8 posts categorized "December 2009"

Three Things for Startupers to Track in 2010

Here are three start-up oriented issues to track in 2010:

1. Will new models for financing IT startups continue to gestate? Or will the venture capital financing paradigm, predicated on professional management of other people's money and an imperative for predictable liquidity, reassert itself after that industry's "right-sizing" has been completed?

2. Will Senator Dodd's financial regulatory reform legislation be shorn of its disasterous provisions that would end federal preemption of all-accredited investor offerings, and require the SEC to raise accredited investor thresholds and tie them to CPI?

3. What other legislation may be proposed that could help our hurt the efforts entrepreneurs make to innovate and create jobs? This has to be watched jealously, because there is no organized, single voice speaking for the start up founder and angel financing community on a national level. Venture capital firms are politically organized through the NVCA, but at least in the flurry of financial regulatory reform under the Obama administration so far, their legislative agenda has been more parochial (avoiding adviser registration requirements, taxation of VC management's carried interest) and missing the big picture.

And by the way, here are two additional subjects I'll be tracking in the new year (not startup oriented necessarily, but interests of this blog):

4. Will newer social networks bring us further to the promise of content delivery free of advertising?

5. What other tax policies or innovations might be proposed for executive compensation? I like Brad DeLong's idea that exec comp generally might follow the VC carry model.

If Talented US Bankers Head for the UK, They May Find They Have to Keep Moving

I’m posting this from an Internet café in Balham, which is on the Northern Line of the London Underground, ten stops south of the Bank station in London’s financial center. 

I read an item from the weekend’s Manchester Guaradian, written by Martin Farrer, the pertinent bit (for me) coming as follows:

A senior Bank of England official has claimed that bankers moving overseas to avoid the bonus super tax could be a "price worth paying" to achieve lasting reform of the sector.

Andy Haldane, head of financial stability, also said that banks have become too big and was sharply critical of the culture where bankers could take huge risks in the knowledge that the taxpayer would bail them out. . . . 

His comments underlined the gulf between Threadneedle Street and the City over how to deal with the fallout from the financial crisis. The Bank's financial stability report, published yesterday, stepped into the row over bonuses by calling for banks to build up their capital rather than make large payments to staff as many are expected to do.
This mirrors the same controversy, and threat, in the US, where all year Wall Street execs. have been responding to exhortations by President Obama and other politicians to clamp down on Wall Street pay by predicting/threatening that banking talent will respond by leaving Wall Street for firms overseas. 

I’m wondering where the talented bankers are all now headed. Asia? 

It could be the European continent, but then again an official from Deutsche Bank was quoted in the same Guardian article to say that it would not be fair to their UK-stationed bankers to let the UK tax fall just on them; Deutsche Bank intends to spread the impact of the tax around the firm globally. Might that not be the global industry’s response, unless and except as they find they can quit a geographic market altogether? Add up the employment taxes imposed by the US, the UK, perhaps other governments, figure out what profits are available for bonuses firm-wide, then adjust the bonuses by region accordingly with an eye toward the after-tax consequences for bankers in each market? 

Making money by moving money has been around since the 19th Century and I’m not sure that industry will ever go away (though in the US I gather Philadelphia and other cities were more vital financial centers before the function was ceded altogether to New York). 

The other thought that is resonating as I think about this subject is what Senator Mark Warner said a month or so back, at a hearing of the Senate Banking Committee:

"I think one of the things we need to recognize is that, you know, over the last few years, banking and investment banking have been the place to be, as year after year we've seen banks record record profits. But I think that we've seen that many of those gains were really based upon black magic. And that the magic of the marketplace has turned into a nightmare for an awful lot of families and businesses and in many ways for the country. To a degree, it's time to make banking a little bit more boring again. . . ."

Is the Attack on Reg D an Overbroad Solution to a Different Problem?

Some of us who have been worried about the threat to all-accredited investor offerings exempt under federal Reg D have been wondering why Senator Dodd's financial regulatory reform bill would attack it.

