Analysis

SEC Rule Tweak A Partial Fix For Underrepresented Founders

Law360 (September 18, 2020, 5:55 PM EDT) -- Ramona Ortega, a former associate who left the legal world to found a millennial-centric personal finance education platform, knows off the top of her head how much funding her startup's competitors were able to raise.

"There are several platforms that are similar in nature to what we're doing and all of them have raised over $20 million," Ortega told Law360. "And they're all white boys."

But her company, My Money My Future Inc., which she launched in 2016, has received just under a million dollars from family and friends, angel investors and Backstage Capital — a venture capital firm focused on supporting companies founded by people from underrepresented groups — in the same amount of time.

Harold Hughes, the co-founder and CEO of consumer data management and analytics company Bandwagon, said he observed a similar discrepancy when his South Carolina-based business began raising money. Hughes said Bandwagon has secured just over $2.2 million since its September 2015 launch, whereas one of its white-owned competitors raised $12 million last year before even developing a product.

Ortega and Hughes aren't the only founders of color that feel they've had to clear more barriers to raise capital than their white counterparts.

On Aug. 26, the U.S. Securities and Exchange Commission said it took a step toward addressing that discrepancy when it expanded its nearly four-decade-old accredited investor definition — which governs who can invest in the private capital markets — to include individuals with certain professional accreditations. The change came after various members of the private investment community, including the SEC's Small Business Capital Formation Advisory Committee, said the policy has made it harder for women and entrepreneurs of color to raise capital.

But as the new definition moves closer to becoming effective, some investors, founders and regulators are questioning how beneficial it will really be.

In the United States, 22% of Black entrepreneurs, 15% of Latino entrepreneurs and 13% of Asian entrepreneurs said an inability to obtain capital hurt their company's profitability, compared to just 9% of white entrepreneurs, according to a 2019 report from the Ewing Marion Kauffman Foundation. The report also noted that Black-owned businesses start with about three times less capital — an average of $35,205 — than their white-owned counterparts.

The report was cited in an Aug. 4 presentation by the Small Business Capital Formation Advisory Committee, which was launched in 2016 to assess policy matters related to small businesses.

Experts who spoke with Law360 pinpointed two primary factors that have made raising money harder: venture capital and seed investors who are unwilling to take a chance on nonwhite entrepreneurs or products serving underrepresented communities; and a wealth gap that has left the majority of people of color without the means to invest.

The Importance of a Diverse Investor Base

Obi Omile Jr., who co-founded barber-booking app theCut with his high school best friend Kush Patel in 2016, said one of the major roadblocks they encountered when trying to attract venture capitalists was that the predominantly white older men they spoke with didn't understand how big the target market was.

"Many of the VCs we were talking to were older white guys, who might have gotten their hair cut once every couple months," Omile told Law360. "The idea that people were going to get their hair cut twice a month — even weekly — to them was wild, just unfathomable."

But Omile said the proliferation of pop culture references to barbershops — including the "Barbershop" movie trilogy, Los Angeles Lakers player LeBron James' barbershop-set talk show "The Shop" and barbershops appearing in Apple advertisements — proved there was a growing interest in men's grooming services even if investors didn't see it yet.

Omile added that his D.C.-based app now boasts 1.8 million users and 65,000 barbers around the country. Although theCut has secured $850,000 since it was created, he said most of the company's growth happened when it had roughly $350,000 in the bank.

Businesses targeting consumers of color would likely be able to receive more money if investors were more diverse, according to Mariah Lichtenstern, the founding partner and managing director of investment firm DiverseCity Ventures.

As Lichtenstern and other entrepreneurs have noted, it's apparent that people of color are underrepresented in the investor pool.

According to a June 2019 report published by the National Venture Capital Association and Deloitte & Touche LLP, 76% of investment professionals identified as white, 17% as Asian or Pacific Islander, 5% as Latino, and just 3% as Black. To compile the report, the NVCA and Deloitte surveyed 2,700 employees at 203 venture capital firms with a total of $149.4 billion in assets under management in 2018.

"There are a multitude of studies that show that investors tend to invest in people like themselves," Lichtenstern said. "Most investors don't have a network that would even allow them to recognize and be familiar with underrepresented founders and the problems and perspectives they have in solving them. So there needs to be representation among [general partners]."

The lack of diversity was one of the problems Lichtenstern outlined solutions for when she spearheaded the Tech Funding Equity project — which explores ways to close the early-stage funding gap — during her time as an Aspen Tech Policy Hub fellow earlier this year. The Silicon Valley hub arms technology entrepreneurs with the tools to consider policy issues affecting the industry, according to its website.

Lichtenstern's project advises that the industry could boost diversity among investors through a commitment called the Opportunity Pledge, which aims to increase funding to underrepresented fund managers and founders tenfold by 2025. As part of the pledge, venture capitalists and their limited partner investors would commit to using scout programs to increase diversity among their staff.

