How Dodd's Reform Plan Hurts Startup Finance

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(The National Venture Capital Assn. reports that approximately 10% of sales and employment in this country are accounted for by the less than 1% of startups that received venture capital backing.)

Venture capitalists prefer to invest in startups backed by accredited informal investors rather than unaccredited ones. Venture capitalists typically invest their money through a sale of securities under Regulation D of the Securities Act of 1933. Rule 506 of Regulation D provides for an exemption from registration if all of the investors are accredited and requires additional disclosure requirements if any of the investors are unaccredited.

In terms of complying with securities laws, it is cheapest and easiest for venture capitalists to focus their investments in companies that have received money only from accredited investors. Therefore, the dramatic decline in the number of accredited informal investors that would occur if Senator Dodd's bill became law would mean a massive reduction in the number of startups receiving their initial capital in a way that makes them attractive to follow-on investment by venture capitalists. Such a reduction would make it more difficult for many entrepreneurs to obtain venture capital financing.

Second, if the level of income and net worth required for accredited investor status were increased, many currently accredited informal investors would no longer be able to invest as part of an organized angel group, thus lowering their investment performance. (To facilitate compliance with securities laws, angel groups generally require their members to be accredited investors.) According to Rob Wiltbank of Willamette University, who analyzed this question using his data on angel group members, only 40% would meet the new net worth requirements.

The inability to invest as part of a group is likely to lower angel investor performance because of the myriad advantages that group investing provides. First, group investors get better access to deal flow because entrepreneurs can more easily identify angel groups than individual angels. Second, group investors can make use of each other's expertise to make better investments. Third, groups benefit from scale economies in due diligence and investment management and can better standardize investment processes. Fourth, groups can pool resources and make larger investments than individuals can make alone, and allow investors to better diversify their investments across ventures, industries, and technologies.

The Problem of State Regulation

Senator Dodd's bill would also permit the states to impose their own set of regulations on securities offerings, something that is currently prohibited. Different state regulations on securities offerings could pose several problems for startup finance.

First, the kind of informal investing in high-potential startups by accredited investors tends to take place in areas around major cities. Many of these cities are located in places where investors live in different states. For instance, companies located around our nation's capital could easily raise money from investors in Maryland and Virginia, while those in New York City could easily raise money in New Jersey, New York, and Connecticut. If different states imposed different securities regulations, making accredited informal investments in affected cities would become more difficult and costly.

Second, entrepreneurs sometimes raise money from investors located in a different state from where the startup is located. Angelsoft, a provider of investment tracking software for angel groups, found that 26% of the investors in the average angel deal undertaken by a group using its software were located in a different state from the startup. Thus, the proposed legislation would likely require one-quarter of entrepreneurs raising money from angel groups to comply with more than one state's regulations on securities offerings.

Third, many angel groups now co-invest, with some of that co-investment occurring across state borders. Cross-state co-investment by angel groups (or individual accredited informal investors) would become much more complicated if the states were permitted to impose their own regulations governing investments in startups.

In short, there's nothing wrong with Senator Dodd's efforts to reform our financial system. However, his bill needs to take more precise aim at the sources of our current problems to avoid adversely affecting our system of financing startups through informal investments.

Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.

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