I'm still trying to get a handle on what would drive such a devastating change in policy. We know federal preemption of state regulation in this arena is working to enable angel investors to make seed investment in startup tech companies. The process is safe (protective of investors who need protecting), predictable (one set of substantive rules), and efficient (legal fees, under the current system, don't chew up a disproportionate amount of the monies raised, though of course entrepreneurs and angels could always stand for legal fees for securities compliance to be even lower).

I've learned in the last few weeks that the North American Securities Administrators Association (NASAA) has been calling for removal of federal preemption of state regulation over offerings exempt under Rule 506 of Reg D. Other attorneys active in bar association committees have told me that NASAA has revocation of federal preemption as a key policy goal.

A Dow Jones "Compliance Watch" column by Suzanne Barlyn came out last week that gave me further insight. Ms. Barlyn's column was about a surge in fraud claims connected with private placements under Reg D. A theme of the piece is whether the accredited investor thresholds should be raised, as Reg D offerings are, according to the piece, "reaching a crowd of individual investors for whom they were never intended, lawyers say." The column goes on to state that "investor attorneys say they’re handling three to five times the number of private-placement cases they did even just a year ago."

Something struck me, however, about all of the problematic private placements Ms. Baryln referenced: all of them involved broker dealers. None involved issuers placing securities directly with angels. I don't want to over-extrapolate, but presumably the investors who were swindled in the cases cited did not have pre-existing business relationships with the entrepreneurs or the companies in which they were investing.

I thought these distinctions were important and should make a huge difference in the kind of securities regulation reform one might advocate. So I wrote a comment, and Ms. Barlyn and her editors were kind enough to publish it, here. Because this link may require a subscription to access, I am also inserting, below, my full comment to Ms. Barlyn's column.

Two points in Suzanne Barlyn's article suggest that the problem she writes about is characterized in the wrong way.

First and foremost, the cases of abuse Barlyn cites all appear to involve a broker. So I don't think it's fair to equate the problem with registration exemptions or accredited investor thresholds under Reg D. The problems cited in the article all have to do with broker-dealers who are syndicating the stock of other companies in manners that may well not even meet the requirements of Reg D on its face, let alone comply with antifraud rules, which Reg D does nothing to eclipse. All legitimate Reg D issuers are subject to the antifraud rules and to state enforcement action (even when separate state registration requirements are pre-empted under Rule 506 of Reg D).

Why is it so important to paint the problem with a precise brush? Because there are many, many thousands of technology entrepreneurs and many, many thousands of active angel investors, who start and "seed" technology and other start-up companies in the U.S. in reliance on Reg D. This vibrant segment of our economy does not use broker-dealers. Far from it. Instead, the start-up companies deal directly with the angel investors, with whom they are networked or otherwise have pre-existing business relationships, just as the rules say they should.

It's important to draw the right inference. I don't know if the solution for the problem Barlyn describes is for federal and state regulators to bring more enforcement actions or for broker-dealer laws to be strengthened or better enforced, but the problem is not with Reg D. Reg D is being used safely and efficiently every day in our country by technology start-up entrepreneurs and the angel investors who know them and appreciate the risks.

The second point is a bit more nuanced: When an issuer places securities with a nonaccredited investor under Reg D, it has heightened disclosure requirements that greatly increase the cost and complexity of the offering. For that reason, among others, technology seed financings almost always are restricted to accredited investors only. So, again, the problem cited by Barlyn is a characteristic of private placements conducted through broker-dealers who would appear to be casting as wide a net as possible to churn securities and earn fees.

It is critical that we get this right. Sen. Chris Dodd's financial system reform bill has provisions in it that would gut Reg D and potentially squeeze many active angel investors out of the start-up ecosystem. If we need to reform law to deal with broker-dealer behavior, let's not make it impossible for start-ups to get off the ground in the process.

