While exempt offerings now involve twice as much money as public offerings, only accredited investors (“AIs”) get invited to the private company party. Thus, individuals who fail to meet the net worth or income thresholds (“non-AIs”) cannot invest early in high-growth ventures and therefore miss out on a lot of investments and upside. Moreover, because non-AIs make up 87 percent of U.S. households, new and other privately held businesses are not raising capital from a vast majority of society’s individuals. To these people and firms, well-intentioned rules are keeping the capital out of capitalism.
Expanding the AI definition would increase opportunities for Main Street investors, create a much-needed source of capital for new and growing ventures, and strengthen our economy. Yes, some investors will lose money, and some will lose too much. However, it would be a material omission if the rules surrounding entrepreneurial finance did not acknowledge and accept that failure is an unavoidable part of entrepreneurship. An AI exam would not only increase the AI pool while ensuring investors can fend for themselves – it would educate investors and encourage smarter deals.
Below are 10 key points from my recent article, “Redefining Accredited Investor: That’s One Small Step for the SEC, One Giant Leap for Our Economy,” The article will be published in the Michigan Business & Entrepreneurial Law Review. A draft is available here.
- New ventures are critical to our economy. In case anyone missed the memo, the article provides evidence that new ventures play an important role in our economy by contributing jobs, fueling innovation, and increasing productivity.
- New ventures need capital. The article also shows that a vast majority of entrepreneurs need financing to assist with startup costs and grow their businesses. In fact, recent data from the Ewing Marion Kauffman Foundation shows that only 5-10 percent of businesses with paid employees do not need financing at the startup stage. Thus, 90-95 percent of entrepreneurs who will hire people will require funding to launch their businesses.
- New ventures must raise capital through exempt offerings. New ventures have a false choice when issuing stock and other securities to raise money. They can register their securities with the SEC, or they can find an exemption from the registration. However, in reality, new ventures always utilize exempt (i.e., private) offerings. This is because it is far too expensive for them to participate in registered (i.e., public) offerings. Going public is likely to cost an issuer over $1 million. Moreover, to paraphrase the character Eddy from National Lampoon’s Christmas Vacation, these expenses are the gift that keeps on giving. That is, staying public is likely to cost a company an additional $1 million each year.
- Exempt offerings are significant and securities laws effectively limit them to AIs. In 2018, more capital was raised under one specific exemption, Rule 506(b), than pursuant to all registered offerings. I repeat, more dollars were raised under Rule 506(b) than in all public offerings combined. In addition, a vast majority of issuers limit their Rule 506(b) offerings to AIs to avoid the additional disclosure requirements and the associated costs that would arise if any non-AIs participated in the offerings. Further, other transactions, such as primary offerings under Rule 506(c), require sales be made only to AIs. Thus, non-AIs are shut out of far too many investment opportunities. These opportunities are not only important because of the dollar amount involved – they provide investors with the unique ability to “get in early” and thus share in a company’s hyper-growth and related economic gains.
- Because the current AI definition requires individuals to have high net worth or income, there are not enough of them. To date, the AI definition has completely ignored the sophistication of individual investors. Instead, it focuses on one’s net worth and income. Under Rule 501(a)(5), an individual is an AI if his or her net worth exceeds $1 million, excluding the value of any equity in a primary residence. Under Rule 501(a)(6), an individual is an AI if he or she has income in excess of $200,000 (or joint income in excess of $300,000) each of the two most recent years and has a reasonable expectation of earning that much in the current year. Because of these thresholds, AIs make up only 13 percent of U.S. households. The percentage is even smaller in the Midwest and South, where net worth and income levels are lower. Yes, this means areas of the country with less venture capital activity also have less potential capital available from individual AIs. New ventures in these areas need help.
- Only a small fraction of individual AIs actually invest in exempt offerings and, when they fail to do so, other sources of capital are unlikely to pick up the slack. My article cites an estimate that only percent of AI households actually participate in exempt offerings. This means only 1.17 percent (or, 3 percent of 13 percent ) of U.S. households are likely to invest in new ventures and other private companies. Unfortunately, when these individual investors do not invest, venture capitalists and banks are unlikely to be substitutes. Thus, even areas with significant venture capital activity depend on individual AIs who are likely to invest much earlier in a company’s lifecycle. My article references research (by Laura Anne Lindsey & Luke C.D. Stein) in support of these propositions.
- Because of the AI definition’s limitations and importance, there have been several calls to expand it. My article mentions SEC-related initiatives, U.S. House bills, and commentators supporting expansion of the AI definition. These proposals include welcoming individuals to the AI pool if they (a) have certain educational backgrounds; (b) have certain business experiences or professional credentials or certifications; (c) have experience investing in exempt offerings; (d) are advised by qualified professionals; (e) stay within investment limits; or (f) pass an AI examination. Please do not read too much into the AI exam being item (f) on this list because,
- An AI examination offers the best way to expand the AI pool. After considering various proposals to expand the AI pool, my article concludes that the AI exam provides the best approach. This is because an AI exam could (a) be tailored to assess appropriate topics; (b) educate investors on best practices and thus encourage smarter deals; (c) provide certainty as to whether a particular investor is an AI; (d) assess whether individuals, regardless of their formal education or experience, are truly able to fend for themselves; and (e) be linked to other criteria, such as investment limits.
- An AI exam should be focused, consider how venture capitalists invest, and help investors spot and deal with inevitable gaps – and it could be linked to investment limits and exempt offering experience. My article summarizes topics covered by two exams the SEC staff has previously mentioned as models for an AI exam: FINRA’s series 7 and 82 exams. It also recommends considering how venture capital-backed companies are formed and financed. Because these firms utilize standard structures, deal terms, and documents, they provide robust educational and testing materials. While their practices will not fit all private companies, investors would benefit from knowing what the exempt offering professionals do and how and why their deals are different. This know-how should lead to smarter investors and deals. Further, instead of trying to prepare investors for every potential issue, an AI exam should enable them to spot knowledge gaps and other risks and empower them to seek help to mitigate or factor in those risks. For example, it would be difficult for the exam to cover relevant issues in every potential market (e.g., software, hardware, biotech, media, commercial services, and consumer goods). My article also explores how an AI licensing system could efficiently link the AI exam to investment limits and relevant investment experience.
- An expanded AI definition could be part of a larger initiative to harmonize exempt offerings. While just expanding the AI definition could prompt a giant leap for our economy, the article’s conclusion shares a bigger vision: creating a private company market for AIs. By significantly increasing the pool of AIs (via an AI exam) and making a few additional changes to securities laws, we could permit companies to stay private indefinitely while increasing opportunities and liquidity for Main Street investors. While this would empower some companies to avoid going public altogether, investors who demonstrate they can fend for themselves could still invest in these ventures. Moreover, they could get in early (i.e., at a low price) and thus realize economic gains historically reserved for individuals meeting the net worth or income thresholds.
This post comes to us from Professor Jeff Thomas at Central Michigan University. It is based on his recent article, “Redefining Accredited Investor: That’s One Small Step for the SEC, One Giant Leap for Our Economy,” available here.