
Startups Get Hit By Shrapnel In The Banking Bill - ankeshk
http://www.avc.com/a_vc/2010/03/startups-get-hit-by-shrapnel-in-the-banking-bill.html
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grellas
A few observations:

1\. Under federal and state securities laws, an issuance of stock can lawfully
be done only if the issuance meets SEC registration requirements or if it is
exempt from registration.

2\. Registration is an elaborate and expensive process and is basically what
companies do when they go public (it has many other variations as well).

3\. Therefore, startups can realistically issue their stock only if any given
offering is "exempt" from securities law registration requirements.

4\. SEC registration requirements arise from the Securities Act of 1933.

5\. The 1933 Act contains a statutory exemption under Section 4(2) for private
placements.

6\. Whether something is a private placement or a public offering is a factual
question turning on such factors as the size of the offering, the number of
purchasers, the use of advertising to induce investors to invest, the
sophistication of the investors, etc. This is basically a highly murky area
and it is therefore normally somewhat treacherous to structure an offering
purely under Section 4(2).

7\. Why treacherous? Because if you think your startup is doing an exempt
private placement and investors can demonstrate that it was not truly exempt,
then it is an illegal offering and investors can rescind and get their money
back from the issuer and from its officers and directors. Thus, that great
success you thought you had when you raised that $5 million can become a
personal judgment against you as a founder who sat on the company's board when
the offering was made.

8\. In addition to federal law, all U.S. states impose their own forms of
securities regulation. Therefore, in issuing stock to investors, a startup
must make sure that all shares sold are exempt under both federal _and_ state
securities laws. In practice, this means that you need to fit the offering
within an applicable exemption for each state in which one of your investors
resides. Since state laws of this type are referred to as "blue sky" laws,
this is known as blue sky compliance.

8\. Regulation D, adopted in 1982, brought tremendous benefits to startups by
taking the murky standards of Section 4(2) and blue sky compliance and
simplifying them greatly. It did so by setting forth specific criteria that,
if met, would ensure the startup that its offering was exempt. No more
murkiness. That is why the relevant categories are known as "safe harbors."
Regulation D also preempted significant aspects of state regulation, meaning
that, if its standards were complied with, the issuer would not need to worry
about states trying to impose special regulatory burdens in excess of whatever
was required by Regulation D itself.

9\. The "accredited investor" concept is an integral part of Regulation D and
it lies at the core of its simplification of the offering process. In essence,
if an issuer deals only with accredited investors, the process of keeping the
offering exempt is highly certain and very easy.

10\. In practice, this has meant that, if a startup sells stock to investors,
the "securities law compliance" aspects are easy to meet and become pretty
much a checklist item that is done by junior attorneys or even by paralegals
working under an attorney at very little cost.

11\. While the "accredited investor" concept thus worked to bring great
rationality to this process, Regulation D itself does not preclude issuing
stock to some non-accredited investors even under its own rules and, moreover,
Regulation D did not and does not supersede the prior regime under Section
4(2), meaning that any startup can issue stock to any person (accredited or
not) in any "private placement." Thus, startups can and do issue stock all the
time to persons who are not "accredited investors." This can be done in many
cases without problem, including to friends and family investors. The problem
is that it is _riskier_ to do, leaving the issuer and its officers and
directors at greater potential legal risk whenever they issue stock to non-
accredited persons.

12\. The Dodd bill would sharply reduce the pool of persons who would qualify
as accredited investors and would also require issuers in more situations to
meet special regulatory burdens imposed by various states in which their
investors reside. Since there have been no big problems in this area, I
believe this is a step backward in the world of startup funding, and it will
hurt startups in their funding efforts. With the Dodd changes in place, the
pool of investors from which to draw will shrink and the process of complying
with securities laws will likely go up significantly for many offerings for
which formerly accredited investors will need to be treated as non-accredited.

~~~
messel
It appears that Regulation D is a band aid on a shotgun wound. If I can gamble
away my wealth on public stocks, or better yet at a casino, I can certainly
back my friend who's building a startup.

The act of getting capital from folks that are under the bar shouldn't damn a
startup, there's something wrong with this whole process. We shouldn't stop at
just nixing the Dodd bill, we should fix the process of angel investing and
pooling resources to back those we trust, even if we don't have net worths
over an arbitrary line.

Could a group of people who have net worths under the qualified investor line,
pool resources and be considered over the line?

~~~
grellas
If the pool is formed for the purpose of making the investment, it does not
help. The law in that case requires that each individual within the pool be
evaluated to determine his or her investment status.