Not All Private Fund Registration Requirements May be Created Equal

As noted earlier on this blog, the House Financial Services Committee last month approved a bill to require advisers to hedge funds, private equity firms, and other private pools of capital of a certain size to register with the SEC under the Investment Advisers Act of 1940. Advisers to venture capital funds would be exempt from the requirement to register, as such, although VC fund advisers would still face record-keeping and reporting obligations "as the Commission determines necessary or appropriate in the public interest or for the protection of investors."

The bill as earlier approved by committee appears to remain intact as Section 5001 through Section 5011 of the 1,279 page "Wall Street Reform and Consumer Protection Act of 2009," which Reuters reports the full House began debating today. Intact, with one interesting amendment proposed by Rep. Stephanie Herseth Sandlin of South Dakota. 

Rep. Herseth Sandlin's amendment would modify the section of the Investment Advisers Act of 1940 that delineates the kinds of information that an investment adviser may need to supply to the SEC in the process of registering. Specifically, her amendment provides that the SEC "shall take into account the relative risk profile of different classes of private funds as it establishes, by rule or regulation, the registration requirements for private funds." In other words, the kinds of information a private fund may have to supply to the SEC when registering should vary depending on what kind of private fund it is.

Rep. Herseth Sandlin's amendment would not appear to directly impact the interests of venture capital funds in the House legislation, as the bill otherwise exempts advisers to VC funds from registration. However, I wonder if the instruction to the SEC to "take into account the relative risk profile of different classes of private funds" with regard to information supplied at registration might impact how the SEC approaches drafting the venture capital fund adviser record keeping and reporting requirements that are yet contemplated in the bill before the House. (As also reported earlier on this blog, the Senate version of private fund registration legislation has neither registration nor reporting requirements for advisers to VC funds.)

And just what kinds of information might be required of a fund adviser when registering with the SEC? Here's what the current statute says (15 USC 80b-3(c)):

An investment adviser, or any person who presently contemplates becoming an investment adviser, may be registered by filing with the Commission an application for registration in such form and containing such of the following information and documents as the Commission, by rule, may prescribe as necessary or appropriate in the public interest or for the protection of investors:

(A) the name and form of organization under which the investment adviser engages or intends to engage in business; the name of the State or other sovereign power under which such investment adviser is organized; the location of his or its principal business office and branch offices, if any; the names and addresses of his or its partners, officers, directors, and persons performing similar functions or, if such an investment adviser be an individual, of such individual; and the number of his or its employees;

(B) the education, the business affiliations for the past ten years, and the present business affiliations of such investment adviser and of his or its partners, officers, directors, and persons performing similar functions and of any controlling person thereof;

(C) the nature of the business of such investment adviser, including the manner of giving advice and rendering analyses or reports;

(D) a balance sheet certified by an independent public accountant and other financial statements (which shall, as the Commission specifies, be certified);

(E) the nature and scope of the authority of such investment adviser with respect to clients’ funds and accounts;

(F) the basis or bases upon which such investment adviser is compensated;

(G) whether such investment adviser, or any person associated with such investment adviser, is subject to any disqualification which would be a basis for denial, suspension, or revocation of registration of such investment adviser under the provisions of subsection (e) of this section; and

(H) a statement as to whether the principal business of such investment adviser consists or is to consist of acting as investment adviser and a statement as to whether a substantial part of the business of such investment adviser, consists or is to consist of rendering investment supervisory services.

Observations From a Silicon Valley Start Up Lawyer and Former SEC Attorney on Proposed Reg D Changes

My name is Mike Prozan. I want to thank Bill for inviting me to post on the proposed changes to Reg. D. My background played a part in the invitation, so allow me to give you a summary for context. I am a lawyer who began practicing in the Division of Corporation Finance at the SEC in Washington. I currently practice with start ups here in Silicon Valley and have practiced corporate/securities law in Oregon as well.

