On November 10, 2009, Senator Christopher Dodd introduced proposed legislation aimed at reforming our financial regulatory system. The bill is over 1100 pages long and many of its proposals will undoubtedly be debated for months to come. Two specific proposals, though, if enacted, would seriously hinder efforts of startups and small businesses to raise capital.
The first proposal is the repeal of federal preemption of state regulators for Reg D offerings. Currently, Regulation D provides several safe harbors that apply in all fifty states and if followed allow a company to raise capital without having to register their securities for review by state or federal authorities. Repealing federal preemption would allow states to make their own rules regarding these types of offerings and would significantly increase the legal expenses of compliance. Looking back, I can think of several angel rounds I’ve assisted with that would likely have been cost-prohibitive under the proposed rule changes.
The second concern is Senator Dodd’s proposal to raise the bar for investors to qualify as “accredited investors”. Current federal securities law deems investors with a net worth of at least $1,000,000 or yearly income of over $200,000 ($300,000 with spouse) to be less in need of regulatory protection. Offerings that involve only these types of investors is simpler and entails significantly less accounting and legal fees than those that involve investors that do not meet these thresholds. Senator Dodd proposes to tie the thresholds to inflation and, since these numbers were originally set in 1982, the net effect would be to more then double the current thresholds. I’ve not come across statistics regarding the number of potential investors that would meet these standards, but this change would certainly thin out the ranks.
I’m also concerned that these changes would put midwest startups at even greater disadvantage to their coastal counterparts. First, midwest rounds or typically smaller in size than those on the coasts and would thus be disproportionately impacted by the increase in legal expense associated with complying with various state regulators. Second, although I don’t have statistics to back this up, my hunch is that due to the cost of living differences between, for example, Columbus, Ohio and New York or San Francisco, the pool of accredited investors available to a midwest start-up would shrink disproportionately more for midwest companies than for those on the coasts.
This bill is far from becoming law and is almost certain to change in the coming months. I’ll continue to update as I learn more.