Make the SBA More Responsive to Startups
Congress should instruct the Small Business Administration to initiate an ongoing dialogue with lending institutions and startups regarding how SBA programs, products, and procedures can more clearly distinguish between existing small businesses and new, high-growth startups. The SBA should also be instructed to determine how SBA-backed lending can be tailored and more responsive to the unique nature and needs of startups (e.g., less complex, less reliant on cash-flow and physical asset collateral).
Increase the SBA Guarantee to SBICs
On June 6, 2018, the Senate passed the Small Business Investment Opportunity Act (SBIOA) to modify the SBA’s Small Business Investment Company (SBIC) program and increase the amount of capital SBICs can invest in qualifying small businesses. SBICs are privately-owned and managed investment funds that use their own capital – plus funds borrowed with an SBA guaranty – to invest in new and small businesses. Since Congress created the program in 1958, SBICs have channeled more than $67 billion of capital to 166,000 American businesses across a variety of industries. Some of America’s most iconic companies have received investment capital from SBICs, including Apple, Tesla, Whole Foods, Staples, Intel, FedEx, and Costco. Until recently, the SBA was authorized to guarantee up to $150 million for each SBIC investment fund. The SBIOA increased the cap to $175 million. While certainly a step in the right direction, CAE is of the view that an increase of $25 million is insufficient – especially since the cap was last raised in 2009. CAE urges policymakers to increase the cap on the SBA guarantee to SBICs to $250 million.
Re-structure and Re-launch the SBA’s Early Stage Innovation Fund (ESIF) Initiative
In January 2013, the Small Business Administration (SBA) launched the Early Stage Innovation Fund initiative (ESIF) – an offshoot of the SBA’s Small Business Investment Company (SBIC) program (see recommendation above). Whereas licensed SBIC’s invest primarily in the growth of existing small businesses, ESIF licensed firms were required to invest at least half their funds in early- and seed-stage startups. By guaranteeing up to $50 million in additional capital per licensed fund, the ESIF initiative was intended to help leverage private capital already raised by active funds, providing additional investment capacity to venture capital funds beyond the venture capital centers of Silicon Valley, New York, and Boston, which attract three-quarters of all venture capital. In announcing the program, the SBA said it planned to guarantee up to $1 billion in additional startup capital over five years at no cost to the American taxpayer.
On September 19, 2016, the SBA proposed changes to the ESIF program because as of June of 2016, the SBA had licensed only five venture capital funds. On June 11, 2018, the SBA announced that it was withdrawing its proposed rule and ending the ESIF program. According to the SBA, the initiative failed because the SBA-backed portion of ESIF-affiliated investments were structured as subordinated debt that paid quarterly interest back to the government equivalent to the rate of a 10-year Treasury bill plus 1.5 percentage points and “debentures are not well-suited to an early stage investing strategy sine many early-stage investments do not provide ongoing cash flows needed to pay the current interest an annual charges associated with SBA guaranteed debentures.” Given the importance of early- and seed-stage risk capital to startups, together with the relative scarcity of venture capital in heartland states, CAE recommends that the SBA work with the venture capital community to determine a financing structure consistent with the earnings and repayment realties unique to startup and relaunch the Early Stage Innovation Fund initiative as soon as possible.
In conducting its reassessment, the SBA should look to more successful models that help fill the early stage funding gap. Between 2010 and 2015, Treasury’s State Small Business Credit Initiative (SSBCI) provided nearly $450 million in funding for states to allocate to venture capital markets, catalyzing significant private investment in the process. Recognizing the important early stage funding gap, states allocated nearly two-thirds of these funds – which carried no federal payback requirement – to seed and early stage investments.
The Administration should also examine the experience and successful approach of the Israel Innovation Authority (formerly the Office of the Chief Scientist), which was created in 1974 and charged with fostering the development of Israel’s industrial R&D and venture capital industries. The authority has taken a multi-pronged approach – not only co-investing public money to help launch new venture capital funds, but also lending money directly to promising but risky new ventures that otherwise struggle to find private investment. The lending program, which has played a critical role in the growth of successful Israeli firms such as Waze, receives payback through sales royalties in lieu of equity.
