Senator Dodd is Killing Startup Companies Before They Even Get Started

In light of the overwhelming attention given to health care reform this year, perhaps it is not surprising that little attention has yet been paid to Senator Dodd’s banking bill.  In the wake of the mortgage crisis, perhaps more regulation of certain segments of the financial system is warranted.  I have not studied the entire Dodd bill, so perhaps there are larger issues to love and hate within its pages.  However, questions should been raised as to why the Senator has chosen to kick venture capital, angel investors and startup companies in the teeth.

The Senator’s bill contains two provisions that are just now getting some attention:  The first would change the thresholds that define who may or may not invest in startup companies or other private offerings – known as “accredited investors.”  Under the current rules, to take advantage of the SEC safe harbors and legally invest in a startup company or a venture capital fund, you need have either $1 million in net worth or make $200,000 per year.  This rule was adopted to help protect “less sophisticated” people from being fleeced.  Under the proposed legislation, those thresholds would be significantly raised, thereby further restricting the ability of individuals to invest in aspiring entrepreneurs.  But more importantly, it would make it even more difficult for startups to access much needed capital.

The second area of concern is a rule that would eliminate federal preemption of state laws for this type of investing.  Under the current law, federal rules take priority over, or preempt, state law when entrepreneurs or a startup company seeks to raise funding for a new business.  This gives the startup one set of rules to follow.  Under the Dodd bill, however, state rules would take precedence, leading to enormous complexity that startups would need to navigate, even as they struggle to get off the ground.  No doubt the entrepreneurs can comply, but even in the best case, this will dramatically raise the cost and time required.  I am a lawyer, so I may prosper as a result this change, as both startups and investors will need additional help from their attorneys.  But this comes at a time when founders and their companies can least afford to pay lawyers, and can better deploy their limited assets – say, to launching their business and creating jobs.

Although the hardest hit by these provisions will likely be the startups of tomorrow, close behind are angel investors, many of whom will now be kicked out by Senator Dodd.  For those that are not familiar with the term, an angel investor is typically a private person, normally a middle-aged, successful business person, who invests their time, effort and money at the seed-stage of a startup.  They are called angels as they are typically more altruistic than the larger VC firms and more interested in helping younger business teams learn how to start and run a company.  People that decide to become angel investors understand the risks they are facing; they go in with eyes open.  Unless Congress wants to ensure only the fattest of fat cats are allowed to invest in private companies, this change makes no sense.  By raising the threshold for participation, Senator Dodd will certainly decrease the number of people and dollars available for investment in the businesses of tomorrow.  Angels are good.  Period.  Making it harder for these people to help the next generation of business people is simply a bad idea.

Our country needs more jobs.  Our economy needs a boost.  We need more investment and activity to get people working, spending and in general create prosperity.  Democrats and Republicans alike have acknowledged that small business is one of the engines of jobs creation and growth in our country.  And there is no question that startup companies put people to work – whether it is just the founders or people they hire as new companies ramp up and grow.

The cost associated with this portion of the Dodd bill will be paid by small business and small investors.  The benefit?  Good question.   The existing laws and regulations already require a reasonable level of sophistication to invest in private stock offerings.  There are already laws and regulations that prevent fraud.  The breakdowns in our financial system that Dodd’s bill is aimed at fixing have nothing to do with venture capital, angel investing or new, small or emerging growth companies.

The venture capital and startup system has worked wonderfully for many years, creating an enormous number of jobs, great companies, magical products that have changed the world and wide-spread wealth.  In short, the system is not broken.  Lets not fix it.