This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat. Below is a longer, more comprehensive version. Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998. Many thanks, Scott
I read a few articles and blog posts a few months ago about how Senator Dodd’s financial reform bill was going to destroy angel investing. Then I heard about certain amendments made in the U.S. Senate that watered down some of the provisions. Now that the bill has passed, what’s the story with this issue? Will the bill hurt angel investing?
The bill was signed into law this morning. There is good news and bad news. First, some background:
The U.S. Securities Laws. As I have previously discussed in my securities laws post, a company may not offer or sell its securities unless (i) the securities have been registered with the SEC and registered/qualified with applicable State securities commissions; or (ii) there is an applicable exemption from registration. The most common exemption for startups is the so-called “private placement” exemption under SEC Regulation D, which comprises three different types of private offerings under Rules 504, 505 and 506.
If a startup sells stock only to “accredited investors” (discussed below), compliance is much simpler, faster and cheaper because it can rely on Rule 506, which has two important advantages over the other SEC rules. First, Rule 506 preempts or overrides State securities laws, which means that the startup doesn’t have to deal with State securities regulators for compliance purposes, other than filing a brief notice known as a Form D (which is also filed with the SEC). Second, there is no written disclosure requirement under Rule 506 if the investors are accredited.
On the other hand, if one or more of the investors is not accredited, SEC Rule 506 generally may not be relied upon – which opens-up a Pandora’s box of compliance and disclosure issues under both (i) SEC Rules 504 or 505 and (ii) state law. Indeed, the cost, risks and onerous disclosure requirements generally outweigh the benefit. That’s why startups have been overwhelmingly (and effectively) relying on Rule 506 for nearly 15 years in connection with their seed and angel financings.
The Good News. The good news is that the financial reform bill just signed into law omitted the most troubling provision in Dodd’s original proposal, which essentially required a filing with the SEC in connection with any private placement (even if all the investors were “accredited investors” and the issuer were relying on Rule 506), and then gave the SEC 120 days to review the filing; and if the SEC did not review the filing within such 120-day period, then the applicable States securities commission(s) would have the right to review the merits of the financing.
As I discussed in my letter to Senator Dodd, this obviously would have created significant delay and cost in connection with seed and angel financings and also would have put the State securities commissions back in the private placement game – which is exactly what SEC Rule 506 is designed to prevent, as noted above.
The fact that this provision has not become law is very good news indeed.
The other piece of good news is that under Dodd’s original proposal the definition of “accredited investor” would have been revised to require individuals to have (i) a net worth of at least $2.3 million (up from $1 million) or (ii) annual income in each of the two most recent years (and a reasonable expectation of such income level in the current year) of $449,000 individually or $674,000 jointly with his/her spouse (up from $200,000 and $300,000, respectively). According to Business Week, this revision would have lowered the number of individual accredited investors by 77%.
The new law leaves the net-worth test at $1 million (subject to the change discussed below) and leaves the annual-income test at $200,000 individually and $300,000 jointly. Again, good news.
The Bad News. The bad news is that the net-worth test no longer includes the value of the investor’s principal residence. Clearly, this is a big change and could significantly lower the pool of accredited investors.
The other piece of bad news is that the new law expressly permits the SEC to conduct an immediate review and modification of the annual-income test if “deem[ed] appropriate for the protection of investors. . . .” Thus, the annual-income test may go up; we’ll have to wait and see.
Finally, the new law also requires the SEC in four years (and once every four years thereafter) to review the “accredited investor” definition “in its entirety” and make appropriate changes — though the applicable provisions are poorly drafted and this four-year review may not apply to the “accredited investor” definition for purposes of private placements under Regulation D.
I hope the foregoing was helpful. Indeed, as I am constantly advising my clients, the securities laws are a potential minefield of problems; and non-compliance could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.