The Implications of AngelList and SEC Reg D Rule 506c - 1

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The Implications of AngelList and SEC Reg D Rule 506c - 1
Bill Bing is formerly the founder of Durham startup Loyalese and Square 1 Ventures and currently co-founder of DAS Communications.

You may have heard or read about the recent changes to Reg D 506c—the SEC's rules related to general solicitations for private offerings. Here's a link if you haven't.

If you don't want to read it or find the link confusing, here's the synopsis: private offerings can now be issued through general solicitations (including online), provided that reasonable steps are taken to ensure that all buyers (i.e. investors) are accredited.

To be accredited, investors must have a net worth of at least $1 million, or an annual income of at least $200K (or $300K jointly with a spouse).

I believe this change to Reg D is a huge development that will alter the landscape of early stage venture capital. The change enables companies to raise capital online through platforms like AngelList and WeFunder that are essentially marketplaces for early stage companies and accredited investors to connect. At face value this might not seem to be all that momentous, but here are three reasons why I believe that in time this will be a game changer.

Equal Footing

Historically, companies founded in areas other than San Francisco, Boston and New York have little if any leverage when it comes to dealing with angel investors (excluding perhaps the very few that are founded by repeat entrepreneurs with big exits on their resume).

Most investors outside of the markets listed above rightfully feel that there is no risk of losing out on the opportunity to invest in a regional deal due to competition from other investors. This also gives regional investors leverage in negotiating deal terms and with conduct in general, I can say from firsthand experience that angel investors who treat companies poorly do not suffer significant social repercussions in our region (the Triangle).

With the rise of AngelList and other online fundraising sites, companies that demonstrate traction and prove out the scalability of their revenue model can find and be found by investors who are focused on their space, but may not be in close geographic proximity. This means that a regional startup is no longer constrained to the pool of local angel investors, now any accredited investor anywhere could potentially invest in a business if the numbers look right.

Taken a step further, this means that regional investors must compete with national angels, and must conform to fair market value and best practices if they want to invest in top companies.

Of course it also means that regional startups are now competing with national companies for regional angel capital, but that's a trade-off most entrepreneurs in underserved markets will gladly take.

Filling out a round

A brief but important point; once a company finds a lead investor, attracting other investors is much easier (particularly if that lead is respected and influential).

In the past companies were unable to publicize that they had a big lead investor, and it wasn't easy to use that commitment to recruit other prospective investors. With AngelList and other similar sites, a big influential lead can literally share a link with her cohorts to let them know that she has invested in your company and that there's still room left for them to participate in the round.

Furthermore, other investors can follow her activity (similar to Twitter following) and receive notifications when she makes an investment.

This improved transparency is a major benefit to the company and can significantly accelerate the process of closing out a round with quality investors once a strong lead is on board.

New competition for seed and early stage VC funds

In the past, regional seed and early stage funds have been able to raise capital primarily because of their involvement in that region's entrepreneurial scene. The primary values they sell investors on are access to the best local entrepreneurs and companies, the ability to identify and assess these companies, and their ability to counsel and guide them as they grow. In return for this, funds typically charge investors a 2% management fee and 20% carried interest (basically an additional share in the fund's profits; google 'carried interest' for more details).

AngelList and other online fundraising sites reduce the value of a regional fund's awareness of and access to local companies, as companies are increasingly creating profiles on these public platforms and making themselves visible and accessible to any investor on the site. As a result, the primary value-add that remains for regional funds to sell investors on is their expertise in investment selection and company management.

Accredited investors looking to put, say, $250K into early stage venture capital suddenly have new options. Over the last couple of months, AngelList has added a feature they are calling syndicates. Credible high-profile investors like Kevin Rose from Google Ventures and Foundry Group out of Boulder, CO have created groups (syndicates) that other investors can join. The leads (like Mr. Rose and Foundry) make the investment decisions and negotiate terms with companies on behalf of the syndicate, and the follow-on investors in the syndicate get to participate in these deals with the same terms as the leads.

It gets even better—there are no management fees for joining a syndicate, and the carry is typically 0-15% compared to the traditional 20% most funds charge. Also, unlike a venture fund, syndicate members can leave a syndicate at any point and retain their existing investments if they decide to stop investing with that group. Finally, they can opt-out of investing in certain companies if they don't like a particular deal (not permitted in virtually all VC funds).

All of a sudden, the accredited investor's decision of where to invest $250K just got a lot more interesting. She can either put her money in a regional fund at 2% management fees and 20% carry, or she can join a syndicate on AngelList and invest alongside some of the most highly regarded investors in the industry (whose VC funds are likely oversubscribed and/or inaccessible to her by the way), for no management fees and with lower carried interest than the regional fund takes. It's fair to say that AngelList has a pretty compelling offering.

I suspect that many regional seed and early stage funds hate AngelList, or will soon if they don't already. I also predict that many of them will have to change their models if they want to survive beyond the new few years. That's a subject for another post however.

Not everyone will agree with or appreciate my opinion on the impact that the changes to Reg D 506c and AngelList will have for early stage companies and investors, but I hope we can all agree that it's an interesting and worthwhile subject to consider. I welcome a discussion on the subject and am curious to see what develops and how long it takes for changes to occur.