Pass the HALOS Act
CAE supports enactment of JOBS Act reforms passed by the House in 2017, including S. 588, “Helping Our Angels Lead Our Startups (HALOS) Act”: The bill, received by the Senate on January 11, 2017 after passing the House with broad bipartisan support (H.R. 79), would clarify that promotional events organized by entrepreneurs known as demo days, venture fairs, or pitch days (“demo days”) are exempted from general solicitation restrictions. Uncertainty regarding demo days and general solicitation restrictions has created confusion among investors and potential legal liability for entrepreneurs, reducing the value of demo days and capital availability for startups.
Raise the Cap on the Reg A Exemption (or “Mini-IPO)
The JOBS Act of 2012 sought to revive the Regulation A exemption – sometimes called a “mini-IPO” – which allows public companies to raise capital through general solicitation without the full burden of disclosures typically required of a conventional IPO. The Act increased the amount of capital that could be raised under the exemption from $5 million to $50 million and instructed the SEC to reevaluate that cap every two years. As of year-end 2017, 185 qualified offerings have raised a total of $670 million under the new Reg A – only limited progress. Companies seeking more than $50 million in capital, say $75 million or $100 million – still small amounts by any standard – must resort to the conventional IPO process and the burden of standard disclosures. Given the significant decline in the number of IPOs in recent years – and especially the more than 90 percent plunge in sub-$100 million listings since 2001 – CAE urges the SEC to raise the Reg A exemption cap to $100 million.
Raise the Cap on 3(c)(1) Investment Funds
On May 24, 2018, the “Economic Growth, Regulatory Relief, and Consumer Protection Act” was signed into law by President Trump. Title V of the legislation addresses capital formation – including a provision, “Supporting America’s Innovators,” Section 504, that had previously passed the House (H.R. 1219) and Senate (S. 444) by wide margins. The section amends section 3(c)(1) of the Investment Company Act of 1940, by raising the permitted number of investors from 100 to 250 for investment funds not making a public offering of securities that are exempt from registration as an investment company with the Securities and Exchange Commissions and from the filing of costly disclosure requirements associated with registration – provided the fund size does not exceed $10 million.
The increase in the number of permitted investors is a welcome change that will facilitate the formation of angel investor funds and smaller venture capital funds that will fuel new generations of startups. However, the fact that the cap on qualifying funds was not raised will limit the value and impact of the increase in permitted investors. Moreover, because institutional investors prefer larger funds of at least $30 or $40 million, the $10 million limit means that fund managers are generally unable to attract institutional investors to smaller funds. With these realities in mind, CAE recommends that the cap on funds exempted from registration as an investment company be raised to at least $50 million – and potentially to $100 million, which would be consistent with the recommendation above regarding capital raises under the Reg A exemption.
Eliminate Volcker Rule Barriers to Bank Participation in Venture Capital Funds
Prior to the passage of the Dodd-Frank Act in July of 2010, many banks across the country – including many community and regional banks – participated in venture capital funds as limited partners. Banks’ participation in such funds was beneficial to both banks and new businesses – banks served as an important source of early-stage capital for promising young companies in their towns and regions, while earning healthy returns and helping to develop the next generation of business customers.
Following enactment of Dodd-Frank, however – and, in particular, following the promulgation by regulators of rules to enforce Volcker rule restrictions – bank participation in such funds was prohibited. In drafting rules to implement Volcker prohibitions, regulators cast a wide net – banning any trading or covered fund investment activities that might possibly be considered proprietary, regardless of their value to banks, their customers, or the broader economy – rather than specifically targeting those activities that were clearly the object and intent of the Volcker rule’s systemic risk concerns.