In other words, forming a pool does not allow otherwise non-accredited
investors to get around the accreditation requirements. It does not take them
"over the line," to use your phrase.

~~~
messel
Appreciate the legal explanation grellas.

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URSpider94
While I plan on calling my Congresspeople in opposition to this measure, I
think it's important to understand WHY it's a part of the banking reform bill.
Start-ups aren't the only companies that operate under this exemption. So do
hedge funds and folks like Bernie Madoff. A company that only sells shares to
accredited investors doesn't have to provide information on its operations to
its shareholders or the public, and so has much more opportunity to hide shady
business practices. If the limit comes down far enough in real dollars, you
open up the opportunity for a "shadow stock market" that essentially skirts
the regulations that we voted into place.

That said, my inner libertarian ranks the potential damage to legitimate
start-ups much more highly than saving millionaires from ill-advised
investments.

~~~
dantheman
If you choose to bear the additional risk hat should be your choice.

~~~
sethg
Two words: counterparty risk.

If you borrow from A (or if A invests in you) and lend to B (or invest in B,
or, if B is a bank, deposit money in B), then any risk that B might default
translates into a risk that A will have trouble getting its money back too.

One could, of course, say that every lender is responsible for not only
checking out its debtors but also its debtors’ debtors and debtors’ debtors’
debtors and so on, and if a lender finds itself on the end of a chain of
defaults, them’s the breaks. However, the experience of the late nineteenth
century—never mind the Great Depression or the recent unpleasantness—teaches
us that when this idea is implemented as law (perhaps I should say, as
absence-of-law), we have periodic crises where the whole engine of credit
seizes up, the economy goes into the toilet, and impoverished workers take to
the streets.

Securities regulations weren’t passed to save you from the capitalist system.
They were passed to save the capitalist system from _you_.

------
apinstein
> In fact, what we need is to eliminate all accredited investor requirements
> for small investments of up to $25k. Why does someone have to be a
> millionaire to invest in a friend's startup?

IIRC, you don't have to be an accredited investor to invest in a friend's
startup. You only need accredited investors _if_ you're soliciting investment
publicly. It's part of "Regulation D" of the SEC code:
<http://en.wikipedia.org/wiki/Regulation_D>

This bill looks like it might have negative side effects on the startup
economy, but "friends & family" isn't one of them.

~~~
TimothyFitz
While it's not illegal to take "friends & family" investment, it adds a lot of
legal headache and it's something VCs really don't want to deal with. Startup
Lawyer puts it better than I can: [http://thestartuplawyer.com/convertible-
notes/life-is-too-sh...](http://thestartuplawyer.com/convertible-notes/life-
is-too-short-to-deal-with-non-accredited-investors)

------
fnid2
This doesn't hurt startups, it hurts investors by making some people who are
currently investors unable to invest in certain types of investments.

It _could_ help startups. We don't really know what the effect on startups
will be. There's no clear evidence that investment in startups by outside
forces is actually good for those startups.

In fact, it may benefit startups in general by giving more of them a more
level playing field for longer. A great startup without investment can compete
more effectively against a lesser quality startup with investment, so I'm not
convinced that this will really hurt startups.

It's no wonder that it is investors who are claiming this law is going to hurt
startups. There's lots of evidence that _not_ getting investment can be _good_
for startups, so I'd like to see some evidence that making it hard to invest
actually _hurts_ startups.

If startups were more focused on generating revenue to keep themselves alive,
we'd be less focused on seeking investment and perhaps be more likely to
survive.

~~~
messel
I hadn't considered the absence of capital as a potential benefit before.
Interesting inverse thesis. I think it depends heavily on the form of startup,
and how much investment it takes to become a profitable business entity.

By the way your kind of (in)famous on Fred Wilson's blog today. I still never
heard back from you (beyond the initial Mark Pincus TC buzz) why you thought
Fred was such a villain.

------
pierrefar
Thinking out loud here without being well-versed in the details.

If the US moves towards a state-by-state regulatory framework, wouldn't that
set up competition between the states to attract investors? To rephrase this,
wouldn't it set up a market allowing entrepreneurs and investors to shop
around? If California wants to keep Silicon Valley, they're going to have to
compete with other nascent and potential tech hubs, and those competitors will
be doing their best to attract investors.

Let me be clear; I do not like this scenario, but it could be an outcome that
makes this item in the bill not as bad as it could have been.

~~~
daeken
Why is that not a good scenario? If the states are competing with each other
to make investments better in their state, how does this do anything but help
out investors and startups alike?

