On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”). Reforms introduced by the Act are broad and will affect many aspects of the operation of the U.S. capital markets. Today, I would like to mention one reform in particular, the new “accredited investor” standard. Only one word has changed, but this change may have an immediate and profound impact on the way small businesses access capital markets.
The Act has amended Rule 501(a)(5) of Regulation D and Section 215(e), both under the Securities Act, to provide that an accredited investor is one whose net worth, individual or joint with the spouse, at the time of purchase, is $1,000,000, excluding the value of a primary residence. Previously, the net worth had to be $1,000,000, including the value of a primary residence. This change is effective immediately upon enactment of the law. When raising a limited amount of capital, Regulation D does not require companies to provide disclosures to accredited investors. However, if offers are made to non-accredited investors, then companies have to provide extended disclosures about their business, industry, risks and also their financial statements.
On one hand, this change has been long overdue. The definition of an “accredited investor” had not been changed since 1982, when it was first adopted. The standard that is supposed to describe high net worth individuals who earn high salaries and can afford the services of a financial representative has lost its purpose as the inflation and rising real estate values made more and more people “accredited”. For example, all those who were fortunate enough to purchase their apartments in Manhattan in the early 1980s have all become “accredited” by the mid-2000s just by virtue of owning apartments, when the real estate boom had quadrupled the prices. However, not all of these individuals have enough other income to afford the services of a financial representative to guide them through the risks of private investments. Therefore, the Congress has decided to protect these individuals by making them “non-accredited”.
On the other hand, this change makes it more difficult for small businesses to raise money. Providing extensive disclosures for non-accredited investors will add up legal fees, as attorneys will have to draft lengthy private placement memorandums. Since the pool of accredited investors has shrunk, raising capital in the initial rounds (in “Family and Friends” or “Angels” rounds) has become more expensive. This comes at a critical time for many businesses that cannot obtain bank financing and whose only option is to resort to raising capital from investors.
Of course, the change is needed, since the definition of “accredited investor” has not been updated in almost 30 years. However, it comes at a cost to small businesses, a high cost, given the current economic environment.