Angel Groups Seek to Assure Entrepreneurs They Are Accredited
The angel investing horror story goes something like this: An entrepreneur publicly solicits seed capital under new securities laws, but accidentally accepts investment from an unaccredited investor. When this violation of JOBS Act rules is discovered, the entire investment round must be rolled back and the money—if there’s any left—returned. It’s the ultimate lose-lose situation.
“Everything shuts down and everyone loses money,” says Yi-Jian Ngo, managing director of the Alliance of Angels, a long-tenured angel group in Seattle.
It almost doesn’t matter whether this has actually happened under new rules born of the 2012 JOBS (Jumpstart Our Business Startups) Act, which lifted the longtime ban on general solicitation of securities offerings by small companies, provided the companies verify that all investors are accredited. The fear that it could, along with continuing uncertainty, has caused some entrepreneurs and investors to avoid generally solicited deals altogether. (It had been illegal since 1933 to advertise a non-registered stock offering to the general public. Until the JOBS Act, small companies selling equity did so privately, through quiet offerings in which shares were sold only to accredited investors with whom the company had a pre-existing relationship.)
This caution can also be seen at startup accelerators such as Techstars, which have dialed-down the specific financial details presented on stage at their demo days and even explored new company presentation models to ensure they don’t accidentally generally solicit investment.
Now some angel investing groups are taking steps to clear away some of the ongoing JOBS Act confusion, and remove the costly burden from startup entrepreneurs of verifying that all of their investors are indeed accredited.
The Alliance of Angels is among about 15 groups to have the Established Angel Group Certification from the Angel Capital Association (ACA), a national nonprofit trade organization based in Overland Park, KS. The certification essentially provides a company seeking investment verification that all the investors in the angel group are accredited, meaning—for now, anyway—they have net worth in excess of $1 million or annual income of at least $200,000 (or $300,000 for married couples).
Other groups to receive the certification so far include Hub Angels Investment Group of Cambridge, MA; Launchpad Venture Group in Boston; the Bellingham Angel Investors in Bellingham, WA; and the Tech Coast Angels, with various locations in Southern California.
The ACA issues the certification to groups that are established with the purpose of early-stage investment; have a code of conduct; include processes to allow individual members to invest their own money or participate in the group’s investment decisions; regularly require members to self-certify that they are accredited and aware that angel investing is risky; and vet new members thoroughly.
While the Securities and Exchange Commission hasn’t made an official pronouncement on the certification, it is in keeping with guidance that SEC officials have intimated, says Marianne Hudson, executive director of the ACA. Keith Higgins, who heads the SEC’s corporate finance division, speaking for himself at an ACA event last year, “essentially endorsed” the certification, she says. In the speech, which is posted in its entirely online, Higgins described a “principles-based approach” in which companies issuing stock can look at “the particular facts and circumstances to determine the steps that would be reasonable to verify that someone is indeed an accredited investor,” and that reliable third-parties could undertake this verification.
Angel investing remains a relationship-based endeavor. New investors are frequently invited in by business and social acquaintances (though that too is starting to change with efforts such as Seattle Angel Conference and The Lion’s Den casting a wider net for would-be investors).
That social aspect is a big part of what makes the EAG Certification work, proponents say. “It’s very unusual to join [the Alliance of Angels] without any references, without any kind of background,” Ngo says. “So in most cases, when someone applies, chances are we would know someone who’s connected to that person and we would be able to tell fairly quickly whether or not this is really someone who’s accredited.”
The EAG Certification will also be a competitive differentiator, Ngo says, as angel groups jockey for deal flow in a marketplace where entrepreneurs—particularly the best of them—have more options for raising early capital, including crowdfunding platforms, startup competitions, and proliferating angel groups.
It’s worth stepping back for a moment to remember why lifting the ban on general solicitation—in place for more than eight decades—was significant in the first place, and how we ended up with Rule 506(c) of Regulation D of the Securities Act of 1933. There was no Internet to speak of the last time SEC regulations were updated, says Dan Rosen, chairman of the Alliance of Angels and a prior chair of ACA’s public policy committee.
“While before the Internet, it was virtually impossible to get information about companies like these, once the Internet was out there, information was very easy to find,” he says.
The status quo regulations required an investor to have a pre-existing, substantive relationship with an entrepreneur or company in order to invest in unregistered securities, in what is called a quiet offering, because it’s not advertised to the general public. (That relationship can be established by sending investors a questionnaire to ascertain their sophistication and accredited status, provided that the relationship is established some time before the offer to invest.)
“There was a feeling that with a lot of the trends in society on social networks and the Internet that that no longer made sense,” Rosen says.
Allowing companies to generally solicit their offerings gives angel investors access to deals they might not have known about otherwise, and broadens the pool of potential sources of capital for the companies.
Lawmakers concerned about potential fraud at the last minute added a requirement that companies take “reasonable steps to verify” that investors in their generally solicited stock offerings are accredited. It was previously sufficient to obtain a signed form from the investor stating he or she was accredited. That’s still the case for the so-called quiet offerings, which are used much more frequently than the generally solicited ones.
The SEC interpreted “reasonable steps” to mean companies must do things like collecting and retaining investor tax returns. Some businesses and law firms have sprung up to aid in the process, but it remains cumbersome, costly, and off-putting.
“You might as well call it full-employment-for-lawyers act,” Rosen says. “We fought this very hard.”
The EAG Certification was developed as a way to shift the burden of verifying accredited investor status away from the companies and back to the investors themselves, at least in the case of organized angel investing groups.
“The problem is there’s still a lot of uncertainty about taking in money from strangers,” Rosen says. “I think this is an important step in the right direction.”
There remains a need for more clarity in other startup fundraising scenarios—accelerator demo days, for example—where companies have become wary of accidentally generally soliciting their offering, thereby triggering the verification requirement.
“There is a bill pending to basically exempt demo days from the general solicitation definition,” says Gary Kocher, a partner at K&L Gates who focuses on emerging growth companies and venture capital, and serves as outside counsel to the Alliance of Angels.
Higgins, in his speech to the ACA last March, said the advent of Rule 506(c) “may have caused some to focus on the definition of general solicitation itself and wonder, perhaps for the first time, if a particular longstanding practice may in fact be a general solicitation. Some may even be under the erroneous impression that the [SEC] has broadened the definition so that activities such as ‘venture fairs’ and ‘demo days’ are now prohibited. The truth of the matter is that the recent rulemaking has not changed any notions of what constitutes a general solicitation.” But he also acknowledged the uncertainty: “In a funny way, it was probably easier when general solicitation was simply impermissible in all instances.”
Another major issue being watched closely by angel investors is the mandate—imposed by the 2010 Dodd-Frank Act—that the SEC evaluate and update the definition of accredited investor. Raising the net worth and income thresholds would obviously exclude more people. Higgins said the SEC has explored using other criteria, such as stock ownership or professional certifications in relevant investing and financial fields.
“It’s become a very partisan issue,” Kocher says. “But the SEC has to take some action on it, so I think we will see some more activity on that in the course of the year.”