The only real downside is that you may end up going to Montana to get the best
investment, but lots of people already go to the bay for investments as it is,
not to mention things like tax incentives for starting datacenters in a given
state.

~~~
hga
Problem: as I understand it, the issue is with the state of residence of the
investor(s). California today has a critical mass of angels (but how much
further can the state decline before enough of them flee???).

But let's say I was in Arlington, Virginia (not hard for me to imagine since I
was there from 1991 to 2004 :-). My potential investor pool would ideally
include residents of D.C. and suburban Maryland. If Dodd passes I've now got
to worry about three different sets of state laws, and I'm sure at least one
will be insane.

As far as moving to Montana to get that great angel investment (hardly out of
the question, look at Simplot and Micron in Idaho), well ... how likely are
you to be successful there? Recruiting people to come there wouldn't be quite
as hard as to Yellowknife in Canada, but, seriously....

There's reasons the SV startup ecosystem is so good, and Boston's is good
enough to make it the undisputed #2. Expecting to go just anywhere and
replicate the same success strikes me as unrealistic.

------
hristov
As it was discussed to death in a previous thread, Dodd's bill does not
include any direct increases to the accredited investor standards.

So, when AVC says: "Dodd's bill would increase that to $2.3mm and $450k
respectively", he is pulling the numbers out of thin air. Dodd's bill says
that the SEC shall increase the amount "as the Commission determines is
appropriate and in the public interest, in light of price inflation ..."
quoted directly from the bill.

So the SEC has wide discretion as to how to increase these standards and has
to consider the public interest. It is extremely unlikely that the SEC would
make the drastic increases this article mentions. It should also be noted that
the SEC has had the power to change these numbers at any time since 1982, and
has chosen not to do it. So, again it is unlikely that they will now decide to
double the numbers.

Of course you may think that the bill is still undesirable, because one should
not prod the SEC to raise these numbers. But the way the original article
worded things was simply not correct.

------
jcnnghm
When writing an article like this you should include the name of the bill,
Chris Dodd's Restoring American Financial Stability Bill, and a link to where
you would go to contact your senators,
[http://www.senate.gov/general/contact_information/senators_c...](http://www.senate.gov/general/contact_information/senators_cfm.cfm).
It's also wise to include a sample letter that people can quickly modify and
send.

Dear Senator Mikulski,

In Senator Dodd's Restoring American Financial Stability Bill, there is
currently a provision to change the definition of an accredited investor as
defined in Rule 501 of Regulation D of the Securities Act of 1933. At present,
an accredited investor is defined as someone with a net worth of over $1mm or
net income of over $200k. Dodd's bill would increase that to $2.3mm and $450k
respectively. And then index those numbers to inflation. Unfortunately, while
these changes may look good on paper, in practice they will severely dampen
the flow of money into job creating early-stage technology companies.

Many early-stage technology companies are funded by one or more angel
investors. Increasing the accreditation requirements will reduce the pool of
potential angel investors, reducing the flow of money into the technology
industry. Between 1994 and 2004, employment in the technology industry
increased by 616,000, a staggering 8% annual growth rate. Through 2014, an
additional 453,000 jobs are expected to be created by the industry as a whole.
Reducing, and in some cases eliminating, the flow of investment capital into
this industry will hamper the job-creation potential while our nation needs it
the most.

Early-stage technology companies are also responsible for the creation of
innovative new products and services that spread throughout the world. Many of
these companies are funded with small private investments; some have the
potential to go on to become the next Google, Facebook, Twitter, or Apple.
Entrepreneurial innovation has been in the character of this nation since its
founding.

Please oppose the modification of the definition of accredited investors in
Senator Dodd's Restoring American Financial Stability Bill.

Thank you for your time and consideration of this matter,

jcnnghm include your address, telephone number, e-mail address, and
congressional voting district
(<http://www.redistrictingthenation.com/search.aspx>)

~~~
anigbrowl
_At present, an accredited investor is defined as someone with a net worth of
over $1mm or net income of over $200k. Dodd's bill would increase that to
$2.3mm and $450k respectively._

Untrue. The bill would direct the SEC to review the existing financial
thresholds in the light of inflationary changes since 1982 but does not
mandate any particular change. The SEC might, for example, choose to leave the
limits about where they are at and simply index to inflation from now on.

I am not in favor of shrinking the pool of accredited investors unnecessarily.
I am, however, in favor of accuracy when discussing the contents of the bill.

------
mlinsey
Naive question: if as described in point (2) of the OP, the bill would
"eliminate federal pre-emption of state regulations of accredited offerings",
would this not allow some states to create less burdensome regulations than
other states or even than Federal regulations? State governments who wanted a
Silicon Valley in their state could then take advantage of this to attract a
much better community of investors and startups.

~~~
anigbrowl
Sure.

1\. I haz bizness idea

2\. LOL credit cardz

3\. ????

4\. OH NOES

I'm not being facetious here, really. Lot of businesses get off the ground
using bank credit. Kevin Smith famously made _Clerks_ on his credit cards (a
film = a startup), won a prize, and sold the IP for a lot of money and further
success. But lots of other people have followed the same recipe and failed.

Moral: do not assume 'less burdensome regulations' = 'level playing field',
especially if you are the needy party.

------
sethg
_In fact, what we need is to eliminate all accredited investor requirements
for small investments of up to $25k. Why does someone have to be a millionaire
to invest in a friend's startup? I understand that we don't want someone
mortgaging their home, or betting their entire life's savings on a startup.
But for a small amount, like $25k, we should not be regulating angel
investing._

How many non-millionaires would have $25k lying around that they could throw
at a friend’s startup _without_ mortgaging their home or doing something
equally rash? OK, maybe they wouldn’t have to bet their _entire_ life savings,
but cashing in a third of one’s 401(k) to put into a startup isn’t very
bright, either.

