#5 Episode: Accredited Laws of Inclusion
Regulatory Changes & Social Norms are Expanding the LP Base in Venture Capital
Key Takeaways: (1) knowledgeable employees now qualify as accredited investors to their venture fund, (2) these employees are exempt from the 100 LP limitation, and (3) sign up below to add a Diversity Rider to your term sheets to diversify cap tables.
Last week, two regulatory changes at the SEC got a lot of people’s attention:
Accredited Investor—expanding who qualifies based on credentials & job titles
DPO plus—allowing capital raises alongside a direct public offering
Even Serena Williams paused from competition at the U.S. Open to tweet about it:
Both changes will increase access to capital. But that’s not the exciting part. People will now be eligible to invest not based on their income or net worth, but on their knowledge and skills. While not much has actually changed, the Securities and Exchange Commission (SEC) is taking small steps in the right direction.
Rules on Accredited Investors
Accredited investor—means owning $1 million in net assets, not counting primary residence, or at least $200,000 in annual income ($300,000 with a spouse).
Most startups and all venture funds only permit accredited investors.
An overwhelming majority of founders and investors believe that the definition of accredited investor is too exclusionary and doesn’t make any sense:
On August 26th, by a narrow vote of 3-2, the SEC agreed in principle—expanding the definition of accredited investor to include a few new categories:
As a VC herself, Serena was most excited about this particular change:
Forces Against Change
But not everyone was stoked.
A parody account on Twitter summed up what the opposition was thinking:
The definition of accredited investor is at the core of the SEC’s mission: “(1) to protect investors, (2) to maintain fair, orderly, and efficient markets, and (3) to facilitate capital formation.”
The two SEC commissioners that dissented against the change had three main gripes:
Failure to Keep Pace: The laws haven’t changed since 1982, so the available pool of accredited investors jumped from 1.3 million in 1983 to 16 million in 2019.
Seniors Most Vulnerable: Failure to index to inflation allows more people to be exposed to the risks of fraud, which impacts senior citizens the most.
Lack of Transparency: Private offerings are less transparent and illiquid, which makes them harder to track or police for bad behavior.
Can Non-Accredited Investors Get Jail Time?
Bryce Roberts (@bryce), Managing Director of Indie.vc, raised a great related question:
In response to @bryce, Scott Kupor (@skupor), Managing Director of a16z and author of Secrets of Sand Hill Road, gave the best answer:
Securities laws are meant to protect retail investors, not the startups or funds. Liability flows to the issuer who relies on the law. The SEC only has civil authority, so criminal prosecutions of investors aren't likely to happen. Plus, what matters is not if the investor is, in fact, an accredited investor, but if the startup or fund took proper steps to verify the suitability of the investor under applicable law (usually Rule 506(b), but if advertising, then 506(c).)
VC is largely a self-regulated industry. Most insiders follow the rule of law regardless of personal feelings because doing so means risk mitigation and, ultimately, self-preservation.
Impact on Venture Capital Funds
🔥 For emerging fund managers, the biggest impact you need to know is that (1) knowledgeable employees of your venture fund now qualify as accredited investors, and (2) these employees will be exempt from the 100 investor limitation under Section 3(c)(1) of the Investment Company Act. 🔥
“Knowledgeable Employees” include:
GPs, equity partners and other executives (VPs), and
Members of a team who “participate in the investment activities” for at least 12 months—not administrative or clerical in nature.
Group #2 includes venture partners, principals, associates & analysts—who otherwise would not qualify as accredited investors. Importantly, these individuals will not count against the 100 person limitation under Section 3(c)(1) of the Investment Company Act.
This might sound obvious but this exemption only applies to employees investing in their own fund. It doesn’t allow non-accredited investors to invest in startups directly or in other funds. That’s still not allowed.
Note: Knowledgeable employees have long been able to invest in private funds, but they needed to separately qualify as accredited investors otherwise they would count against the 100 LP roster. This rule change closes that gap. For more information, click here (see also Rule 3C-5).
