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Startup Diversity At Risk: SEC To Recommend Stricter Accredited Investors Criteria

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The U.S. Securities and Exchange Commission (SEC) Small Business Capital Formation Advisory Committee recently met to discuss the accredited investor definition. The Commission is expected to demand higher hurdles to qualify as an accredited investor.

Expanding not shrinking the pool of accredited investors will drive innovation, stimulate economic growth, and improve the quality of life in underserved communities. How? Because individual investors are more likely than VCs to fund women- and other diverse-founded startups, which, in turn, bring jobs to their communities.

Oh, and diverse founders also give great returns to those who invest.

Who Are These Accredited Investors?

The SEC defines accredited investors as financially capable individuals who can absorb potential investment losses without affecting their standard of living. To qualify, investors must meet at least one of four criteria:

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  • a net worth of $1 million (excluding primary residence)
  • an individual income of $200,000 in each of the previous two years
  • a household income of $300,000 for joint filers in the previous two years
  • certification/credentials in specific professions (e.g. Series 7, 65, and 82 licenses)

The SEC is mandated review ensures that the definition remains appropriate and up-to-date in a constantly evolving investment landscape and changing economic conditions.

The review ensures the definition reflects the diverse range of investments available and the evolving financial sophistication of investors. This balances inclusivity and safeguards against investors who may not possess the necessary knowledge to invest in high-risk ventures.

Between 2020 and 2023, the number of accredited households grew 42.3% to 19,444,975 in the U.S., according to DQYDJ. They represent 14.8% of households and control $109.5 trillion in wealth.

Why Accredited Investors Matter

Accredited investors matter because they can invest in startups. “Main Street” investors are deemed less sophisticated. However, they can invest small amounts of money in private companies via investment crowdfunding platforms.

Whether investing as an angel or a limited partner (LP) in a VC fund, investing in private companies allows accredited investors to diversify their portfolios, potentially yielding higher returns. They typically diversify their portfolios across multiple companies and industries, reducing their exposure to the risks associated with any single investment and improving overall returns.

Investing in startups also has a long-term investment horizon, giving companies time to develop, mature, and achieve significant growth. This long-term perspective can mitigate the impact of short-term market fluctuations.

If the SEC increases the income or net worth needed to be accredited, the number who qualify would be reduced significantly. This would hurt middle-America founders more than the coastal tech hubs of Silicon Valley, New York City, and Boston, commented Marcia Dawood, SEC Advisory Committee member, Chair Emeritus ACA, venture partner at Mindshift Capital, and angel investor. Most angel investors invest close to home.

First Money In: How Angels Drive Venture Capital Funding for Startups

“Angel investors usually are the first money in a startup,” Dawood said. “The National Venture Capital Association (NVCA) has informally told the ACA that about 90% of the deals that receive venture capital were funded by angels first.”

Of the 19 million plus people who could invest as angels, only 369,000 people do so, according to the Center for Venture Research at Peter T. Paul College of Business and Economics at the University of New Hampshire.

This may be due to the misperception that when an early-stage, angel-backed business shutters, it is because of fraud. Highly publicized examples of fraud exist, such as FTX and Theranos, but fraud is rare—less than 0.5%. According to an analysis by John Harbison, Chairman Emeritus of Tech Coast Angels (TCA), ACA board member and treasurer, and angel investor, early-stage investing fails due to the risk of starting a venture-backed business.

Rigorous due diligence processes and continuous monitoring of investments mitigate potential failures or fraud. Angel groups share due diligence responsibilities, but many angel investors do this for themselves. When they do invest in startups, the benefits are significant for the angels and their communities:

  • Return: Investing an equal amount in all 247 TCA investment opportunities would have yielded a cash return of 6.4 times the initial investment and an impressive IRR (internal rate of return) of 25%.
  • Jobs: An analysis of Tucson, Arizona-based Desert Angels investments between 2010 and 2019 revealed that they invested $47.3 million into 95 portfolio companies. For every $100,000 investment, these companies produce 5.8 direct jobs, $458,000 in wages, and $2.1 million in economic output.
  • Diversity: “[Importantly, angels] tend to invest in more women and people of color than you see at the venture capital stage [Series A and beyond],” said Dawood.

The ARI HALO Report, which analyzes PitchBook data about angel investments in the U.S., found that as more angel capital flowed to startups between 2019 and 2021 funding:

  • for women CEOs, decreased from 17.5% to 13.3%
  • for minority CEOs, increased from 15.2% to 18.0%

In part, these changes may be due to outside factors. After the killing of George Floyd, the media focused on the disparities between Black and white people rather than on gender disparities. The change in focus may have resulted in the shift of capital.

Accredited Investors Are Critical To Small, Diverse, Emerging Fund Managers

Venture capitalists are professionals who invest in startups on behalf of investors—LPs. Small, diverse emerging managers (SDEM) are VCs whose individual funds are less than $100 million and who have raised fewer than three funds. They are likelier to be members of underrepresented groups and invest in pre-seed and seed companies.

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Despite the strong performance of emerging managers—72% of the top returning firms between 2004 and 2016, per Cambridge Associates—fund activity of emerging managers dropped from a high of 49% in 2017 to 27% in Q3 2023, per PitchBook-NVCA Venture Monitor.

Accredited investors play a critical role in funding SDEMs. They are the first money into these funds. Once traction has been established, institutional investors such as family offices, corporations, and endowments follow.

Institutional investors, such as pension funds, allocate hundreds of millions of dollars to venture capital funds, but SDEMs are not high on their list of investments. Due to the significant amount of capital they invest, most deem writing checks to small funds inefficient. Often they have limitations on the percentage they can represent in a venture capital fund. This is a key component of their risk management strategy.

Some progress has been made. In 2018, an exemption enabled funds of $10 million or less to increase the number of accredited investors from 99 to 249. Fairview Capital found the number of women and minority-owned firms grew from 627 firms in 2021 to 760 firms in 2022. Fairview connects institutional investors with top-performing PE and VC firms, diverse emerging managers, and co-investment opportunities.

But that’s not enough. How Women (and Men) Invest in Startups,* found that additional policy changes are needed to lower barriers for women and other diverse fund managers by:

  • lifting the ceiling on the size of micro funds that can raise money from accredited investors to $50 million
  • raising the number of accredited investors allowed in micro funds from 249 to 499

The bottom line: We need more accredited investors and education about managing the risk of investing in startups such as joining angel groups or becoming an LP in a VC fund.

Yet, most—85%—of Americans are excluded from investing in private companies.

How will you advocate to change the ratio?

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Source: Forbes

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