In our previous post (Let It Be) we noted that Senator Chris Dodd’s financial reform bill that is on the way to the House floor contains new provisions that would reduce the number of individual eligible to invest in private ventures. The original draft of the bill would increase the $1 million net worth threshold that defines an “accredited investor”, which in turn determines an individual’s eligibility to invest in exempted private securities offerings under Regulation D of the 1933 Securities Act.

These Reg D offerings enable startup businesses access to “angel” capital — the critical means of finance for early-stage ventures that could not otherwise bear the prohibitive costs and regulatory burdens of SEC registration.

The angel investor and entrepreneurial community responded vociferously against the proposed legislation citing the chilling impact that an estimated 77% reduction in the ranks of accredited investors (per Bloomberg BusinessWeek’s estimate) would have on angel investment, financing startups, new job creation and reviving the reliable stalwart of economic growth—the small business sector.

Now we hear that the Angel Capital Association announced that Dodd and his Senate Banking Committee have drafted amendments to the initial proposal whereby the threshold for “accredited investor” would stay the same, although the standard for net worth of $1 million would be revised to exclude the investor’s primary residence.

The ACA has proclaimed that although “we would have preferred no adjustment to the standard for angel investors, we believe this is a good compromise” adding that the amendments “improve the bill so that it balances the importance of small business capital formation while protecting angels and other types of private investors from securities law violators.”

What bunk. The ACA should be opposing such compromising compromises. The opportunity to make a private investment in a private venture should be every investor’s right. The ability to invest in a new business should not be an exclusive privilege bestowed by politicians upon persons of a certain economic class.

Moreover, there are ample investor protections already in place. The SEC’s powerful Rule 10b-5 is all about protecting investors, and it applies to private investors just as it applies to the general public. Every state has securities laws on the books that protect private investors from fraud. Indeed, the registration requirements of the 1933 Act also serve that protection purpose.

As explained by SEC alumnus Patrick Daugherty of Foley & Lardner, “Regulation D is an exemption from those registration requirements. It’s part of our law precisely because there exists a class of investors who can ‘fend for themselves,’ in the words of the Supreme Court’s venerable Ralston Purina holding. Congress, the SEC and the Supreme Court have believed for fifty years that offerings limited to investors who are ‘rich and smart’ about finance need not be registered.” 

Although there is no doubt that the majority of frauds have occurred in highly regulated or visible investment schemes (remember Refco, Enron, Worldcom), there is ample history of unscrupulous brokers, dealers, issuers and promoters abusing Reg D and defrauding investors. The SECs recent indictment of Provident Royalties, LLC for a massive $485 million ponzi scheme is a good example of how the SEC’s limited resources could be effectively allocated away from surfing porn on the web.

But I have never heard a cogent argument that supports the notion that any individual should be restricted from the opportunity to invest in a startup or new business venture that has appropriately disclosed the risk of failure and loss of all capital that is inherent to venture investment.

Private venture investment in startup and early-stage businesses should be entirely exempt from the Reg D accredited investor provisions.

Angel investors know the risks are high and that a significant portion, if not the majority of their venture investments will fail. There is absolutely no evidence that angels investing in startups played any role whatsoever in the recent financial crisis that has prompted Dodd’s proposed reform bill. So, who does this compromise “protect”?

The notion that net worth is an effective indication of an individual investor’s sophistication or ability to bear the risk of loss is laughable. The bright-line standard used to ascertain an investor’s sophistication is ironically unsophisticated and utterly under-inclusive.

I align with Richard Rahn, chairman of the Institute for Global Economic Growth that “the rule makes little sense and strongly discriminates against knowledgeable people who are not yet wealthy but are quite capable of making good investment decisions.” Rahn refers to this as “financial fascism”.

In this connection, there is no reason to suppose that investors who are millionaires only after including home equity are unable to fend for themselves while those who are millionaires exclusive of home equity are self-reliant. Consider Sid and Nancy. Sid has $500,000 in financial assets and a $1 million home with no mortgage. Nancy has $1.4 million in financial assets and a $1 million home with a $900,000 mortgage. Both Sid and Nancy have a net worth of $1.5 million. Sid has constructed a more-conservative balance sheet for himself. But Senator Dodd says that Sid needs federal protection while Nancy doesn’t.