~~~
secret
What's funny (well, sad) is that the government considers one an accredited
investor by virtue of having money, not actual investment knowledge. You could
have a PhD in finance, on the other hand, and be considered by law
unsophisticated enough to make an educated investment.

~~~
anigbrowl
Actually, that is only one of the criteria for accreditation. There are
multiple ways to qualify as such without meeting the specified financial
thresholds.

~~~
gojomo
They're harder to prove, more subject to dispute, or require greater
entanglement in a venture's management (like taking a title). Essentially, the
wealth tests are _the_ bright-line rules an investor needs to meet to have the
legally-cheapest/safest/standard financing terms.

------
jakarta
my comment from AVC:

One of the things I really hate is how VCs are lumped with PE and HFs when it
comes to financial legislation.

I feel like with VCs role in helping create entirely new industries and the
level of risk involved in the kinds of ventures they fund VCs should be held
at a separate standard that offers more leniency/hands off.

I think that one of the best things right now is how you are seeing an
increase in angel investing, often by ordinary engineers who are choosing to
invest in co-workers that are leaving to start new ventures... and now with
this qualified investor rule, the Senate is potentially legislating to reduce
that kind of activity.

------
ojbyrne
Umm, this article quotes the numbers on accredited investors from the Business
Week article
([http://www.businessweek.com/smallbiz/content/mar2010/sb20100...](http://www.businessweek.com/smallbiz/content/mar2010/sb20100318_367600.htm))
as fact, when it was clear they were poorly thought out speculation. How do
people this stupid actually become VCs?

Original discussion here: <http://news.ycombinator.com/item?id=1213658>

~~~
skmurphy
see [http://www.angelcapitalassociation.org/resources/public-
poli...](http://www.angelcapitalassociation.org/resources/public-
policy/federal-policy-issues/highlights/) The Angel Capital association has
looked at three sections

    
    
        o Sec 412 (page 380) Adjusting the Accredited Investor 
          Standard for Inflation
        o Sec 413 (page 381) GAO Study and Report on Accredited Investors
        o Sec 926 (pages 816-819) Authority of State Regulators
          Over Regulation D Offerings
    

and concluded "These 3 sections that threaten to reduce the number of
accredited angel investors in the United States by about 75 percent and
complicate the regulation of Regulation D offerings (which include angel
investments) to increase the time needed for entrepreneurs to raise money and
make it more difficult to get investors across state lines."

~~~
anigbrowl
A valid opinion, but let's not forget that this is a worst-case scenario from
an interested party. I might note in contrast that the SEC has considered this
change before and decided against it after public consultation.

Now, asking them to review it again in the wake of a serious financial crisis
might result in the effects described, but then again it might not. I don't
think that the idea of re-examining the regulatory environment is inherently
bad. Capital formation is not being singled out, just reviewed as part of a
comprehensive regulatory overhaul.

And yes, I do support a comprehensive regulatory overhaul, which is not the
same thing as a general increase in complexity or strictness. It might even
result in simplification of regulation by clarifying some of the ambiguity in
existing regulation (bear in mind that regulation D was itself written in the
wake of a severe recession). Our financial system has been at the epicenter of
a truly severe crisis and I think it's quite appropriate to re-examine the
rules it operates under.

~~~
skmurphy
I think most folks on Hacker News are interested parties. These three sections
seem completely unrelated to any of the problems in our financial system.

------
danskil
>You have to be a qualified investor.

Does this mean that startups can no longer take money from friends and family?

~~~
bilbo0s
No.

See comment from apinstein above.

------
pxlpshr
Repeal this bill here: <http://gopetition.com/online/32354.html>

~~~
anigbrowl
That'd be a nice trick, considering it hasn't even been debated or brought to
a vote yet. Repeal is the process of reversing an existing law. Anyone who
doesn't understand this basic concept isn't qualified to have an opinion.

~~~
pxlpshr
next time i'll more carefully monitor my word choice in haste, but then again
why bother when I have trolls that auto-check my grammar for me?

Maybe you should concern yourself with the proposed legislation, instead of
illustrating that you have waaay toooo much time on your hands.

------
cakeface
Could this hurt startups? Yes.

Is this a reasonable compromise when considering the entire financial
industry? Yes.

