September 2014
Practice Group(s):
Emerging Growth and
Venture Capital
Public Policy and
Law
Global Government
Solutions
Angels in Limbo: Congress and SEC Consider
Regulatory Changes with Potential for Profound
Effects on Start-Up Investments
United States Emerging Growth and Venture Capital and Public Policy and Law Alert
By Gary J. Kocher, Eric D. Jay, Tim L. Peckinpaugh, Andrés Gil
Three events occurred during 2013 that have the potential to significantly affect angel
investment around the country: (1) the Securities and Exchange Commission (“SEC”) lifted
the prohibition on general solicitation for exempt offerings under certain circumstances; (2)
the definition of “accredited investor” was put up for debate; and (3) at the end of the year,
the 100% capital gains tax exemption for investments in qualified small businesses expired.
This Alert provides a brief summary of the background of these events and an update on
recent initiatives that relate to or address their consequences.
The events of 2013
On July 10, 2013, the SEC adopted new rules to eliminate the prohibition against general
solicitation and general advertising in certain securities offerings under Rule 506(c) of
Regulation D and Rule 144A under the Securities Act of 1933, as amended, as mandated by
the Jumpstart Our Business Startups Act (the “JOBS Act”) (see this Alert discussing
adoption of the JOBS Act). These new rules provide significant opportunities for start-ups
and other private issuers to expand the scope of marketing activities in connection with
private placements under Regulation D. However, with these expanded opportunities, the
SEC increased the level of diligence that issuers must undertake to verify the status of
purchasers as “accredited investors” within the meaning of Rule 501 (see Reasonable Steps
to Verify Alert for more detail on these requirements). These new obligations have raised
privacy and compliance concerns among issuers and investors, which, in turn, have led to an
unintended consequence of chilling investment activity in the angel investor community.
Contemporaneous with adopting these new rules, the SEC also issued a request for
comments on whether to amend the current definition of “accredited investor” as it relates to
natural persons. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
included two important mandates regarding the definition: (1) the Government Accountability
Office (“GAO”) was required to conduct a study regarding the appropriate criteria for
determining the financial thresholds for qualifying as an accredited investor, and (2) the SEC
is required to undertake a review of the accredited investor definition every four years. The
SEC is still in the process of taking comments on the issue and reviewing the results of the
GAO study. In its request for comments, the SEC indicated that it will be looking at whether
both net worth and annual income should continue to be used as the primary metrics for
determining accredited investor status, and, if so, whether those metrics should be increased
Angels in Limbo: Congress and SEC Consider Regulatory Changes with
Potential for Profound Effects on Start-Up Investments
and indexed to inflation. Any significant change or increase to the thresholds could
significantly limit the number of people who are able to qualify under the definition.
Lastly, at the end of 2013, the 100% exclusion from capital gains tax for investments in
qualified small businesses expired. Prior to 2010, investments in qualified small businesses
were eligible for a 50% capital gain exclusion (but a higher marginal rate applied to the nonexcluded portion of the gain, so there was little practical benefit based on current tax rates).
The 50% exclusion was increased to 100% in 2010, provided that all the conditions are
satisfied (including holding the investment for more than five years) (see Alert summarizing
the requirements). Congress subsequently extended the 100% exclusion in each successive
year through 2013. It is not clear whether the 100% exclusion will be extended once again,
and if it is, whether the extension will apply retroactively to investments currently being
made. If it is not, investors will lose a significant incentive to invest capital in start-up
businesses (but there is a proposed new tax incentive for angel investors in the form of a
direct tax credit that is discussed below).
The HALOS Act
On June 19, 2014, Representatives Brad Schneider (D-IL), and Steve Chabot (R-OH), and
Senators Chris Murphy (D-CT), John Thune (R-SD), Pat Toomey (R-PA), and Brian Schatz
(D-HI) introduced a bill entitled the Helping Angels Lead our Startups (“HALOS”) Act in the
House and Senate, which would alter the new rules permitting general solicitation in
connection with “demo days” and similar corporate showcase events. Co-sponsor Rep.
Chabot said, “The last thing we should do is place new roadblocks in the way of investors
looking to provide much-needed capital to startups. Unfortunately, that is exactly what new
rules from the SEC would do. The HALOS Act is a bipartisan, bicameral effort to clarify these
rules and preserve important forums like ‘demo days,’ so that our startup community can
continue to showcase their ideas to key investors.”
Specifically, the HALOS Act provides that the definition of general solicitation under Rule
506(c) would not apply to a presentation, communication, or event:
 Sponsored by federal, state, or local government; a college or university; non-profit;
established angel group; venture forum, venture capital association or trade association;
or any other group approved by the SEC;
 Whose advertising does not make any specific investment offerings;
 Whose sponsor does not make investment recommendations, provide investment advice
to attendees, engage in investment negotiations, or charge any entrance fees other than
what covers the cost of the administrative cost of the event; and
 Where no specific information regarding investments is communicated by the issuer other
than that they are offering securities, the type and amount of securities being offered, the
amount of securities still available, and the intended use of the proceeds.
Angel Tax Credit Act
On June 24, 2014, Sens. Murphy (D-Conn.) and Schatz (D-Hawaii), and Reps. Chabot (ROhio) and Patrick Murphy (D-Fl.) introduced the Angel Tax Credit Act, a bill that would
amend the Internal Revenue Code to provide a 25% tax credit for qualified equity
2
Angels in Limbo: Congress and SEC Consider Regulatory Changes with
Potential for Profound Effects on Start-Up Investments
investments of $25,000 or more in domestic corporations and partnerships. In a press
release for the new bill, its sponsors explained that the tax credit is modeled after similar
state tax credit initiatives that have seen success in recent years.
