THE BLOG
06/06/2010 05:12 am ET | Updated May 25, 2011

Nanny Sam to the Rescue: Stop the Startups!

One of George Bush's most memorable lines was his complaint that the French had no word for "entrepreneur". Well, if Senator Dodd's new financial reform bill becomes law, we may well have the word, but no longer any need for it.

Dodd's changes would disqualify about 75% of the individuals who currently fund our country's early-stage ventures from making further investments. It would also impose brand new SEC filing requirements and long waiting periods on fledgling businesses before they can accept what is often desperately needed capital. If the idea is to strangle American innovation in its crib, the bill is a masterstroke.

"The Dodd legislation will have a devastating effect on America's entrepreneurial economy", says David S. Rose, one of the country's most active early-stage investors, who has founded or funded over 75 startups during the past decade. "Every entrepreneur and angel investor I know is in a state of absolute shock over the 'unintended consequences' that will result from this otherwise well-meaning legislation."

What problem is being addressed here? Today, so-called "Angel" investors provide the majority of funding for infant American ventures. This group pumped about $20 billion to entrepreneurs in each of 2008 and 2009; no segment of our economy worked better during the crisis. Last year, as unemployment skyrocketed, Angel investments created 250,000 jobs. In fact, Robert Litan of the Kauffman Foundation says: "Between 1980 and 2005, virtually all net new jobs created in the U.S. were created by firms that were 5 years old or less... That is about 40 million jobs." In other words: our current system works extraordinarily well.

But not for long. Apparently motivated by the Bernie Madoff scandal -- which bamboozled a bunch of starstruck rich people more naïve and greedy than Ralph Kramden -- the Senator plans to protect wealthy, sophisticated investors from their own foolishness by preventing about three-fourths of them from investing in startups.

Seriously? Yes. That's the impact of the apparently innocuous sections 412, 413 and 926 of the ironically named "Restoring American Financial Sustainability Act of 2009." The technicalities are no fun to review, so we'll make it quick.

You no doubt know that for a company to sell stock to the public, it has to undergo intensive and expensive scrutiny by the SEC. That's been the law since just after the 1929 Crash, when retail investors were burned by scams dressed up as stocks. But Congress realized long ago that these kinds of protections are unnecessary when a company raises money from a small number of very sophisticated investors.

Therefore, "Rule 506" says that so long as you're only raising money from a limited group of "accredited investors" -- folks with a net worth over a million bucks, or incomes above $200,000--you don't have to file for approval with the SEC. This is the gateway through which nearly all Angel money is raised.

Senator Dodd intends to clip the Angels' wings. Now, to be "accredited" you'll need a net worth of about $2.25 million, or an income of around $500,000. According to Business Week, which evaluated the statistics in several ways, this would reduce the number of investors eligible to fund startups by a whopping 75%.

Let's consider the logic here. There are hundreds of Angel groups in this country, mostly comprised of experienced entrepreneurs and investors who specialize in providing expertise and capital to new companies. They meet regularly to evaluate the technology, finances, management, and business plans of applicant companies, typically using sophisticated software to manage their processes. Overall, they have a stellar record of allocating vital seed capital across the economy. Yet Senator Dodd does not consider three-fourths of their members competent to make these investments with their own money.

Incredibly, the news gets worse. The bill would also require startups to file with the SEC even when all their money does come from this new class of super-accredited investors. This filing isn't the same as a full-blown IPO document, but it still will choke startups that don't have the time (or legal expertise) to file it and wait 120 days for the SEC to say "OK." Note to Senator Dodd: four months is a long, long time for a company trying to make payroll.

And worse. If the SEC doesn't get around to reviewing that filing within 120 days for any reason at all -- including because it is simply overwhelmed by all these little filings with no staff to review them -- then the blameless entrepreneur must go make new filings in every different state in which potential investors reside and start waiting all over.

How well all these changes will protect our gullible millionaires is unclear. Nevertheless, I suppose Sam, our former Uncle and new Nanny, will feel deep satisfaction from knowing that he's protecting his wealthy wards from the evils of startup investing. My take: all he's likely to accomplish is to ensure that kids like Apple and Google won't grow up around here anymore.