As a result, rather than reducing systemic risk, Volcker rule regulations have in many ways impeded the efficient operation of the financial system, driving banks away from providing services valued by their customers, reducing competition, and undermining economic growth. A vivid example of the negative impact on banks of all sizes – including the nation’s community and mid-size banks to which the Volcker rule was not intended to apply – is the prohibition of banks’ participation in covered funds, including venture capital funds. The unfortunate effect has been to stifle investment in emerging growth companies, which, research shows, contribute disproportionately to innovation, productivity gains, economic growth, and job creation.
CAE strongly supported S. 2155 – the Economic Growth, Regulatory Relief and Consumer Protection Act – bipartisan legislation signed into law in April of this year, which exempts banks with total assets of less than $10 billion from compliance with the Volcker rule, and, therefore, lifts current regulatory restrictions on smaller banks participating in venture capital funds. But banks with total assets above $10 billion are still be subject to Volcker restrictions.
Because the damage caused by the Volcker rule stems principally from its implementing regulations and not the underlying statute, CAE is strongly of the view – along with other organizations like the National Venture Capital Association and the American Bankers Association – that financial regulators have the authority and latitude to revise covered fund restrictions in ways that would remove unwarranted obstacles to economic growth and focus more sharply on the specific activity that the statute seeks to prohibit – namely, engaging primarily in stand-alone, short-term proprietary trading.
 The five federal financial agencies charged with implementing and administering the Volcker Rule are the Federal Reserve, Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), Securities and Exchange Commission (SEC), and Commodity Futures Trading Commission (CFTC).
 See ABA Letter to the OCC (Sept. 21, 2017) (responding to OCC RFI on Volcker Rule reform proposals) (available at https://www.aba.com/Advocacy/commentletters/Documents/cl-Revising-Volcker2017.pdf ); Department of the Treasury, Office of the Comptroller of the Currency, Proprietary Trading and Certain Interests in and Relationships with Covered Funds (Volcker Rule); Request for Input, 82 Fed. Reg. 36,692 (2017).
Mobilize More Angel Investors
In recent years, “angel” investors – wealthy individuals who invest in young promising companies – have become a major source of startup capital in the United States. Like venture capitalists, angels invest in new, high potential companies in exchange for an equity stake in the business. Many angel investors – particularly those who are current or former entrepreneurs – also provide advice, mentoring, and other support to the management team of the new businesses in which they invest. As with venture capital, angel capital is recovered and returns realized when financed firms either go public or are bought by another company.
Angel investors also differ from venture capitalists in significant ways. For example, unlike VCs, who invest institutional capital in amounts of $1 million or more, angels invest their own money, typically in amounts between $25,000 and $500,000. Despite smaller individual investments, aggregate angel capital rivals that of venture capital. Each year, angels invest about $25 billion in more than 70,000 new companies. For every new company that receives venture capital, nearly 20 others receive angel capital. Amazon, Home Depot, and Uber are just a few of the thousands of companies launched with angel capital.
Perhaps most importantly, whereas venture capital is typically invested during a later growth phase after initial financing has helped create a viable company, angel investors have emerged as the principal source of outside “seed” or early-stage funding critical to the formation, survival, and growth of new businesses – providing 90 percent of such capital once entrepreneurs have exhausted their own resources and those of family and friends.
According to the Center for Venture Research (CVR), which has analyzed the angel market since 1980, there are currently about 300,000 active angel investors in the United States. According to the Securities and Exchange Commission, another 12 million American households meet accredited investor criteria. Most are likely unaware of what angel investing is and of the opportunity to potentially participate in financing the next generation of great American companies. To be sure, angel investing is risky and, therefore, not a viable or appropriate investing strategy for every accredited investor. But if only 3 percent of the 9 million additional potential angels chose to allocate a portion of their financial portfolios to promising new companies launched in their cities and towns, the number of active angel investors would double to 600,000 – and, presumably, the amount of capital invested would double to $50 billion annually.
With this in mind, CAE recommends that sufficient funds be allocated, either through legislation or Presidential directive, to launch a nationwide initiative – in collaboration with the more than 400 angel investing groups across the country and online angel platforms – to engage, educate, and mobilize potential angel investors.
 Report on the Review of the Definition of “Accredited Investor,” Securities and Exchange Commission, December 18, 2015.
