Is there a trade-off between protecting investors and promoting entrepreneurial activity? Evidence from angel financing

Small businesses, which account for two-thirds of new jobs created in the United States, are the basis for innovation and crucial for economic growth. Raising capital for small businesses is important but not easy in a market with large information asymmetry and high search costs of potential investors. Regulators like the Securities and Exchange Commission (SEC) have called 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 firms that turn out to be unsuccessful. Recently, the debate on this trade-off escalated 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 have certain professional knowledge, experience, or certifications. Immediately afterward, two SEC commissioners issued a joint statement publicly criticizing that the Commission majority failed to protect vulnerable investors and the update was issued without “sufficient data or analysis.” This recent debate indicates that timely research on the aforementioned trade-off is critical, which will not only expand our academic knowledge of the capital market, but also provide useful evidence to regulators for policy making and evaluation. In this paper, I exploit a 2011 SEC regulation change to analyze this trade-off in the context of angel financing.

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, I construct 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

Using this SEC regulation change across U.S. cities as a quasi-natural experiment, I causally estimate the impact of this investor protection regulation change. I show that 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

I further show that the SEC regulation change imposed a real cost on the local economy in the innovation, employment, and sales generated by angel-backed firms. I also show substitution effects between reduced angel financing and alternative financing sources, such as small business loans guaranteed by the Small Business Administration and second-lien mortgages.

Finally, I provide an estimation of the benefits of the regulation change by avoiding angel investors’ losses through investing in unsuccessful firms and the costs in terms of the reduced sales, patents, and employment generated by angel-backed firms. Specifically, assuming the discount rate is 30%, the growth rate is 25% (when early investors require a high return and young firms have high sales growth), and the impact of the regulation change lasts for five years, the present value of total net benefits of the regulation change is negative $6.32 billion at the end of 2011. I also show that the costs of reduced patents and employment generated by these firms are non-negligible. The cost-benefit analysis of this paper suggests that at least the monetary costs of protecting angel investors seem to outweigh its benefits in most scenarios. 

This paper adds to the debate about the trade-off between investor protection in the private market and promotion of 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 arising from potential losses of angel investors through the failure of their portfolio firms. Second, the government could provide more funding to small businesses through government-led venture capital or direct lending through agencies like 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 may have a compositional impact on the industries and riskiness of the firms being funded.  Third, the government needs to be aware of the potential underinvestment problem generated from the shift from equity financing to debt financing when angel investment decreases. Due to entrepreneurs’ risk aversion, they may choose to invest in less risky projects under debt financing even though these projects may bring lower growth to the firm.