The floodgates are now open for lawyers, accountants, CFAs, MBAs, etc. to argue professionals don’t need the SEC’s protection. Ironically, most of the SEC’s watchdogs don’t even qualify as accredited investors.
Going Beyond the SEC: Culture
As the SEC was busy expanding who can lawfully invest in startups and venture capital funds, some VCs were busy expanding access to a broader group of diverse investors.
Alejandro Guerrero (@alexgman12), an emerging fund manager at Act One Ventures in Los Angeles, spearheaded a new diversity program last week:
1. Diversity Rider Clause
The “diversity rider” is a clause that anyone can add to diversify a startup’s term sheet:
Diversity Rider: In order to advance diversity efforts in the venture capital industry, the Company and the lead investor, [Fund Name], will make commercial best efforts to offer and make every attempt to include as a co-investor in the financing at least one Black [or other underrepresented group including, but not limited to LatinX, women, LGBTQ+] check writer (DCWs), and to allocate a minimum of [X]% or [X] $’s of the total round for such co-investor.
2. Demographics of VC
In short, the rider is about opening up access to capital for diverse check writers. It is a starting point for a discussion between startups & their investors about the persistent lack of diversity on startup cap tables. Several studies, including one study by Harvard Business School, found the diversity of venture capitalist GPs woefully lacking in the venture capital industry. As of 2018, the studies found 81% of VCs don’t have a single Black investor; less than 1% of VCs are Latinx; 82% male:
Alejandro had this to share with me about the Diversity Rider and the program:
“This is a step in the right direction where we are helping to encourage more active discussions around diversity. There has been an emphasis on having diverse teams in executive leadership and startup boards. This program extends those efforts by adding diversity on the cap table where generational wealth can be created. The Diversity Rider is meant to be easily embedded as boilerplate language to term sheets, then adjusted as needed, in order to have the greatest impact. Now, more than ever, we need to work together as an industry to create more access and build a better future.”
4. Why It Works
There are four reasons why this program seems to be getting legs:
First, it’s simple. Everyone can participate and it doesn’t need to be an equity financing. Just copy the Diversity Rider above and slap it into your term sheet. VC fund managers can sign up by adding themselves to an Airtable database. Adding your commitment will help provide a public signal to the program.
Second, the program has buy-in from institutional players. Ten venture capital firms initially signed up—Act One Ventures, Equal Ventures, Fifth Wall, First Round Capital, Greycroft, Harlem Capital Partners, Maveron, Plexo Capital, Precursor Ventures, and SVB Capital. Alejandro mentioned the list is quickly growing and has already doubled in less than a week.
Third, it’s a decentralized, bottom-up approach. Many diversity initiatives are top-down, requiring enforcement. Instead, participants in this program have the most riding on the outcome. For example, 70% of Act One’s portfolio companies are founded by people of color, LGBTQ+, or women. Importantly, the program is leveraging change where it has real impact: On startup cap tables.
Finally, the program is aimed at carrots, not sticks. No legally binding promises are made and the standard is “commercially reasonable efforts” to include at least one check-writer from an underrepresented group as a co-investor or follow-on investor. Diverse check writers can gain access to the program by clicking here.
5. Final Thoughts
No one expects the venture capital industry to change overnight. And while it’s understandable to have some doubt whether any meaningful change can happen, having personally met Alejandro and knowing his character—along with the program’s institutional backing and the cultural zeitgeist—this is more than just another diversity initiative.
Lo Toney (@lo_toney), a GP at Plexo Capital, has long been an advocate for this kind of change. Lo also had this to share with me about the program:
“I am excited that Plexo Capital, along with many other amazing firms, is part of the Diversity Rider program. This falls in line with anecdotes we are seeing in the market with regard to a desire and outreach by entrepreneurs to add diversity to their cap tables.” —Lo Toney, Plexo Capital
As @prayingforexits wrote on Instagram Stories:
SHOUT OUT TO EVERYONE WHO WERE DIVERSIFYING CAP TABLES BEFORE IT WAS COOL
Serena, Alejandro and Lo definitely cared about these issues long before it was cool. But now everyone can commit to diversity and join forces with the links below.
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