Traverse City Record-Eagle

September 1, 2013

Harley Luplow: Angel investors and new SEC

Special to the Record-Eagle

---- — TRAVERSE CITY — About 43 percent of the $2.1 trillion of newly offered US securities sold last year were not offered to the public.

This means that $900 billion of investment went through private networks -- investments which often realize better returns than found in public markets. To jump start companies and create new jobs, Congress wants entrepreneurs to tap into this private source of funding and last year passed the JOBS Act to make this possible.

Typically, the expense of taking on a public stock offering is too great for a startup and therefore private placement of investment opportunities are generally used. SEC regulations currently restrict the offering of privately offered securities to mostly accredited investors that have some type of relationship to the entrepreneurs seeking funds. For a startup company, having access to the accredited equity investor, the 1 percent of the population that has the ability to invest privately, is often critical to sustaining a successful business launch.

What has been limiting entrepreneurs financially is the ability to create a personal network large enough to attract sufficient investment interest to launch and grow a company. For new businesses that have the potential to scale up, and therefore offer a good opportunity for investment, family-and-friends funding strategies can only take a company so far. For follow-up investment needs, entrepreneurs network into angel and venture capital groups where these investors look for, and receive, annual investment returns on their portfolios in the 30 to 40 percent range.

As of Sept. 23, startups and other early-stage companies no longer are restricted to making private offerings only to their existing network of accredited investors. Next month, per new SEC rules, general solicitation and advertising of investment opportunities to accredited investors will be allowed, under certain conditions. The rest of us less-prolific investors will need to wait until the SEC gets around to setting rules for other portions of the JOBS Act intended to legitimizing fundraising ads to non-accredited investors via crowd funding.

While the new law seeks to increase access to capital for entrepreneurs, the SEC went beyond Congress’ wishes and decided to add its own protections to presumably safeguard accredited investors. This is a bit odd, since by definition accredited investors are held apart from the rest of the investor community as having the business acumen to make their own well-informed investment decisions.

The SEC wants to “help” these sophisticated investors by requiring that their net worth and or annual income be verified, whereas before investors self-certified their financial status for private investments. The SEC also seeks to protect accredited investors by reviewing investor advertisements 15 days prior to use, whereas before investor information filings with the SEC could occur 15 days after an investment.

Our local angel investment community is not excited about the new rules and predicts it will have a negative effect on angel investors and startups. Deanna Cannon, executive director of the Northern Michigan Angels in Traverse City, said her group’s major concerns relate to the basic functioning of the rules such as what constitutes a general solicitation or advertisement of investment.

Ken Kousky, president of Blue Water Angels based in Midland, said another concern of angel investors is, what if the startup fails to timely file its advertisement or makes an error in updating its investor status with the SEC? If found in violation of these new rules, companies will be banned from the private capital markets for one year…a death sentence for most companies and a reason for investors to be wary of losing their investment due to technicalities beyond their control.

Kousky thinks that the volume of Blue Water Angel deals in Michigan will decrease in the short term as the industry and its attorneys work their way through the new regulations. He also sees a trend toward angel investing in fewer sectors and with fewer companies in their portfolios. Ken believes the new rules add risk, time, complexity, and expenses for angel investors and this hurts, not helps, entrepreneurs starting companies.

Cannon believes entrepreneurs in Michigan already have a leg up on the rest of the nation when it comes to support for startup growth and job creation. She predicts that the JOBS Act provisions related to advertising for accredited investors will have little impact and points to the array of state and local government programs that now work with angel and venture capital groups to support the development of new business formation and job growth.

Both Kousky and Cannon think that angel groups will regularly seek exemption letters from the SEC on each investment opportunity pursued by Michigan angel groups. The exercise of exempting investors from a law designed to encourage them to invest seems a truly Kafkaesque reformation of securities law.

Welcome to the new SEC.