James Dowd, Founder & CEO of North Capital Private Securities | July 6, 2015
The Jumpstart Our Business Startups (JOBS) Act paved the way for a massive expansion of financing through private placements. Three years on, and with potential new regulations regarding the status of accredited investors being mulled over, Jim Dowd, CFA, CPA, managing director of North Capital looks at how investors are faring in this new regulatory environment
Private offerings have become public affairs. While investing in private companies is not new, the rules affecting how deals can be presented and advertised have changed dramatically since 2012. This has been a boon to entrepreneurs, who are now permitted to seek funding through general solicitation of accredited investors. Soon, a new exemption from registration will allow companies to raise up to $1m a year from non-accredited investors.
The JOBS Act, signed into law on April 5, 2012, relaxed securities regulations that had been in place for almost eight decades. The objective of the Act was to improve access to capital by simplifying small offering registration requirements and eliminating some of the more onerous restrictions on private offerings.
The positive impact of the JOBS Act is undeniable, as the number of angel investors and volume of private deals have exploded in the last three years. While some growth can be attributed to the improving economy and an increase in the number of entrepreneurs seeking capital, regulatory changes have undoubtedly helped. The JOBS Act lifted the ban on general solicitation for unregistered private offerings, delivering greater market access for both entrepreneurs and accredited investors.
Online investment portals sprang up almost overnight, promising risk capital for entrepreneurs and direct, early access to innovative, high-growth businesses for investors. Many of these platforms have developed their investor base by publishing deal flows and using online advertising. New technology offers a seamless experience to issuers and investors alike, while potentially driving down costs and automating regulatory compliance.
So, without any evidence of negative effects of general solicitation on investors, it is surprising that the Securities and Exchange Commission (SEC) is considering a change to the definition of an accredited investor. This change would have far-reaching implications by shrinking the pool of accessible capital for most private offerings, without improving disclosure or providing any other investor protections.
Under current regulations, an accredited investor includes individuals who either:
- Have earned $200,000 annually for the past two years,
- Have earned $300,000 jointly with a spouse for each of the past two years, or
- Have a net worth of more than $1m, excluding the value of their home.
Under current guidelines, approximately 8.5 million U.S. households (7.3% of all households) qualify. However, if the SEC’s proposed guidelines are adopted, income thresholds would be raised to $500,000 for individuals ($700,000 jointly with a spouse) — drastically reducing the number of qualified households to 3.7 million, and shrinking the pool of investment capital.
According to the SEC, an accredited investor is someone sophisticated enough to protect themselves in making investment decisions and doesn’t require the additional protections afforded under certain securities laws that apply to everyone else.
However, as opponents of the SEC’s proposed changes have pointed out, income and asset levels are a poor gauge of suitability. They do not consider education, investment experience or risk profile. A sophisticated investor who falls short of the income or net worth standards could be a more suitable investor for a private offering than a wealthier investor with no knowledge or experience. Moreover, uniform thresholds do not account for regional cost of living disparities or annual inflation. They also discriminate against same-sex couples who do not qualify as accredited investors because they are not permitted to marry in their home state.
Why are knowledge and experience so important? A Kaufman Foundation study of early stage investment ranked due diligence as one of the key factors in producing successful investment outcomes. At North Capital, we have looked at hundreds of deals over the past few years. We have found fabricated professional credentials, discovered corporate officers with criminal records, detected exaggerated or fraudulent financial statements and projections, and uncovered a wide range of misleading statements in offering materials. A small percentage of offerings survive our evaluation and due diligence process.
Broker-dealers have a vested interest in investor protection. If investors experience negative investment outcomes as a result of general solicitation, the market will become tainted and investors will leave. But if investors experience positive outcomes and industry participants are able to mitigate fraud and manage risk, then investor interest will grow, the market will expand and the full potential of the JOBS Act will become apparent.