Carleton

Wallin

Bill Carleton and Joe Wallin: Senator Christopher Dodd's massive financial regulatory reform bill is back and it's even uglier than before for startup companies trying to raise seed capital. Ugly for startups?

A bill that means to address "too big to fail" and systemic risk to the financial system? Yes. And we're not talking about some indirect, attenuated, downstream effect from new regulation of big banks or Wall Street investment firms. The bill directly targets the way startups raise capital.

This "reform" occupies only a few pages in Sen. Dodd's massive bill, at Section 926, entitled "Authority of State Regulators Over Regulation D Offerings" (pages 816-819).

Under the old rules, startup companies could raise money from "accredited investors" simply and easily.

Now they are going to have to make a filing with the SEC and the SEC will have 120 days to review the filing.

The bill says:

"The Commission shall review any filings made relating to any security issued under Commission rules or regulations under 4(2), other than one designated as a non-covered security under subparagraph (A)(iv), not later than 120 days of the filing with the Commission."

If the SEC fails to review a filing, the security won't be considered a "covered security" exempt from the scrutiny of state securities regulators.

Moreover, the bill looks to be set up to encourage the SEC to offload review of smaller financings (read, seed financings, if not angel financings altogether) to state regulators. Language in the bill states that “the [Securities and Exchange] Commission may designate, by rule, a class of securities that it deems not to be covered securities because the offering of such securities is not of sufficient size or scope."

The bill also mandates that the SEC raise "accredited investor" thresholds, potentially more than doubling the amount of income or net worth an angel has to have in order to invest in startup seed financings. (See Section 412 of the bill pages 380-381).

If these provisions become law, they will substantially increase the legal fees and other costs associated with obtaining financing (not to mention the cost of delay). You can imagine that, if startups have less of the capital they raise to spend on their businesses (or if the rules are so onerous that the seed financing just isn't legally feasible), this won't help the national agenda to create jobs. (Unless you are talking about jobs for lawyers).

Why would our federal legislators do this?

One strong influence appears to be the North American Securities Administrators Association (NASAA), an association of state and provincial securities administrators. The President of the NASAA, Denise Voigt Crawford, has publicly testified that federal preemption over Rule 506 offerings contributed to the recent financial crisis.

With all due respect, we disagree.

State regulators may need more tools, but gutting the existing angel financing system, a system that works and which entrepreneurs rely on to get startups off the ground, isn't one of them!

Industry leaders like Marianne Hudson, Executive Director of the Angel Capital Association, are on the issue. Together with Mark Heesen, President of the National Venture Capital Association, Hudson has written a letter to Sen. Dodd, urging reconsideration.

Fred Wilson has noted that this issue is important to the entire startup financing ecosystem, even to later stage VCs, insofar as most startups begin with support from angel investors. Venture Hacks recently alerted its base to the threat, as well.

In his post, Fred Wilson put succinctly what is at stake: "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."

We urge the entire Washington State startup community to get informed and get involved, and to take this message to colleagues and contacts in California and to other areas of the country. Seattle 2.0 and a group of entrepreneurs, angel investors and attorneys have been leaders in raising consciousness on this issue, going back to a post that Marcelo Calbucci published in November 2009.

The information is out there. We need to sit up and take notice of this attack on angel financing, taking place right before our eyes.

William Carleton is an attorney at McNaul Ebel. Joe Wallin is an attorney at Davis Wright Tremaine. Both attorneys work with startup companies in the Seattle area. Opinions expressed in guest posts are those of their authors, and don't necessarily reflect the views of TechFlash or its staff. Have an idea for a guest post of your own? Email us: techflashtips@bizjournals.com