Skip to content

Public policy: Protecting investors

Venture south fallback
Venture South Team
Last updated: June 3, 2024
Open book

Do investors need “protecting” from making angel investments? You might have followed the debates about opening or restricting access to startups – congressional ideas of expanding access, like the HB2799 that we discussed at Venture In The South earlier this year, conflicting with the continuing debate between the SEC commissioners to raise (or not) the threshold of wealth/income to be an “accredited investor.” Today’s paper Is There a Trade-off Between Protecting Investors and Promoting Entrepreneurial Activity? Evidence From Angel Financing byJiajie Xu, an excerpt from a dissertation from the University of Iowa. Available here (and here too).

This paper looks at the impact of the change in 2011 to the definition of accredited investor, where the SEC removed the value of a primary residence from the wealth definition. This sounds like an innocuous and minor change to the rules governing who can invest in startups.

Well, this apparently-innocuous change had a significant impact! Removing home equity possibly removed over 20% of previously-eligible households (p.3), because a significant proportion of household wealth for single-digit millionaires would be their home’s equity. 

Even more dramatically, the rule change had a clear, material impact on angel funding, and a whole cascade of downstream impacts.  It “had a significantly negative impact on local angel financing” (p.3), with a decrease in angel funding as “marginal angel investors” had to leave the market; fewer follow-on rounds; fewer exits (p.4); fewer patents, reduced revenue, and fewer jobs; greater borrowing from SBA loans and more entrepreneurs taking out second mortgages. A whole litany of costs on entrepreneurs and society that significantly exceeded the benefit (from estimated lost investments avoided) to the supposedly-protected investors. Yikes!

How did the paper reach those conclusions? The paper looked at the ratio of home value (from Zillow) to individual net worth (from SIPP and IRS data) to create a “HV/NW ratio” for each city. The higher the ratio, the more impact the rule would have, as a higher proportion of high-net-worth people would be removed from the market. It looked at the differential impact in subsequent activity in several different areas, and whether the impacts were worse in areas with higher HV/NW ratios. The results were dramatic (and statistically-significant).

How plausible is this? As always, we can complain about the data – Crunchbase, Form Ds, etc., give incomplete and sometimes entirely wrong information. We could object to some of the concepts and assumptions, in particular that as accreditation by income was unchanged it’s not obvious that just changing the wealth calculation would have impacted angels (who also generally self-certify, so may not have read the rules or necessarily followed them truthfully). And we always question if “ability to raise a next round” (p.28) is very illustrative. (And we’ll leave for you to opine on the benefits and concerns of difference-in-difference analyses more generally.)

Particularly powerful for us, as investors in “local markets” was that the negative impact was particularly acute outside of the traditional hubs of San Francisco , NY, and Boston (p.26). It’s also pleasing (while also being upsetting) that removing the “marginal” angels did not just prevent “marginal” companies being funded, as the impact on jobs, sales, etc., were significant, indicating high quality companies were hurt too. Local market angels do invest in good companies (when they’re allowed to!).

Overall, the paper is disturbingly effective in showing the impact of one small regulation change – a net negative of (at best) $6.32 billion (p.41) (though with major caveats about second-order effects here). 

If this is repeated with new innocuous rule changes, or potentially some dramatic changes like indexing accreditation to inflation, there could be big negative impacts on early stage funding as angels are removed from the market. All the work going on to increase entrepreneurship could be undercut in one easy rule change.

As always, we like to pick out a nugget or two of information or ideas. In this pager we learned (well, confirmed) 60% of 8,832 angel investments in the U.S. have a distance of fewer than 100 miles between the angel and the funded company. I would actually have guessed a bit more.