So, as I understand it, the two changes proposed by Senator Dodd are:
  1. Eliminating federal pre emption of Reg D. Offerings; and
  2. Raising the dollar values on determining who is an accredited investor be raised.
 Why does Dodd care? This guy should be fuming at and addressing Wall Street bonuses and preventing us from being held hostage again under too-big-to-fail. He should be eliminating the anti trust exemption for health insurance. But, the folks that benefit from the status quo under Reg D do not make major contributions to his coffers.

Other than a few paragraphs over on a post at thefunded, I have never read anything to date (or seen anything in my experience) suggesting that either of these issues are problems. The paragraphs are:
In a Sept. 15, 2009 speech by the new President of the North American Securities Administrators Association, Texas Securities Commissioner Denise Voigt Crawford said the following:
"Without question, the most harmful area of state securities preemption has been Regulation D offerings. Since they also enjoy an exemption from registration under federal securities law, Reg D offerings receive virtually no regulatory pre-screening at any level of government. Only enforcement actions are brought and they are rare."

I am not aware of any basis in fact for these statements. If enforcement actions are rare, it suggests lack of a problem. What does pre screening add if the states are not overwhelmed with enforcement actions? If they were flooded with more enforcement actions than they could staff, that might indicate a problem.

Next is the issue of the current dollar value for the exemptions, which, for individuals is $1mm of net worth or $200,000 in annual income for each of the last two years with the expectation of making that this year or the same, with a spouse of $300,000.

I have mixed feelings about raising the criteria. Within the last few years, I spoke with an old friend on the SEC staff who told me this was under consideration. It concerned me because I understood it would be scaled to inflation or something similar. In my experience in this area, those meeting minimal financial requirements tended to be somewhat less financially savvy than those had a higher net worth. I think one reason for that is in the Bay Area, simply buying a home and paying on a mortgage may qualify you for $1mm net worth. But this is a regional phenomenon. The same is not true of Washington.

My concern was that on the other hand, using some sort of formulaic approach, like CPI increases might overdo it. And, as I understand it, such an approach might require a net worth of $2,285,386 in assets or annual income of $457,077.

My experience tells me that while I could see raising the standards, this seems too high. While I acknowledge this is based on nothing more than experience, hunch, and/or instinct, I, for one, still want to see evidence of a problem before searching for a solution.

When There's Trouble on the Hill, Lawyers and VCs Should Take a Back Seat to Startup Entrepreneurs and Their Investors

Even though I haven't written about them, there are other provisions in Senator Dodd's bill that I and other lawyers don't like. For instance, the bill would broaden aider-and-abettor liability and make it easier for plaintiffs to sue lawyers and accountants in securities fraud cases. There are good reasons this kind of exposure was narrowed in the past, and good reasons not to turn back the clock on this issue, either; but I'm not talking about that on this blog.

Similarly, venture capitalists recently worried about proposals by the US Treasury that called on extending investment adviser registration to advisers of private funds, including VC funds. VCs appear to have dodged the bullet on that; venture capital fund advisers are exempt from private fund registration requirements as drafted in both the Frank bill in the House and the Dodd bill in the Senate. TechFlash just reported, however, that the NVCA continues to be worried about proposals to raise tax rates on the carried interest component of compensation earned by managers of venture capital funds.

I don't mean to suggest that it is not important to make sure that venture capital fund managers, lawyers, accountants and other service professionals are able to earn a living in order to effectively play their roles in the tech startup ecosystem. It is important.

Similarly, I don't mean to say that proposals impacting professionals would have zero impact on either (a) capital formation generally, or (b) startup company financing in particular. No doubt all such proposals would, and therefore could indirectly harm startups.

However, we lawyers, accountants, venture capitalists and other vendors are serving a segment of our economy that is driven by people whose journey in life "exists in the tiny space between madness and genius," whose concerns are not primarily monetary (though, longer term, it might be good to restore financial incentives to technology innovation), and who are so busy taking risks a typical service professional would recoil from, they are not necessarily paying attention to proposed legislation in the same, jealous way service professionals do.