This makes no sense, especially since Sid can “become accredited” simply by borrowing $500,000 against his house and investing the proceeds in securities. Does Senator Dodd really want to encourage greater mortgage borrowing as a means of facilitating private capital formation?

Does anyone really believe that an IT professional making $75K is less able to evaluate a web startup than a professional athlete? Is a recent B-school grad less able to assess the merits of a new retail business venture than a trust fund baby? Is a cook any less able to evaluate a new restaurant venture than a lottery winner with an eight grade education? Wealth is simply not an effective proxy of sophistication.

But what I find most offensive is that this “compromise” only compromises personal financial freedoms and investor’s rights and liberties…a viewpoint shared by my old friend John Mauldin, acclaimed creator and curator of commentary at investorinsights.com, a blog focused on private money management.

“Why should 99% of Americans be precluded from the same (investment) choices available to the rich? If you were to tell investors that they would be discriminated against because of their gender or race or sexual preferences, there would be an outcry….It is a matter of Choice…Equal Access…Equal Opportunity…it is time to change a system where Americans are relegated to second-class status based solely on their income and wealth.”

Nice, John. I also see that one of Canada’ top angel investors also shares our opinion that any investor should be able to make angel investments (assuming the proper disclosure of risks).
 

Regulators and politicians whom plead that such provisions protect the poor and unsophisticated from unscrupulous promoters are hollow hypocrites. Presently 42 state governments run lottery programs—a regressive tax that preys on lower-income households to the tune of more than $17 billion in 2007, the most recent annual estimate. Recently, researchers have identified a correlation between economic difficulties and the popularity of lotteries….so we are likely seeing greater lottery ticket sales today.

Single state lotteries usually have odds of about 18 million to 1, while multiple state lotteries have odds as high as 120 million to one. The state lottery and government officials know that it is a sucker’s bet that is disproportionately supported by low-income households and marketing programs make sure to advertise in lower income areas and increase television advertising when welfare and social security checks are distributed. The poor and unsophisticated are left to their own defenses when government acts as the issuer and the promoter.

Government should be encouraging private investment in new businesses which historically account for the majority of the innovation and job creation in the American economy. The Kauffman Foundation, tells us that “between 1980 and 2005, virtually all net new jobs created in the U.S. were created by firms that were 5 years old or less…That is about 40 million jobs. That means the established firms created no new net jobs during that period.”

Startups continue to be a robust and critical engine of job creation as according to Bloomberg, despite the sluggish economy some 259,480 angels invested $17.6 billion in 57,225 entrepreneurial ventures in 2009.

As the average startup employs approximately eight people, increasing the bracket for accredited investors in any manner will only make it more difficult than it already is for startup businesses to raise money and create new jobs.

To the contrary, nothing would be gained by reducing the pool of accredited investors—no additional protections to investors and no benefits to the national financial system or the economy. Private venture investment in startup and early-stage businesses should be entirely exempt from the Reg D accredited investor provisions.
 

Album: Up The Bracket, The Libertines, 2002

Private venture investors consciously embrace the notion of swapping liquidity and safety of principal in the pursuit of positive asymmetrical outcomes and the higher risk premium associated with venture capital. Against the certainty of uncertain outcomes, the venture investor accepts liquidity and principal risks as the apropos quid pro quo towards achieving high double-digit and triple-digit IRRs on investment.

But, venture investors too willingly accept the notion that their investments outcomes will be the result of a binary set of events—characterized either by loss of capital or an attractive multiple on exit as the result of an IPO, sale, merger or other change of control transaction.

These investors can become more effective fiduciaries of their capital by demanding investment terms that broaden the variety of each investment’s potential returns. I refer to this as increasing an investment’s “optionality” beyond a binary set of boom or bust outcomes.

Among the most frustrating venture investment experience is the non-outcome outcome. In an earlier post (Hits & Exit Wounds) we described this sort of venture purgatory as “My Grandkids Company”—a private company that is successful but there is no exit in sight. (Perhaps your grandchildren’s inheritance?). You were prescient enough to back an early-stage venture that is now successful yet all you have to show for it is an annual K-1. This is where investment term sheet mechanisms that enhance the investor’s optionality really come in handy.