Specifically, the tax credit would apply to any investment of $25,000 or more in a domestic
corporation or partnership that: (1) has its headquarters in the United States, (2) has gross
revenues for the taxable year of less than $1 million, (3) employs fewer than 25 full-time
employees, (4) has been in existence for fewer than seven years as of the date of the
investment, (5) has more than 50% of its employees performing substantially all of their
services in the United States, and (6) is engaged in a high-technology trade or business. The
tax credit would be limited to $250,000 for each individual investor in any one taxable year
and to an aggregate of $500 million for the program overall in each calendar year.
Accredited Investor Criteria
The results of the GAO study on alternative criteria for qualifying as an accredited investor
were released on July 18, 2013. In the study, the GAO compared the current criteria of net
worth ($1 million) and annual income ($200,000) to alternatives previously proposed by the
SEC, industry groups, and foreign regulatory regimes. In order to fulfill the intended purpose
of the accredited investor standard (“to protect investors by allowing only those who can
withstand financial losses access to unregistered securities offerings”), the GAO concluded
that the two most useful criteria are minimum net worth and minimum dollar amount of liquid
investments. The GAO also indicated that an investor’s use of a registered investment
advisor might also be able to balance the goals of “investor protection and capital formation”
effectively in certain circumstances.
The GAO study provides a roadmap of other proposals the SEC is considering based on
public comments, as well as their likely consequences. An inflation-based adjustment to the
net worth income criteria would increase the threshold from $1 million to approximately $2.5
million (a corresponding increase to the annual income requirement would increase that
threshold from $200,000 to approximately $450,000), and the number of households that
qualify as accredited would decrease from approximately 8.5 million to around 3.7 million.
Based on a survey by the Angel Capital Association, more than 25 percent of its 12,000-plus
members would lose accredited investor status if net worth and income thresholds were
raised based on these guidelines. Outside of the major tech start-up centers in California,
Massachusetts, and New York, that number increases to a full third of members.
Alternative “qualitative criteria” would have less certain results. A liquid investment criteria
(defined by the GAO as a minimum dollar amount of investments in marketable assets that
can be easily sold and the value of which can be verified) may actually increase the total
number of accredited investors, but individual investors would be affected differently based
on their investment portfolio. Similarly, a requirement that investors use a registered
investment advisor or pass a knowledge-based metric on understanding financial risk criteria
would each have uncertain effects on accredited investor status.
The SEC has a meeting scheduled on October 9, 2014, to hear a proposal from the
Investment Advisory Committee that was established to evaluate this issue and make
recommendations to the SEC. We will provide an update to this Alert following the meeting.
3
Angels in Limbo: Congress and SEC Consider Regulatory Changes with
Potential for Profound Effects on Start-Up Investments
What’s next for Congress?
As of the date of this Alert, Congress is currently out of session and is not scheduled to
return until after midterm elections in November, where they will enter a “lame duck” period
of addressing certain urgent items before the new Congress is convened in January. Those
urgent items include issues such as funding the government through appropriations bills, and
the agenda does not necessarily extend to items like the Angel Tax Credit Act or the HALOS
Act. As a result, there is a significant possibility that those bills will need to be reintroduced
in the next Congress, most likely by their current sponsors and any additional sponsors they
can muster in the next term. Several sponsors of these bills are facing tough elections this
year and may not return after the elections. This possibility presents an opportunity for
advocacy for the next several months and into the new Congress—both to have the bills
enacted or introduced and as a messaging tool to the SEC.
Those wishing to provide input to their elected representatives and the SEC on these issues
can visit the Angel Capital Association’s (“ACA”) website. The ACA materials include
sample letters that can be sent to elected representatives to let them know your opinions on
these topics.
For additional information on these topics, feel free to contact the authors or any of the
attorneys in the Firm’s Emerging Growth and Venture Capital or Public Policy practice
groups.
*********************
Circular 230 Notice: To ensure compliance with requirements imposed by the IRS, we
inform you that any U.S. federal tax advice contained in this communication is not intended
or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the
Internal Revenue Code of 1986, as amended or (ii) promoting, marketing or recommending
to another party any transaction or matter addressed within.
Authors:
Gary J. Kocher
gary.kocher@klgates.com
+1. 206.370.7809
Eric D. Jay
eric.jay@klgates.com
+1. 206.370.8032
Tim L. Peckinpaugh
tim.peckinpaugh@klgates.com
+1. 202.661.6265
Andrés Gil
andres.gil@klgates.com
+1. 202.778.9226
4
Angels in Limbo: Congress and SEC Consider Regulatory Changes with
Potential for Profound Effects on Start-Up Investments
Anchorage Austin Beijing Berlin Boston Brisbane Brussels Charleston Charlotte Chicago Dallas Doha Dubai Fort Worth Frankfurt
Harrisburg Hong Kong Houston London Los Angeles Melbourne Miami Milan Moscow Newark New York Orange County Palo Alto Paris
Perth Pittsburgh Portland Raleigh Research Triangle Park San Francisco São Paulo Seattle Seoul Shanghai Singapore Spokane
Sydney Taipei Tokyo Warsaw Washington, D.C. Wilmington
K&L Gates comprises more than 2,000 lawyers globally who practice in fully integrated offices located on five
continents. The firm represents leading multinational corporations, growth and middle-market companies, capital
markets participants and entrepreneurs in every major industry group as well as public sector entities, educational
institutions, philanthropic organizations and individuals. For more information about K&L Gates or its locations,
practices and registrations, visit www.klgates.com.
This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in
regard to any particular facts or circumstances without first consulting a lawyer.
© 2014 K&L Gates LLP. All Rights Reserved.
5