Re-examine the Definition of “Accredited Investor”
The Dodd-Frank Act requires the SEC to review the definition of accredited investor every four years. The current definition requires an individual to have annual income of $200,000 ($300,000 for a couple) or net worth of $1 million, excluding the value of a primary residence. These parameters limit the number of accredited investors to just 10 percent of the U.S. population. Excluding 90 percent of American investors from important and potentially profitable investment opportunities is overly cautious and restrictive. Moreover, an accreditation framework based on income and financial assets is an arbitrary standard of financial sophistication and unjustly favors investors residing in coastal cities like San Francisco, Seattle, and New York with high costs of living and high property values over investors residing in lower cost areas. The SEC should examine the definition of accredited investor with the aim of more rationally and fairly expanding investment opportunities for more Americans.
Pass the New Business Preservation Act
CAE supports the immediate passage of the New Business Preservation Act. The Act was introduced in the Senate (S. 3515) on March 18, 2020 by Senators Amy Klobuchar (D-MN), Chris Coons (D-DE), Tim Kaine (D-VA), and Angus King (I-ME), and was introduced in the House (H.R. 6403) on March 26, 202 by Reps. Dean Phillips (D-MN), Terri Sewell (D-AL), Ro Khanna (D-CA), and Tim Ryan (D-OH). The legislation would create a new federal program to incentivize continued venture capital investment in America’s most innovative and promising young companies, or “startups.”
Despite their unique economic importance, startups are also extremely fragile because they are new – with half of all startups failing within their first five years. Because of their risk profile, many startups are unable to secure bank financing like existing small businesses and instead rely on venture capital, which has been a major source of financing for young innovative companies since the late 1940s.
Venture capital firms are long-term investors that provide early-stage capital – raised from institutional investors like pension funds, insurance companies, university endowments, and foundations – to new and rapidly growing companies in exchange for an equity stake in the company. Venture firms also assist in the management and professionalization of the young companies in which they invest, typically taking seats on the board. Venture capital has helped finance thousands of American companies, including Intel, Federal Express, Apple, Microsoft, Google, Cisco, Home Depot, and Starbucks.
The coronavirus crisis poses a major threat to this vital source of startup financing. Indeed, a research note issued on March 31st by Pitchbook, the leading source of venture capital data and analysis, predicted “a decline in total venture transaction volume over the next few quarters,” with the greatest impact expected in “ecosystems outside of the major investment hubs” of Silicon Valley, New York City, and Boston. A paper released by the National Bureau of Economic Research (NBER) in May showed that early-stage venture capital investment dropped by 38 percent in March and April.
Meanwhile, thousands of fragile startups have been shut out of the Paycheck Protection Program and the Federal Reserve’s Main Street Lending Program, with many forced to lay-off employees6 or close their doors permanently
Simply stated, the coronavirus emergency has imperiled an entire generation of the nation’s most innovative and promising young companies – and, in turn, the demise of thousands of these companies imperils the post-coronavirus economic recovery.
The New Business Preservation Act would address this threat to the nation’s startups and economic resilience by establishing a program, administered by the Treasury Department, which would allocate $2 billion in federal dollars ($1.5 billion initially, and $500 million in follow-on investment) to the states on a straightforward population basis to attract private venture capital by offering a 1-to-1 match of federal dollars with venture capital investment in promising startups, particularly in states outside the major venture capital centers.
The legislation is modeled on Israel’s “Yozma” program of the late-1990s, which successfully incentivized U.S. venture capital firms to invest in promising Israeli startups, and builds on other successful federal-state partnerships to support small businesses, such as the State Small Business Credit Initiative (SSBCI).
Importantly, the legislation is carefully structured so that the federal government will not “pick winners and losers,” but rather will rely on private entities to source and manage investments in promising early-stage companies in every state. All investment decisions will be based entirely on private investor determination of the economic prospects of the new companies receiving equity capital.
Finally, the program authorized by the Act is intended to be “evergreen,” with any gains from investments following exits to be used to incentivize future rounds of private investment in heartland startups.