The pledge would also see venture capital firms support fund managers from underrepresented backgrounds in starting their own firms. Organizations that want to make the commitment can sign up through the project's website.

Lichtenstern's second suggestion to decrease capital barriers, however, takes aim at a concept deeply embedded in the SEC's regulations governing investments in private companies: the accredited investor definition.

An 'Unsatisfactory' Way to Assess Investors

Prior to the Aug. 26 expansion of the definition, when referring to individuals rather than entities, an accredited investor was primarily defined as someone whose annual income had surpassed $200,000 — or $300,000 if investing with a spouse — for two years prior to investing, according to the SEC's website.

The definition also required that the individual or married couple have a net worth of more than $1 million, not including the value of their primary residence. This wealth requirement has remained intact following the definition's expansion.

Although the criteria for an accredited investor were mentioned in the original Securities Act of 1933 that was created during the Great Depression, today's net worth and income requirements were set in 1982, according to the SEC's website.

The definition is important because private companies have fewer SEC requirements to satisfy if the majority of their investors are accredited, and there are fewer or no limits to how much money they can raise, according to the SEC's breakdown of private investments and share offerings.

These exempt private offerings, or sales of stakes in a company that don't need to be registered with the SEC, accounted for an estimated $1.6 trillion in funds raised between July 1, 2018, and June 30, 2019 — compared to roughly $1.25 trillion secured through public offerings, according to the Office of the Advocate for Small Business Capital Formation's annual report for fiscal year 2019.

And the vast majority of the private offering money — about $1.4 trillion — was raised through Rule 506(b) offerings. When a private company sells shares in its company through this kind of offering, only 35 nonaccredited investors can participate and the company is required to include more disclosure statements to warn investors about ways they could lose the money they invested, according to the SEC's website.

The investors and founders Law360 spoke with noted that meeting additional requirements often increases the cost of preparing for and completing an offering. So it's no surprise that between 2015 and 2018, nonaccredited investors only contributed to 6% of Rule 506(b) transactions, according to the report.

But just 13% of U.S. households qualified as accredited investors, the report noted.

Eversheds Sutherland partner Cynthia Krus said there are ongoing discussions among regulators and attorneys about whether income and net worth qualifications indicate whether someone has the ability to assess investment risks and benefits.

"That's part of the issue that it may have disproportionately impacted, for example, folks who may be starting up businesses, are people in less affluent areas or that don't necessarily have a network of folks who may be considered wealthy or affluent," Krus said. "There's no direct connection that somebody who makes a certain amount of money is going to be more sophisticated than somebody who makes a little bit less."

And that's where the SEC's expansion of the accredited investor criteria comes in.

The SEC said it has added a new category to the definition that "permits natural persons to qualify as accredited investors based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution," according to the announcement about the change. That means if an individual doesn't meet the wealth requirements, they could potentially still qualify as an accredited investor if they match the criteria outlined in at least one of the new categories.

Under the expansion, the SEC has already said individuals with the Financial Industry Regulatory Authority Inc.'s Licensed General Securities Representative, or Series 7; Licensed Investment Adviser Representative, or Series 65; and Licensed Private Securities Offerings Representative, or Series 82, certifications who are in good standing would qualify.

The SEC update also adds indigenous tribes, governmental bodies, funds, foreign entities and family offices to the list. And the term "spousal equivalent" has been added to allow other kinds of couples to pool resources to meet the net worth requirements.

The commission noted in the announcement that the definition's open-ended nature would allow the agency the flexibility to add more qualifying accreditations and credentials as it sees fit and as members of the public call for new additions. The updated policy will go into effect 60 days after it's posted on the Federal Register, a government website that publishes policy proposals and amendments.

SEC Chairman Jay Clayton said in the Aug. 26 announcement about the policy change that using wealth requirements to assess financial sophistication had long been "unsatisfactory" and disadvantaged those in lower income areas.

"There is no doubt persons who have successfully obtained these certifications — and maintained them in good standing — are sufficiently financially sophisticated to participate in the private markets," Clayton said in a statement posted on the SEC's website.

SEC Faces Criticism From Both Sides

Among the entrepreneurs to publicly comment on the policy change was Brandon Andrews, a D.C.-based senior consultant at social impact agency Values Partnerships who has been involved in casting for ABC's startup-focused reality show "Shark Tank." Andrews penned a letter to the SEC that emphasized entrepreneurs' thoughts on various proposed SEC policy changes — including the expansion of the accredited investor definition and changing crowdfunding investment limits — that he gathered through a series of Twitter conversations.

Andrews told Law360 he sent the letter so the SEC could see the opinions of the individuals who are directly affected by its investment policies.

The letter, which was also signed by Bandwagon's Hughes and theCut's Omile, was referenced by Clayton in his announcement.

"It's the first update in 35 years and so, I think by default, it's a step in the right direction," Andrews told Law360. "Does it go far enough? No, I don't think so personally."

