Intro to Angel Investing | Lecture #2 | Know The Rules & Regulations - Taught by Garry Johnson III
Learn the legal do's and don'ts when investing in startups...
Dear Students,
This course is a challenge to the status quo system in place that helps the rich get richer through laws that allow them to multiply their wealth, while those who are not wealthy have limited options to do the same with their own money. In this chapter, we’ll start breaking down the ways that you can invest like a venture capitalist, even if you don't have millions of dollars in assets under management.
It's incredibly important to understand the rules and regulations as we dive deeper into the various methods of investing in privately-held companies. A major key to remember is that all investments involve risk — meaning your investment could become worthless and you could potentially lose your money.
Watch Me Teach Lecture #2:
The U.S. Government gets very particular about how and where money flows within the economy, who gets to invest capital, what types of businesses individuals get to invest in, how much they can invest, and ultimately who gets to build wealth. More specifically, our government operates various agencies such as the Securities and Exchange Commission (SEC) to provide regulations that protect investors from fraud and other illegal investment activities.
Regulations exist to protect investors.
These regulations exist to protect investors from bad actors — individuals or companies creating fraud, manipulating financial markets, or simply failing to operate with the best interests of their investors. Unfortunately, some companies may defraud investors by taking their money and investing in things that are not a part of an agreed upon deal, or even investing in questionable or illegal assets. The SEC exists to ensure that companies and investors in various asset classes such as public stocks, private equity, and other securities are abiding by the rules.
Some of the most prominent laws governing the private markets today, such as The Securities Act of 1933, are nearly 100 years old. Although some may seem antiquated and overly restrictive, companies and investors alike that fail to abide by these regulations can potentially face legal ramifications including fines and jail time.
Our laws have created two classes;
Accredited Investors & Non-Accredited Investors.
Accredited Investors are not necessarily people who have passed a certain test, but they’re deemed to be “accredited” and financially sophisticated enough to invest their capital into privately-held companies such as startups since they’ve amassed some level of wealth to date.
There are specific ways that the SEC deems someone to be accredited:
“An individual will be considered an accredited investor if he or she:
earned income that exceeded $200,000 (or $300,000 together with a spouse or spousal equivalent) in each of the prior two years, and reasonably expects the same for the current year,
has a net worth over $1 million, either alone or together with a spouse or spousal equivalent (excluding the value of the person’s primary residence and any loans secured by the residence (up to the value of the residence)), OR
holds certain professional certifications, designations or credentials in good standing, including a Series 7, 65 or 82 license.
A spousal equivalent means a cohabitant occupying a relationship equivalent to that of a spouse.
If you are a non-accredited investor, then the limitation on how much you can invest depends on your net worth and annual income.”
Basically, an Accredited Investor is someone who makes over $200,000/year alone, makes more than $300,000/year with a spouse, or has a net worth of $1 million dollars or more. Pretty high bar, right? Now, there are ways to become an Accredited Investor even if you’re not individually wealthy, such as taking the Series 7, 65 or 82 exams. This method is typically done by financial advisors and professionals working in various investment firms, as they likely provide financial advice or manage other people’s money.
In the past, only Accredited Investors could invest in private companies — now anyone can.
Thanks to the Obama Administration, which signed the Jumpstart Our Business Startups (JOBS) Act into law, 2012 marked an historic shift in access to the private markets.
“This bill is a potential game changer. Right now, you can only turn to a limited group of investors -- to get funding…
Because of this bill, start-ups and small business will now have access to a big, new pool of potential investors -- namely, the American people.
For the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in.”
- President Barack Obama
The rules have changed to allow a new class of investors to benefit from wealth creation opportunities in the startup landscape. Prior to the JOBS Act, individuals who were not accredited could not legally invest in early-stage startups through the platforms that exist today.
Before this legislation, which wasn’t put into action until 2016, wealth generation from investments in private companies was reserved for those who
were already individually wealthy.
