The House and Senate reached a compromise late last night on the Restoring American Financial Stability Act of 2010. The reforms are fairly sweeping, and I’m not going to attempt to explain them all. The changes to the definition of an accredited investor merit discussion, though, as they will have a negative effect on access to capital for startup companies.
“Accredited” is a legal term used in securities regulation describing a subset of investors that meet certain standards, primarily wealth related. The SEC disclosure requirements are much more onerous when selling to investors who do not qualify as accredited. Because of the extra legal and accounting costs necessitated by the extra disclosure, startups are typically limited to accepting investment from accredited investors only.
The two primary ways individual investors can qualify are either (a) having net income of over $200,000 or $300,000 with their spouse, or (b) having a net worth of greater than $1,000,000. Section 412 of the Act modifies the net worth requirement so that it excludes the value of the investor’s primary residence. This will make it more difficult for individual investors to qualify as accredited and thus shrink the pool of potential angel investors. The Act also requires the SEC to periodically revisit the definition of accredited investor to determine whether changes are necessary “for the protection of investors, in the public interest, and in light of the economy.” So the door is open for further narrowing of the definition in the future, via increasing the net worth and annual income requirements. (For thoughts on apparent loophole regarding future revisions see William Carleton’s post here.)
The Act requires that the net worth limit remain at $1,000,000 for at least the next four years, but the primary residence exclusion will go into effect one year after the Act is signed into law, presumably sometime next week.
I don’t have the statistics to accurately determine the exact impact this will have on the pool of angel investors. My guess, though, is that it will have a greater impact in areas not on the coasts, since, at least based on anecdotal evidence and past experience, a greater cluster of typical angel investors in those communities come in closer to the $1,000,000 line. I hope I’m wrong on this, and welcome counterarguments or further discussion.