Medium and even small businesses are in the majority in the US and they create more than 60% of the jobs and this highlights the basis of innovation and are crucial for economic growth. Raising capital for small businesses is important, but it is not easy in a market with significant information asymmetry and high search costs for potential investors.  Regulators such as the Securities and Exchange Commission (SEC) have called the lack of investor access to private companies a growing challenge. However, there is often a trade-off between promoting entrepreneurial activity and protecting investors, especially for small investors who may lose a significant amount of money by investing in entrepreneurial ventures that turn out to be failures. Recently, the debate over this trade-off intensified when the accredited investor standard was amended by the SEC on August 26, 2020: in addition to the existing tests for income or net worth, the amendment allows investors to qualify when they possess certain knowledge, experience, or professional certifications.  Immediately thereafter, two SEC commissioners issued a joint statement publicly criticizing the Commission majority's failure to protect vulnerable investors and that the update was issued without "sufficient data or analysis." This recent debate indicates that timely research on the aforementioned trade-off is essential, which will not only expand our academic knowledge of the capital market, but also provide useful evidence to regulators for policy development and evaluation. 

Angel investors drive a large portion of the financing for entrepreneurial firms. Many firms were backed by angel investors at their early stage, with some famous examples including Google, Amazon, Facebook, PayPal, Costco, and The Home Depot. Yet, angel investors are individual investors, as distinguished from institutional investors like venture capital and private equity firms. They may be more vulnerable to investing in frauds and scams, have less risk-bearing ability, and be more likely to make irrational investment decisions compared with institutional investors. The concerns about protecting individual investors increased rapidly after the 2008 financial crisis, in which many individuals went bankrupt and lost their homes. On December 21, 2011, the SEC adopted amendments to the definition of accredited investors, requiring that the value of a person’s primary residence be excluded when determining whether the person qualifies as an “accredited investor” based on having a net worth in excess of $1 million. According to a report by the Angel Capital Association, the regulation change is estimated to have eliminated more than 20% of previously eligible households in the United States.

To reflect the average extent of a city being affected by the regulation change, there is  a variable, home value-to-net worth (HV/NW), by dividing the average home value by the average net worth in a city at the end of 2011.  Figure 1 shows that the extent of the impact of the regulation change varies across U.S. cities and the effect does not seem to be merely a metropolitan phenomenon.

Figure 1. Geographical Variation of the Home Value-to-Net Worth Ratio in 2011

Image 

Using this SEC regulation change across U.S. cities as a quasi-natural experiment, there is an  estimate of the impact of this investor protection regulation change.  We can see the 2011 SEC regulation change had a significantly negative impact on local angel financing. After the regulation change, cities with a higher HV/NW ratio experienced larger decreases in the number and amount of angel financing, as shown in figure 2. Translating the estimates into a dollar amount, there would be a $2.35 billion larger decrease per year in angel financing across the United States if the HV/NW ratios increased by one standard deviation in all the sample cities.

Figure 2. Impact of the 2011 SEC Regulation Change on Local Angel Financing

Image It is clearly shown that the SEC's regulatory change imposed a real cost on the local economy in terms of innovation, employment, and sales generated by angel-backed businesses. Also the substitution effects between the reduction in angel financing and alternative sources of financing, such as Small Business Administration-backed small business loans and second mortgages.

There is also an estimate of the benefits of the regulatory change in avoiding losses to angel investors by investing in unsuccessful firms and the costs in terms of reduced sales, patents, and employment generated by angel-backed firms. Specifically, assuming that the discount rate is 30%, the growth rate is 25% (when early investors demand high returns and startups have high sales growth), and the impact of the regulatory change lasts for five years, the present value of the total net benefits of the regulatory change is negative $6.32 billion at the end of 2011. There is also that the costs of reducing the patents and jobs generated by these companies are non-negligible. The cost-benefit analysis in this paper suggests that at least the monetary costs of protecting angel investors appear to outweigh its benefits in most scenarios.

This paper contributes to the debate on the trade-off between protecting investors in the private market and promoting entrepreneurial activity.  The policy implications are as follows. First, the government could encourage more private investment in entrepreneurial firms by allowing more angel investors to invest in these firms. However, there is always a cost associated with potential losses to angel investors due to the failure of their portfolio companies. Second, the government could provide more funding to small businesses through government-led venture capital or direct lending through agencies such as the Small Business Administration. The government should be aware of these potential substitution effects when developing policies to protect investors or promote entrepreneurial activity. Promoting debt financing and equity financing can have a compositional effect on the industries and risk of the businesses financed.  Third, the government must be aware of the potential problem of underinvestment generated by the shift from equity to debt financing when angel investment declines. Because of their risk aversion, entrepreneurs may choose to invest in less risky projects under debt financing, even though these projects may bring lower growth to the firm.