Viewpoint March 19, 2010, 10:40AM EST

How Dodd's Reform Plan Hurts Startup Finance

Though investment in new businesses isn't the target of the senator's proposal, it would cause collateral damage to the way informal investors finance companies

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Tucked into Senator Christopher Dodd's (D-Conn.) massive proposal to fix the U.S. financial system are a few changes that would affect how new businesses are financed. While investors in new businesses aren't the target of the senator's financial reform plan, the proposed bill would cause some collateral damage to the way that informal investors finance companies if it became law.

New Criteria for Accredited Investors

Senator Dodd proposes adjusting for inflation the income and net worth requirements for a person to be considered an "accredited investor" by the Securities & Exchange Commission. This benign-sounding change would dramatically reduce the number of accredited informal investors financing companies in the U.S. today.

Currently, a person must have a net worth of $1 million or an annual income of $200,000 if single or $300,000 if married (and filing jointly) to be an accredited investor. The senator's proposed bill doesn't say what inflation adjustment will be used to convert these numbers, established in 1982, to today's dollars. But if we use the Bureau of Labor Statistics inflation calculator to adjust these figures on the basis of the consumer price index, then the annual income requirements for accredited investor status would become $449,000 if the investor were single and $674,000 if the investor were married, while the net worth requirement would become $2.25 million.

Even under current metrics, there aren't that many accredited informal investors. In 2004, sociologist and business demographer Paul Reynolds conducted a representative survey of the informal investing activity of the U.S.adult population.Updating Reynolds' estimate of the share of the adult population who are accredited investors to the 2008 adult population as reported in the Statistical Abstract of the United States, there were 5 million to 7.2 million American adults who were accredited investors in 2008.

Reynolds' survey found that 10.5% of accredited investors had made an informal investment in the previous three years. So we are talking about 528,000 to 756,000 accredited investors who made a friends-and-family or angel investment in the previous three years.

Adjusting the income and net worth requirements for accredited investing to those proposed in the Dodd bill would reduce the number of accredited informal investors to 121,000 to 174,000 people. (Applying the inflation-adjusted income requirements to 2007 IRS tax return data—the latest available—the number of accredited investors on the basis of the change in the single filer income requirement would drop 77%, from 4.5 million individual filers who earned $200,000 or more to 1.04 million individual filers who earned $500,000 or more.) That's a massive drop in the number of accredited informal investors.

Why Being an Accredited Investor Helps

While the same people who made informal investments as accredited investors under the current net worth and income requirements could make those same investments as unaccredited investors if Senator Dodd's inflation adjustment became law, that the investors would no longer be accredited would have two adverse effects on startup finance.

First, some of the most successful startup companies transition from informal investment to institutional investment as they grow and demand more capital. While only a small number of companies that obtain an informal investment subsequently obtain venture capital financing—perhaps several hundred to a little more than 1,000 per year—these companies are disproportionate creators of wealth and jobs.