Higher Limits For Angels Mean Bigger Hurdles For Entrepreneurs

Todd Saxton

By: Todd Saxton - Associate Professor of Management , IU Kelley School of Business Indianapolis

Category: Entrepreneurship

A new rule being considered by the Securities and Exchange Commission would significantly increase the financial resources needed to qualify as an "angel investor" - individual investors in privately-held startups.

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The SEC currently requires angels to have more than $1 million in net worth or an annual income of $200,000; the proposal could boost thresholds significantly by indexing them to inflation.

For the vast majority of us who get by in lower tax brackets, it's tempting to react with a yawn. To apply a sports metaphor, it's like the NFL lockout a couple of years ago - easily dismissed as a debate between billionaires (owners) versus millionaires (players), far removed from the average fan... or in this case, the typical investor with a 401(k) or an eTrade account.

But this obscure change could have far-reaching consequences. By potentially disqualifying more than half of all active angel investors, it poses an existential threat to fledging companies everywhere.

Angel funding has become increasingly important to early-stage ventures. Established venture capital firms have gravitated towards later-stage opportunities, seeking quicker exits and a balance between maximizing returns and minimizing risk. Angel investors are willing to seek potential earlier in the curve - in recent years, angels have provided more than 90% of all seed-stage equity in start-ups.

This is the funding that makes new ventures viable. Without this initial capital, companies that have created jobs for thousands and great wealth for many (like Exact Target, Aprimo, and Orthopediatrics) never would have launched.

Thinning the ranks of SEC-accredited angels would put a critical source of financing at risk, condemning many promising innovations to the unfunded purgatory between mind and market.

States like Indiana would also be harder-hit by tougher rules. The recent ‘Halo Report' on the state of U.S. angel investing shows that more than 80 percent of investments are made in the angel's home state. Indiana, which lags the nation in per capita income and ranks 45th in millionaires-per-capita (2013 data, CNBC), stands to have a larger pool of angels disqualified by higher wealth standards.

The ownership ambitions of traditionally underrepresented groups like Hispanics and immigrants are also more likely to be dashed. These groups are among the fastest-growing entrepreneurial demographics - but they may be more reliant on angel investors of more "modest" means, lacking long-standing relationships within the technology and finance sectors.

The impact of raising angel investor requirements seems uniformly negative. It's well-documented that smaller, start-up companies are responsible for all net job creation over the last 25 years; recent statistics suggests that nearly two of every ten U.S. companies are less than a year old. Why limit the pool of growth capital to the most dynamic sector of our economy?

The SEC argues that tighter limits on angel investing are necessary to protect investors who don't have the savvy or resources to manage losses in the private equity market.

But this assumes that investing acumen is tied to net worth - the patronizing assertion that wealth equals intelligence. A potential investor could be an expert in a particular area of science or technology, better qualified to evaluate a highly-technical business plan than a layman with a much larger bank account. Or a veteran entrepreneur, with experience far more valuable than liquid assets.

The idea that higher limits are needed to save investors from themselves also ignores resources that are helping angels make smarter choices. For example, angel networks - groups like Indiana's VisionTech who share the burden of identifying and evaluating deals, often bundling investments. The Angel Capital Association estimates that more than 75 percent of investments made in the last two years are syndicated in this way, spreading risk while concentrating knowledge.

The infrastructure of incubators, accelerators, and support services geared towards entrepreneurs also becomes more expansive and sophisticated with each passing day. The idea of angels placing risky bets on ideas hatched in a garage is increasingly anachronistic. Today's start-ups can plug into a community that nurtures better-prepared entrepreneurs... and better results for angels.

In an effort to protect investors from potential losses, the SEC would restrict the opportunity to participate in certain companies to an increasingly exclusive club, a caste system that excludes worthy investors. If we truly believe we must ‘save' the less well-off, should we also limit participation in lotteries? The same logic seems to apply... yet states are eager for the cash that comes from participation of the less economically endowed. In the lottery, the odds of a jackpot are miniscule - but we all enjoy the prosperity that comes with a growing entrepreneurial sector.

Todd Saxton is an associate professor of management at the IU Kelley School of Business Indianapolis, where he is also the Indiana Venture Faculty Fellow. Learn more about the SEC angel investing proposals here.

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