I have become a strong proponent of requiring that venture investors demand a “put right” (or, put option) as a contingency to committing venture capital to an angel round or early-stage equity financing. A well-conceived put option may reduce unintended gifting to your grandchildren by giving you one way out of a private investment without an exit in near sight.

Typically, a venture investor’s exercise of a “put” would require the company to repurchase their equity securities at fair market value. Investor put rights have been around venture transactions for years for the express purpose of providing a way out of an investment with no liquidity event in near site. But, because of the terms by which they have generally been structured, they have been rarely exercised.

That’s because if the company appears to be on the right track, investor’s are more likely to let their fortunes play out. On the other hand, if the company is not performing to plan it is not likely to be able to afford to honor the investor’s put—rendering the option worthless.

With investors rarely exercising these puts and with companies generally apprehensive of the uncertain implications of any non-budgeted hit to their balance sheet, issuers are less willing to draft investor put rights into their offerings…but you should insist.

It works like this…upon completing due diligence and deeming a venture to be worthy of a capital commitment the investor reviews the company’s anticipated revenue projections to identify a period in the future (beginning at 30 or 36 months out) at which the company’s cash flow model and pro forma balance sheet suggests that it would be able to return the investor’s initial capital contribution along with any accrued dividend. As a contingency to financing the venture, the investor requires the company to grant a put option for that future point in the company’s growth trajectory.

If the investor exercises the put, the investor is entitled to redeem all or a portion of their equity interests in exchange for the initial capital contribution value plus a nominal return above the risk-free rate. In addition to the return of investment, the put right allows the investor to maintain a reduced equity position in the company…perhaps, somewhere between 50% to 75%. (This would imply an increase two to four times higher than the company’s initial valuation)

Essentially, the exercise of the put allows the investor the ability to take “risk off the table” (the initial contribution) while still maintaining a material amount of “skin in the game”.

To prevent the investor from exercising the put at a moment when the company’s financial stability or expansion plans could be jeopardized, the company can require that in addition to a prescribed time period restriction, certain revenue and/or R&D milestones must be achieved and set as “triggers” before the put may be exercised.

The put option must be constructed in a manner that enhances the investor’s optionality, without putting the company at balance sheet risk. It is possible to achieve that balance. The company that achieves the predetermined revenue milestones would likely savor the opportunity to buy back its stock to the pro-rata benefit of the remaining stakeholders, and of course the investor benefits from the possibility of a wider variety of liquidity events and exit outcomes…which, in turn, enhances the ultimate appeal of venture capital as an asset class.

Album:    One Way Out, The Allman Brothers Band, 2004

I have noticed that VCs tend to talk to the public and with their peers more about their home runs than their strike outs. Angel investors, on the other hand, prefer to relentlessly revisit their pain—often comparing their battle scars like veteran samurai. Probably because angels put up their own capital. Because they truly do eat their own cooking it’s harder for angels to forget their fallen soufflés.

VCs achieve their highs from the opium of OPM…so even a bad trip is still a free trip.

I recently had lunch with an inveterate venture investor (aka “angel”) whom I had co-invested with in a biotech, as well as, a med-tech company, several years back. Our conversation inevitably turned to peck at our past portfolios.

The biotech company was a true home run—a high-multiple exit realized in a 2004 IPO. (When was the last time you saw biotech, high-multiple and IPO in the same sentence?)

But, rather than relishing in a reminiscence of our raison d’être, we chose to get muddy in the mire of our miss—the medical device company that (nearly seven years later) was still trudging along with neither an exit, nor a write-off in sight.

There is the baneful scenario–five or more years in an illiquid private investment that just keeps rolling over but never plays dead, and, there is the painful scenario–a company running profitable for several years straight but no IPO, acquisition or distribution on the near horizon.

Two questions dominated our discourse. First, what would become of the med-tech investment? And secondly, what can we do differently as investors to avoid non-outcome outcomes in the future?

My most previous venture ovation opined, “There is very little that is binary about venture investing outcomes. It is not just feast or famine…outcomes are diverse and asymmetric. You can lose your entire investment, just lose a portion, break even, receive periodic distributions producing double-digit IRRs or achieve exits at 5X, 10X, 20X multiples or greater…”

That list of outcomes would be just fine if it was indeed comprehensive, but I employed some autistic license. The reality of the absence of binary outcomes in private venture investment occasionally includes the potential absence of any outcome at all.

