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When Less Is More for Investors

Sunday, April 18, 2010

How the financial regulation bill under debate in the Senate would harm informal investors.

When entrepreneurs raise money from investors, the government permits them to disclose less information to potential investors if the latter qualify as “accredited investors.” While the requirements to be one of these investors are different for institutions, individuals are “accredited investors” if they have a high income or net worth.

The financial reform bill under debate in the Senate would increase the financial requirements for accredited investors to a net worth of $2.25 million and an income of $449,000 for single investors ($674,000 for married ones). The government’s theory is that by reducing the number of accredited investors (who can make investments with less information disclosed to them), more information will be disclosed to potential investors, preventing them from investing in fraudulent or poor business opportunities.

While this theory might sound good, increasing the financial requirements to qualify as an accredited investor would actually increase the risk that informal investors would lose money in their investments in young, private companies.

While this theory might sound good, increasing the financial requirements to be an accredited investor would actually increase the risk that informal investors would lose investment money in young, private companies. As I have argued elsewhere, if the government really wants to protect informal investors, it should reduce the financial requirements to be an accredited investor and encourage informal investors to invest as part of a group.

The term “informal investment” refers to the money that friends, family, and business angels put into private companies someone else runs. These are risky investments. The companies that receive them are typically young and small, without a performance track record. And, unlike public equities, these companies have no analysts providing information on them to investors.

According to estimates from the most recent Global Entrepreneurship Monitor (GEM) report, approximately 7.7 million Americans between the ages of 18 and 64 invested informally in the last three years. Only 13.4 percent of these informal investors are accredited investors, while 86.6 percent are unaccredited, according to analysis by Paul Reynolds of a 2004 survey of American adults.

Start-ups that have the potential to go public or get acquired by public companies prefer to obtain financing from accredited investors rather than from unaccredited ones.

By increasing the financial requirements to be an accredited investor, the government would move some informal investors from the accredited to the unaccredited category. That shift will expose the investors to greater risk of loss on their informal investments.

One reason is the lesser access that unaccredited investors have to informal investments that offer the potential for high returns. Start-ups that have the potential to go public or get acquired by public companies prefer to obtain financing from accredited investors rather than from unaccredited ones. As long as these companies might need to tap venture capitalists or other institutional investors for future capital, they will seek their initial capital from those sources that facilitate subsequent venture capital financing.

Venture capitalists prefer to finance businesses previously backed by accredited investors because they typically buy shares in the companies under Regulation D of the Securities Act of 1933, which provides the company an exemption from registration and reduces the amount of information the company needs to disclose if the investors are all accredited. Because many high-potential start-ups limit their initial fund-raising efforts to accredited investors to preserve the option of obtaining venture capital, government efforts to exclude people from accredited investor status will force those investors to put their money in lesser potential ventures, imposing greater risk of financial loss on them.

Government efforts to exclude people from accredited investor status will force those investors to put their money in lesser potential ventures, imposing greater risk of financial loss on them.

Moreover, unaccredited investors are generally excluded from informal investor groups because groups composed solely of accredited investors are exempt from disclosure requirements. Raising requirements to be accredited will bar some informal investors from participating in these groups, exposing them to greater risk of financial loss. Unscrupulous entrepreneurs favor individual investors over groups because groups can conduct greater due diligence and thus have a higher chance of identifying fraudulent business opportunities. Group investors can also draw on a wider range of expertise in evaluating entrepreneurs and business opportunities, making it easier for them to separate fraudulent or poor quality opportunities from high quality ones.

Ironically, by lowering the financial requirements to be an accredited investor, the government would provide greater protection for informal investors. These investors would have greater access to high-potential business opportunities and could make more diversified investments with greater due diligence as part of an investment group. Moreover, entry into investment groups would provide these investors with access to more sophisticated investors from whom they can learn to make better investments.

In short, the benefit of greater information disclosure that comes from limiting the number of people who are exempt from such disclosure is much less than the cost of lacking access to high-potential ventures and the lesser ability to conduct due diligence and diversify investments that come from being part of informal investment groups. Imposing high financial requirements to be an accredited investor won’t keep unaccredited investors from making the lion’s share of informal investments in this country; it will just makes it more difficult for informal investors to make good investments.

Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University. The author recently released a book from Oxford University Press: Born Entrepreneurs, Born Leaders: How Your Genes Affect Your Work Life.

FURTHER READING: Shane has also written “Give Me Your Tired, Your Poor, Your Entrepreneurs,” “The Genetics of Job Choice,” and “From Start-up to Stop: The Recession and Entrepreneurship.” The American Enterprise Institute’s Alan Viard and Amy Roden discuss “Big Business: The Other Engine of Economic Growth,” and Alex Pollock lectured on “Protecting Consumers in the Financial Marketplace.”

Image by Rob Green/Bergman Group.

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