determining and administering these new requirements will require complex and slow-moving bureaucratic rulemaking that would unduly limit capital formation in the intervening period.