In an amusing piece “10 Exits”, Angel Capital Association’s chairman John Huston further parses this purgatory. He evokes the venture vernacular “Zombie” as “a walking dead venture that will never become a great company, nor will it die so I can declare the loss.”

There are a number of ways to euthanize a zombie but what do you do about the investment that Huston calls, “My Grandkids’ Company…a company that is successful but there’s no exit in sight”? (“Maybe it will occur after my grandchildren inherit the portfolio.”)

That is the second question, and yes, there are methods that an investor can apply at the outset of the investment that mandate distributions from profitable private companies.

I have developed some effective term sheet and funding mechanisms that enhance the optionality of a private investment’s outcomes that avoid inadvertently gifting your grandchildren. I will share them in an upcoming post. They are the byproduct of my own experiences, and as you know, experience is what you get when you were looking for something else.

Album:   Hits and Exit Wounds, Alabama 3, 2008

As my career has been largely devoted to the intersection of money management and venture finance, I am no stranger to the independent RIA universe.

I have worked with dozens of wealth managers and family offices that regularly evaluate and allocate to private venture investments. Although they represent a fraction of the RIA universe, they are invariably among the most successful of their peers. These progressive wealth managers represent the primary audience of this blog.

I regularly advocate that RIAs that possess the requisite mandate, the means and the mindset should embrace private venture investments–for the benefit of their client’s portfolios, as well as, their practices. Yet, the majority of independent wealth managers should best leave this sandbox to VCs and angel investors.

Does your advisory practice possess the rationale and the resources to advise clients in start-up, early-stage and other private venture investments?

Your advisory practice may be uniquely qualified, if you consider:

• (To begin by stating the obvious…) You are in the business of wealth preservation and wealth creation.  Without question, the primary source of family wealth in America is the result of private enterprise and private venture investments characterized by their potential for positive asymmetric outcomes.

• You embrace Modern Portfolio Theory.  Despite its flaws, MPT advocates diversification into non-correlated asset classes. One-off investments in private ventures are distinctly non-correlated to broader asset classes and major market indices and have exhibited less correlation during negative black swan events.

• You possess the proper due diligence skills.  In addition to those skills you also posess the doubting disposition that is critical in evaluating private investments. The skills that advisors have developed in the course of investment manager evaluation are relevant and applicable to the private equity universe. Moreover, your experiences have taught you to be cynical and skeptical of assumptions regarding future performance.

• You are an entrepreneur.  As an independent wealth manager have chosen to compete in a highly-competitive, low margin industry. Your personal experiences should render you more prone to recognize the prerequisite personality traits of a successful entrepreneur…de rigueur in the executive team due dilly process. You also recognize the mission-critical elements beyond the strengths of the management team that determine the probability of successful enterprise.

• You understand finance.  As a stock, sector and industry analyst you know your way around balance sheets, cash flow, valuation issues and income statements. I am frequently surprised at the number of professional private venture investors that have little understanding of business and finance.

• You possess both an awareness of regulatory issues and a fiduciary responsibility that is consistent with the best practices of seasoned angel investors and VCs.

• You are networked. Beyond your practice, you have access to an expansive network of tools, resources and expertise that are essential to evaluating new technologies, industry sectors, new business models, intellectual property and other elements of private investment. Your industry colleagues offer incomparable access to the analysts, research, legal and domain expertise that is required in the course of successful private investing.

• You have access to the critical resources.  As an independent wealth manager you have enviable access to the two most important resources of private investment….investor capital and deal flow. Your HNW clients most likely became HNW clients as a result of their own ventures in private investment. Serial entrepreneurs and HNW investors are an excellent ongoing source of deal flow.

Advisors that affirmatively identify which each of these traits may have the mandate and the means to expose their client’s portfolios to the asset class that has historically created the vast majority of our nation’s private wealth and can dramatically differentiate your practice from its peers.

More advisors should explore asset allocation beyond the lame limitations of highly-correlated asset classes, stale style boxes and pointless pie charts.

Album:    Playing the Angel, Depeche Mode, 2005