The Crash of 29 was driven in meaningful way by fraudulent private equity sales – sales of stock in companies that had no value or intention of creating it because there were few if any restrictions on the sale of stock in private companies. However, with the Crash, many things changed. First, the Securities and Exchange Commission (SEC) was formed along with immediately outlawing all private equity investing. And, the SEC has never forgotten why it was formed.
What followed this ban on private equity investing between 1929 and 1934 was a period of pronounced economic stagnation. This is not surprising. Startups need cash to grow. The banks were in a panic. There was no legal private equity investing. The vast majority of people in the country were economically wounded by the Crash. So, the simple equation is no capital, no startups. No startups, no economic growth. All this finally drove Congress to act to move the SEC in1933 to create what we know as Regulation D, Rule 506 (“Reg D”), an exemption for private equity investing and the “Accredited Investor” definitions.
Essentially, anyone with an income of $200,000 ($300,000 filing jointly) per year or a networth of $1M was allowed to invest in private equity so long as the company did not generally (openly advertise) solicit the investment. It was amended in 1934 and remained intact until 2008. That amount of income and network represented a fabulous amount of wealth in in 1934. In 2008, it simply meant you had a nice house. So, in the interim, we essentially minted angel investors left and right, heavily fueled by the tech run up in the 1990’s and the real-estate run up in the 2000’s.
Enter the Great Credit Contraction of 2008….. Crash v2.0 brought the first material changes to the Reg D investor definition. As of 2008, an Accredited Investor can no longer count their primary residence as part of their networth calculation. So, half the angels in the market were removed from the market in 2008. Not surprisingly, we see the same economic stagnation between 2008 and 2012. The irony was that during that period, private equity investments were the bright spot as one of the best performing asset classes. Granted, this is mostly due to long harvest cycles and the investments providing returns in 2008 were made in 2003. But, it does point to the fact that this industry is not correlated to the broader public equity market over short timescales. The public and private markets are almost completely decoupled.
So, yet again, we see pressure on Congress to compel the SEC to act again to restore the angel market. It came in the form of equity-based “crowdfunding,” as opposed to rewards based crowdfunding such as KickStarter, IndiGoGo, etc. In 2012, Congress passed the Jumpstart Our Business Startups Act, the JOBS Act. Initially the SEC pushed back with great force on lifting of long term prohibitions of “general solicitation.” For the first time since 1929 startups can publicly advertise they are raising capital and selling shares, driven largely by the advent of and opportunities presented by the Internet. It took two years for the SEC to finally create new statues and definitions that allowed for an expanded angel market. And, from that point, we see an economic recovery taking root and growing. Some may say this is coincidence, but we don’t believe so. We believe economic growth in our economy is directly tied to the private equity/angel market. It is the cornerstone of our economy.
According to the Bureau of Labor, all net job growth between 1980 and 2010 was in startup companies. Big corporations fluctuate in their hiring and firing. Small companies create new jobs, become growth companies, and scale to the point they become stable or they are acquired by big corporations. That is how jobs are truly crated in our economy, not by tax incentives to big corporations, but by good old American ingenuity and hard work. We should never forget that. The American dream is not lost, just obscured from view at times.
With the advent of Crowdfunding, we now have several distinctions in the regulations that essentially allow ALL to participate in private equity financing:
- 506(b) – unlimited traditional “quiet” solicitation to accredited investors that has remained unchanged since 2008.
- 506(c) – unlimited crowdfunding/general solicitation to accredited investors only.
- 506(cf) – crowdfunding/general solicitation to non-accredited investors based on a percentage of their annual household income.
Looking back, what we observe is a trend that speaks to the importance of angels and angel investing. When angels are successful, our economy grows. There are many problems with crowdfunding regulation, such as the fact that for the first time in history, an investor can be penalized for the actions of a company in which he invested. Consequently, most professional angels and VC’s are staying away from crowdfunded companies until MUCH more precedent is set by the SEC. This also means the crowdfunding market has never reached the potential that was projected in the 2012 – 2014 period, once projected at $500B annually by Forbes and realized at approximately ~$1.4B annually. But, it is a critical piece of the future puzzle. We believe it will become an important part of the market. It should have a long term sustaining effect on angel funding, which should be good for the economy.
So, What comes next? Private equity suffers from one major drawback, it is illiquid for the vast majority of its life. We expect to see private equity exchanges come to life to mimic the public exchanges. This will require new technology, possibly new regulations, and potentially additional oversight. But, the ability to liquidate private equity at healthy commercial stock prices will be the ultimate evolution of this market.
Copyright Eric L. Dobson 2017
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