We startup service providers are special, too, though: we know our tech entrepreneurs are a source of energy, innovation and pride; we also know that America's chance to not be overtaken by bigger political economies in the 21st Century depends on how well we continue to broaden the tent of hospitality for innovation. America should continue to be the place where business renegades stick their thumbs in the eyes of folks who like things the way they are. So in this time of tumultuous financial change, regulatory reform and a government seeking new revenues, it behooves we servants of the entrepreneur to speak with a coordinated sense of priorities.

I'm not smart enough to prioritize the full public policy agenda for the startup world that Fred Wilson summarized last week (including the startup visa movement and net neutrality). When it comes to how we support entrepreneurs with financing for startups, however, I'll throw out the following list, in a suggested order of importance:

  • Ask the government to make good on the Obama Administration proposal to eliminate capital gains tax on qualified small business stock. Joe Wallin has a good post on this.
  • Leave the accredited investor thresholds alone, at least for the next few years; the current levels are protective enough, and raising them now would keep out many professionals who will otherwise naturally cycle into angel investing.
  • Save Rule 506 under Reg D from being again subject to substantive state securities regulation; as much as possible of the money raised in all-accredited seed financings should go to productive uses, and not to doubled or tripled attorneys fees.

This list might be added to or revised. I am sure, however, that aider-and-abettor liability for lawyers and accountants, and higher taxes on VC management, are not as important concerns for startups or for innovation in our country than any of the three initiatives listed above.

A Call to Action: Fred Wilson Highlights Public Policy Initiatives Impacting Startups, Including Dodd's Bad Proposals

Fred Wilson blogged this morning about the bad policy in Senator Dodd's financial system regulatory reform bill that would make it harder for startups to raise seed financing from angels. Fred put it in the context of public policy concerns generally that impact startups, including immigration reform, software patents, net neutrality and open spectrum.

I'll just speak here to Dodd's bill. As currently drafted, Dodd's bill would hurt seed financing for startups in two ways: (1) it would require the SEC to raise the net worth and income level thresholds needed to meet the "accredited investor" definition, and (2) it would end federal preemption of "all accredited" offerings, so that every state in the country would be permitted to regulate such offerings, even though they already met the federal requirements. See this post on Seattle 2.0 for a good overview of the current law and how federal preemption of state law in this area makes sense. Suffice it to say here that Dodd's bill, as written, could knock many angels out of the startup ecosystem, and would certainly greatly increase legal fees and costs for financings (perhaps even make modest seed financings not do-able at all where investors may be from different states).

Awareness of these provisions in Dodd's bill is just beginning. I'm very hopeful that Fred's post will ignite discussion and flush out who may be behind putting these provisions in Dodd's bill in the first place. I'll be interested in hearing the arguments, if there are any, but at the moment it is very, very difficult to see how it could be in our nation's interest to make it harder for entrepreneurs to raise seed money for startups. (I have heard from a prominent lawyer that NASAA (the National Association of State Securities Administrators) has as a key goal repealing federal preemption.)

The issue is indeed of most pressing concern to entrepreneurs and angel investors at the earliest stages of a new venture. I've heard a few people react by saying that this isn't an issue for venture capital firms. But of course it is; it is an issue for the entire startup ecosystem. Seattle-area VCs, such as Bill Bryant and Geoff Entress, who are among the 25 entrepreneurs, investors and attorneys who signed a letter to Sen. Murray and Sen. Cantwell on this issue, understand that. Fred Wilson totally understands it, too, and in fact expresses the point better than anyone (this from his post this morning):

"The angel funding mechanism is potentially the single most important funding mechanism in startup land. Most entrepreneurs get their first real investments from angels, not VCs. If you lower the amount of angel capital in startup land, you'll end up lowering the number of entrepreneurs who can get their projects off the ground."

You can do something about this. Write or call your representatives in Congress. Consider signing on to this petition. Blog about this, and ask others to comment, share information and share concerns.

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