Andrews told Law360 the accreditations that have been added should have been part of the definition all along, and their addition doesn't necessarily mean there will be an increase in investor diversity. He noted, for example, that FINRA doesn't reveal demographic information about its licensed members.

In response to criticisms that the expansion of the definition didn't go far enough, Martha Miller, the SEC's advocate for Small Business Capital Formation, said in a statement sent to Law360 that the team has been focused on identifying and addressing the challenges facing underrepresented founders and highlighting data regarding the issue in its annual report to the SEC and Congress.

"Changes to the accredited investor definition are just one piece of the capital formation ecosystem that the market identified as potentially improving outcomes for underrepresented founders and investors," Miller said. "We are committed to amplifying the voices of those with ideas of where changes could improve opportunities for entrepreneurs and investors seeking to bring their ideas to fruition."

While some have criticized the criteria expansion for not removing enough limitations, others fear the change will put more people at risk of making poor investments.

Chris Gerold, chief of the New Jersey Bureau of Securities and former president of the North American Securities Administrators Association, was among those who publicly criticized the SEC's decision to expand the definition when he still represented the NASAA, even though its regulators could eventually benefit from the expanded version.

Founded in 1919 — more than two decades before the SEC — the NASAA has historically been in favor of increasing the wealth requirements to adjust for inflation and limit the number of eligible investors, Gerold told Law360. The NASAA's 67 members are governmental regulatory bodies at the state, provincial and territorial level in 50 states, D.C., the U.S. Virgin Islands, Puerto Rico, Canada and Mexico, according to the organization's website.

"Income and wealth threshold are not perfect to measure an investor's level of sophistication and their ability to assess the risks, but they are the best way that we've seen in order to reduce investors' risk," Gerold said, noting that logic could be reassessed if the SEC started collecting more data on the private market and the dangers of investing in it.

In Clayton's announcement about the expansion, the SEC addressed calls to both increase and decrease the wealth requirement. Clayton reiterated that it's unclear if wealth and financial sophistication are correlated and said the question should be: "How do we improve the system we have to more closely track our mission?"

"We do just what we are doing: We add an alternative test that more accurately tracks the commission's policy goal — 'to identify investors that have sufficient financial sophistication to participate in investment opportunities' in the private capital markets," Clayton wrote. "We do not take the current unsatisfactory test and attempt to tweak it either (1) to exclude persons who currently are eligible or (2) to include additional persons based on a wealth test that many recognize does not, in itself, meaningfully track financial sophistication."

Other Ways to Bridge the Funding Gap

Other proposals the SEC has floated to reduce roadblocks to fundraising include lifting caps on regulation crowdfunding, or raising money from the public via SEC-registered online platforms. Many of the founders Law360 spoke with have turned to crowdfunding to sidestep the accredited investor definition and problems with attracting investors.

However, private businesses can only raise $1.07 million in a 12-month period through crowdfunding. The 2012 Jumpstart Our Business Startups, or JOBS, Act established the rules on crowdfunding, according to the SEC.

Serial entrepreneur Dawn Dickson was able to raise $2.3 million of the $3.3 million for her fifth venture, retail technology business PopCom, through crowdfunding alone. Dickson said she completed the second fundraise in just 47 days.

Although she lamented that the crowdfunding limit prevented her from raising even more capital in her oversubscribed rounds and signed Andrews' letter to the SEC protesting the cap, the Columbus, Ohio-based entrepreneur said she thinks that with increased exposure to investors, founders can gradually break down any biases that exist.

"I'm so exhausted with the narrative that we're struggling," Dickson said. "If you go out to be a founder, there are things that are our responsibility to do and going out there and being the face and the ambassador for my company — that's my job."

She suggested, too, that founders network as much as they can rather than rely on the SEC. 

"When people expect things to just come to them or think that there should be special provisions or contingencies for you because you're a woman or because they're a person of color, it's not realistic," Dickson said. "In theory, it sounds as nice as reparations does, but I think that's not going to happen and I think we just have to go out there and push forward."

Dickson also added that as an accredited and angel investor in the Backstage Capital investing firm, she has directly contributed to underrepresented entrepreneurs' businesses, though she said she prioritizes their profitability when cutting checks.

Bandwagon founder Hughes has also become an angel investor, contributing $150,000 overall to five businesses in the past two and a half years. Hughes said he's most excited about his investment in gluten-free, vegan, non-GMO cookie maker Partake Foods Inc., which was recently included in the music video for Pharrell Williams' "Entrepreneur" featuring Jay-Z.

"As people of color, as Black founders, we do have an opportunity to really be someone else's first 'yes' and invest earlier as our companies succeed," Hughes said. "It's really got to be a by-us kind of situation where we can only wait so long to find ways to navigate the system itself."

--Editing by Kelly Duncan and Alanna Weissman.

For a reprint of this article, please contact reprints@law360.com.

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