With the JOBS Act, this opened up a new opportunity for startup companies, the same types of businesses that raise money from traditional angel investors and venture capitalists, who could now fundraise through SEC-regulated platforms. These are basically websites that allowed for everyday people to invest into startups listed on an investment marketplace. These platforms are very similar to sites like GoFundMe where an individual can set up a campaign to raise money for a cause or some emergency need that they might have. In the same way, a startup or a small business can set up a campaign on an investment platform and raise money from everyday people. In some cases, you can make an investment for as little as $10, but in most cases, the minimum is at least $100. Needless to say, this was a gamechanger.
“While these asset classes make up a significant portion of a high net worth individual’s portfolio, access to these types of investments wasn’t available to the average individual due to regulations and the risks associated with private markets.”
On the startup side, there's a cap on how much a business can crowdfund within one year — with companies legally allowed to raise between $25,000 and $5 million on an investment platform. On the investor side, you can invest in these businesses, but the SEC has limits on the total amount of money that you’re allowed to invest in a given year. For most, that number is $2,500.
“If either your annual income or your net worth is less than $124,000, then during any 12-month period, you can invest up to the greater of either $2,500 or 5% of the greater of your annual income or net worth. If both your annual income and your net worth are equal to or more than $124,000, then during any 12-month period, you can invest up to 10% of annual income or net worth, whichever is greater, but not to exceed $124,000.”
So, the SEC has determined that they’ll allow you to invest in privately-held businesses, but they won’t allow you to invest more than they want you to.
In their eyes, Non-Accredited Investors are not financially sophisticated enough to bear the brunt of the risks involved with private investing — potentially losing their entire investment. Their reasoning is that they want to protect you, the investor, from making financial decisions that could have an adverse effect on your net worth.
So, the SEC has decided to "protect" investors by limiting the amount they can invest.
You could still go out and buy all the lottery tickets you want — the SEC does not care how many lottery tickets you buy.
The likelihood of that lottery ticket paying off for you is very low — it's extremely low, but there are no rules limiting the amount of lottery tickets you can buy.
Investing in startups is similar to playing the lottery, because startups are very risky — "As of March 2021, only 80% of startups survived after one year."
These are businesses that have a limited operating history — they haven't been around for very long. Oftentimes, they're still trying to figure out their business model and what's called their "product market fit."
Other reasons for failure include:
Losing market share to competitors.
Lacking skillsets required to scale.
Running out or money.
Knowing this, it might sound like a bad place to invest if most startups are going to fail, but venture capitalists know that there will be successes.
Venture capitalists don't invest in one company and expect it to increase their wealth — they're going make multiple bets by investing in a portfolio of startups. They spread their bets out on different startups, in different markets, with different entrepreneurs running them. In doing so, they're increasing the odds that one of the companies they invested in is not only going to create a return on their investment, but it's going to make up for all of the losses they will likely incur from investing in those other startups.
Now, the SEC knows that most people are not educated in startup investing, so they require investment platforms to also provide thorough educational materials. It's in the best interest of those platforms to offer those educational materials anyway because the platforms are only successful when startups successfully raise funding. In order to successfully raise funding, there needs to be a pool of investors educated on how to invest in those companies. With this in mind, investment platforms work hard to create educational materials for their user base to make informed decisions when investing in startups.
There are a wide variety of investment platforms you can use to find and invest in startups:
*Full disclosure; I’m an investor in this platform.
The rules, as they exist today, state that an individual can invest a maximum of $2,500 in one year — and that counts for all platforms they might use. The SEC puts the responsibility on the investor to ensure that they are not exceeding their investment limit, even if they're investing in 10 startups on one platform (ie. Wefunder) and 20 startups on another (ie. Republic). The reality is that when you go on these investment platforms, you are self-certifying that you are managing your own investment limit across all platforms that you might be using. That’s why it’s important to know the rules.
As an example, if you’re Non-Accredited and invest $2,000 in a startup raising on the Wefunder platform, then you go to Republic and invest $1,000 in another startup, you'd be $500 over your SEC limit. But remember, the platforms don't speak to one another, so you’d technically be able confirm both investments. Each site will, however, have you self-certify that you're maintaining your investment limit across platforms. Now, if you went on one platform and tried to invest $3,000 without proving you’re an Accredited Investor, the platform would not allow you to finalize your investment in that particular campaign.
It's not clear what the penalties are for investing more money than the SEC sets forth, but you likely want to avoid finding out.