To Get More Capital to Entrepreneurs of Color and Women, Reform Section 3(c)(1) Investment Funds
December 13, 2021
Launching a new business requires money. Entrepreneurs need money to pay expenses, develop their product or service idea, research the marketplace, develop and implement a strategy for identifying and targeting customers, and, hopefully, begin paying initial employees. Because such costs typically arrive long before the first dollar of revenue, capital and credit are the lifeblood of any new business.
Many new businesses – particularly businesses that have the potential or intent to grow very quickly – rely on investors who provide early-stage capital in exchange for an equity stake in the company. Unfortunately, the overwhelming share of equity capital goes to entrepreneurs who are white and male. In recent years, women entrepreneurs have received only about 2 percent of total venture capital and entrepreneurs of color have received less than 1 percent.
The inequitable distribution of equity capital is attributable to both explicit bias on the part of some investors, but also to unintentional bias. Recent research has documented a phenomenon known as “homophily” – investors tend to invest in entrepreneurs who look like them, have similar backgrounds and life experiences, and who are launching companies that investors can relate to. At present, startup investors are predominantly white and male, with the predictable result that most of the startups in which they invest are launched and run by white male entrepreneurs. Greater diversity among those who invest in startups would result in more capital being directed to entrepreneurs of color and women entrepreneurs.
But what can policymakers do to encourage and facilitate greater diversity among startup investors? A potentially powerful policy opportunity lies within one of America’s landmark laws pertaining to capital formation.
The Investment Company Act of 1940 establishes the legal framework for the establishment, operation, and regulation of investment funds. The Act, along with the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Advisers Act of 1940, and the many rules issued by the Securities and Exchange Commission (SEC), form the backbone of financial regulation in the United States.
The Act defines an “investment company” as an issuer that “holds itself out as being engaged primarily or proposes to engage primarily, in the business of investing, reinvesting or trading in securities.” Many investment funds in the United States are organized to fall outside the purview of the Act in order to avoid costly disclosure and regulatory requirements associated with registration. Instead, many funds raise capital by issuing interests in their funds to investors pursuant to a private placement exemption under Rule 506 of Regulation D, which provides a “safe harbor” under the Securities Act of 1933.
In addition to not making a public offering of its securities, a fund seeking exemption from registering as an investment company must either (a) limit the fund to no more than 100 accredited investors – individual investors who meet certain wealth and income criteria – or (b) limit the fund’s investors to only “qualified purchasers.” The first option is addressed in section 3(c)(1) of the Act, the second in section 3(c)(7). Qualified purchasers are large wealthy investors including: 1) individuals or family-owned businesses that own $5 million or more in investments; 2) a trust sponsored and managed by qualified purchasers; 3) a person, acting for their account or the account of someone else that owns an investment portfolio of at least $25,000,000; and, 4) any entity exclusively owned by qualified purchasers. Funds organized under Section 3(c)(7) can have up to 2,000 investors.
In short, private funds seeking exemption from registration have two options: 1) fewer than 100 accredited investors; or, 2) only very wealthy and sophisticated investors. Both exemption options reinforce deficiencies in diversity among startup investors – and, therefore, among entrepreneurs who successfully secure funding. Very few investors of color meet the criteria to be a qualified purchaser investor in a 3(c)(7) fund. And the limitation on the number of permitted investors in 3(c)(1) funds to 100 means the contribution from each investor – except for very small funds – is very high. For example, in the case of a $30 million fund, the average investment is $300,000 – too large for many accredited individual investors, particularly investors of color.
In 2018, Congress passed and President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act, the principal purpose of which was to ease certain aspects of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which Congress passed in 2010 following the 2008 financial crisis. The Act also amended section 3(c)(1) of the Investment Company Act by allowing funds smaller than $10 million to have up to 250 investors.
The increase in the number of permitted investors improved circumstances for 3(c)(1) funds in two ways: 1) it helped get more capital to early-stage companies; and, 2) it allowed more accredited investors to allocate smaller amounts of capital to a potentially lucrative asset class.
But the $10 million fund cap is highly problematic. First, funds of $10 million or less are too small to have a meaningful impact on the diversity of entrepreneurs who secure financing. Moreover, funds larger than $10 million are still subject to the 100-investor limit, meaning the average capital allocation for a participating investor is too large for many investors of color.
The problem can be addressed – and the diversity among startup investors significantly improved – by simply expanding the parameters of the 2018 subcategory change to section 3(c)(1). First, the cap should be raised from $10 million to $100 million – still small by modern fund standards, but providing emerging funds managers significant additional capacity to invest in a more diverse range of entrepreneurs. Second, the number of permitted investors should be raised from 250 to 2,000, harmonizing that parameter with section 3(c)(7) funds.
Aligning permitted investor limits of 3(c)(1) funds with 3(c)(7) funds would simplify regulatory compliance, facilitating capital formation for all new companies. Most significantly, a higher number of permitted investors means smaller amounts of capital would be required from each participating investor. For example, for a $100 million fund with 2,000 investors, the average investment would be $50,000, making participation by investors of color and women much more likely.
Together, the higher fund cap and higher number of permitted investors would promote greater diversity among investors and emerging fund managers – and, therefore, more investment in entrepreneurs of color and women entrepreneurs.
Legislation to accomplish this important goal might be entitled The Expanding Diversity of American Entrepreneurship Act.