This is supposed to be the most disruptive and important year in tech finance since 1933. This is supposed to be the year in which anyone can be an angel investor — the year we get not just virtual-reality headsets but actual-reality shares.
81 years ago, Congress erected the biggest bar to crowdfunding in American history. It said that if you want to sell securities publicly — the original form of crowdfunding — you first need to register them with the Securities & Exchange Commission. Registering securities is a laborious process that costs millions of dollars. What this means is that “taking a company public” is only possible for large, mature corporations. A startup would need to go through seed and Series A through n before it grows to a size where a public offering is feasible or sensical. It took Twitter eight years.
Of course, companies can raise money by selling securities without going public. These “private” or “exempt” offerings are how companies raise money in pre-IPO rounds. 90 percent of these offerings are under Rule 506, an exemption created by the Commission that requires investors be “accredited.” To be “accredited” you must either (a) have a net worth in excess of $1,000,000 or (b) an income in excess of $200,000 (or $300,000 combined with a spouse) for each of the last two years. It is pretty much impossible to “angel” invest in America if you don’t meet one of these two standards.
These standards make little sense, constrain individual opportunity, and harm the economy. For one, income and net worth are questionable proxies for the ability to make intelligent or responsible investment decisions. Someone who makes $250,000 dollars per year managing a Ford dealership is likely less equipped to make an intelligent seed investment in a mobile-gaming startup than a mobile product manager who earns $100,000 per year at Facebook. Indeed, I’m not aware of another point in American law where we blatantly and blindly equate money to the ability to make an intelligent, responsible decision. We don’t pass laws that bar people in lower tax brackets from gambling in Las Vegas or donating large sums to political campaigns.
It also creates two classes — an “investor class” that can participate in lucrative early investments and an excluded class of would-be investors that must wait until IPO. This is unfair on an individual basis and harmful on an aggregated, economic one. That Facebook product manager should be allowed to invest in a pal’s mobile-gaming startup. A high-school physics teacher who carefully follows cleantech shouldn’t be barred from using his education and research to make wise investments in a solar startup. It’s anathema to the American political spirit — and law — to divide people into classes on the basis of money. Where else do we say that if you don’t make enough money, you’re not allowed to do something? It’s equally anathema to quash the spirit of entrepreneurship inherent in angel investing.
Title III of the JOBS Act was supposed to correct this inequality by allowing for the public sale of securities that would not need to be registered in a laborious and costly manner. This “equity crowdfunding” legislation was driven by the success of “regular” crowdfunding platforms like Kickstarter, which demonstrated the willingness and effectiveness of the crowd in acting like angel investors. The idea behind the JOBS Act was to create a platform where Oculus Rift could have sold shares, rather than just headsets, to the 9,522 folks who ponied up $2.4 million.
Thus far, the Commission has dropped the ball. Their draft rules are predicated on the same condescending and classist belief that anyone making less than $200,000 per year is a simpleton incapable of making intelligent and responsible investment decisions (surely we’re all much better off having our investment advisors put our money in collateralized debt obligations). Equally importantly, they reflect a fear of change, poor understanding of the internet, and unwillingness to re-imagine how capital formation should work in a nimble, web-based world. The Grahamian touchstone of any startup is scalability. In this sense, the job of a funding portal (the official term for equity crowdfunding platforms) is to facilitate the sale of securities by young companies to willing angels. Ignoring this necessity, the Commission’s requirements for portals — in the layers of required due diligence — repeatedly conflate the lean nature of online platforms with the hulking structure of Manhattan broker-dealers. The Commission’s rules don’t just reflect a desire to protect investors — they reflect the subordination of the real and beneficial effects of capital formation to an abstract fear of fraud that many believe is little more than a rhetorical faceplate for institutional malaise.
The Commission needs to evolve — to let go of a regulatory paradigm rooted in the age of the telegraph and taxi medallion. Importantly, the opportunity gap between the angelic and the earthly has never been wider. With the removal of the ban on general solicitation, platforms like AngelList have been effectively converted into exclusive stock markets for the rich. The strong movement on intrastate crowdfunding exemptions is a reaction to this — it reflects a growing consensus that deregulation is both economically necessary and morally correct. A good place for the Commission to start in remedying this inequity would be by embracing the lean nature of funding portals, rather than burying them in regulation sufficient to asphyxiate Goldman Sachs. A bold — and better — place to start would simply be to create a flexible “accreditation” standard that considers factors beyond just income or net worth — professional experience in the area of the investment being an excellent focus. Indeed, nothing in Section 4(2) of the Securities Act of 1933 (pursuant to which the Commission creates these rules) contemplates income or net worth as the sole touchstone of accreditation. Given the highly illiquid nature of privately held securities, it is farcical to think that this would cause a dangerous or tectonic shift in capital formation.
This is supposed to be the year that anyone can be an angel — the year that everyday Americans go from early adopters to early investors. Thus far, it is still too early to see whether the Commission will clip our wings.