General solicitation and the mistakes investors make

By Rodney Loo , written on December 14, 2012

From The News Desk

What if startup businesses were allowed to place advertisements on television or radio asking for investors? For a long time it was assumed by many in the financial industry that if companies pursued these tactics, they would potentially subject themselves, and their possible investors, to fraud. That’s why “general solicitation,” as the Security and Exchange Commission (SEC) calls it, has been illegal. Now the federal government wants to overturn the solicitation ban, but some concerns about it remain.

Startups are only allowed to seek out “accredited investors,” investors who meet certain financial guidelines set by SEC Rule 501a of Regulation D. Accredited investors may be banks, brokers or corporations. They may also be people with net-worths higher than $1 million and salaries above $200,000.

General solicitation was banned in part because of its potential to saddle companies with those posing as accredited investors. General solicitation was also used by conmen to draw investors to fake start-up businesses. As such, startups have had to seek out investors through other financial channels, like financial advisors and angel investor groups.

Unfortunately, the old rules regarding general solicitation have made it difficult for many startups, especially companies located away from investment hotspots like Silicon Valley, to find competent financial backers. In the Great Recession, it has become even harder for startups to attract accredited investors. That’s why President Obama and Congress want to overturn the ban on general solicitation. The president and Congress have already approved a law, the Jumpstart Our Business Startups (JOBS) Act, to reverse the ban. It’s now up to the SEC to create the proper rules for reversing the ban – although they've been draggin their feet.

The SEC has proposed letting start-ups use general solicitation to sell their securities if they take “reasonable steps to verify that the purchasers of the securities are accredited investors,” according to The SEC does not suggest ways for companies to verify accredited investors. If the SEC’s proposed rules were to pass, its lack of verification guidelines could still make it possible for companies to misidentify potential investors.

Even if the SEC added strong new verification rules to its proposal, there are still problems that could arise from general solicitation. When wealthy individuals want to lend to companies, they tend to consult with financial advisors or experts. They are normally well-connected people who know the best venture capital companies to get involved with and the best angel investors to talk to. With general solicitation, companies may attract new capitalists who have never invested in startups before and who don’t know the ropes.  People who aren’t multi-millionaires could start to consider themselves worthy investors.

Take for an example, an older couple that has just retired. These investors may not be well informed on startup investing. They may have a net-worth over $1 million in investable assets, excluding their house. But while startup investing may offer long-term growth returns, it's not without risk of principal loss, illiquidity, and an absence of steady income – something most retirees need. These people, though wealthy by most standards, should probably not invest. If this couple were to see a compelling ad for a startup and invest in it without knowing the proper questions to ask, they could lose a substantial portion of their money. Much of these suitability concerns exist today with accredited seniors, however a change in general solicitation regulations only stands to broaden the scope of the issue.

Regardless of age, potential investors need to fully understand the nuances of investing in startups, which is very different from simply investing in public equities. Understanding the illiquidity of these investments and asking the right questions is essential. What is the cash burn rate of the start-up? When does the start-up expect to be cash flow positive? How is the company currently being valued? What is the target exit strategy of the company, and over what time horizon? These are the types of questions new investors don’t tend to ask.

Now, the new rules may be beneficial to some new investors. There are a whole host of new multi-millionaires out there that are looking to expand their net worth. The San Francisco Bay Area in particular, is filled with new millionaires who are young and have long-term investment horizons, who are more familiar with the start-up process, and who have steady incomes to fund their lifestyles in the face of any losses or potential future capital calls. Their liquidity needs are different at this stage of life.

These individuals may be more likely to take chances on startup companies that they have been made aware of by general solicitation. They may not be as risk averse as an older couple and could potentially afford the risk for substantial return. But obviously, each situation is unique.

In the end, changes to the general solicitation regulations would force a entirely new category of the investing public to confront the challenges of evaluating startup investments. Given the superficial appeal of the category and the meager success rates even the most sophisticated venture capital investors achieve this looks to be a disaster waiting to happen. The merits of increasing capital accessibility for companies just don't outweigh potential negative consequences.

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