98. Public Policy for Angel Investors, Part 1 (David Verrill)

*Please excuse any errors in the below transcript

Nick: Today #David Verrill joins us from Boston. #David is Founder and Managing Director of the #Hub Angels Investment Group. And he’s one of the most well regarded Angels in the country as Chairman Emeritus of the #Angel Capital Association. In addition to serving as Executive Director for #MIT on their digital economy initiative, #David also spends a great deal of time focusing on public policy issues for early stage investors. #David, it was a pleasure to get a chance to meet you recently in Massachusetts, and I appreciate you making the time to come on the program.

David: Happy to be here with you #Nick, thanks

Nick: Yeah. So can you start out with sort of your origin story and how you became involved in startup investing?

David: Yeah, for sure. Really a, a story of happenstance I guess if you will. I went to MIT for business school and ended up staying at MIT for a decade in, basically in corporate fund raising. And left MIT to work with one of the, actually one of the clients that I had. I got a feel for what a big company was like. I, I did sales and business development. And we were in a turnaround situation with a small division of the company ultimately was divested, and I’d find myself with a lot of time on my hands. And connected with a former fund raising colleague. And we started a little fund raising firm. And so one of the core abilities that, that I’ve used and leveraged over my angel career is, is in fund raising. It’s basically a sales opportunity. And in, in talking with a lot of people, many of them in the MIT ecosystem about what was going on in the startup space, a lot of them were complaining about all of the startups that were coming out of places like MIT, and this is the late 90s, and their lack of ability to access those direct investments. Sure they could invest through a venture capital fund, but those were financial investments and there was really no transparency in, into the underlying investments. And I, and I had a couple of friends at MIT that were starting companies, so I thought to myself, well, looks like you’ve got a marketplace here of likeminded people. One, a set of people looking to start a company, and others looking to invest in them. And so #Hub was born in, in late 1999. And 2000 another Sloan alum had a very similar idea. And we were put together, and #Charlie Cameron and I started #Hub in April of 2000 with two company presentations and 4 angel investors. And #Hub as we know it was born.

Nick: Well, it’s good to hear that, that some of us have some modest beginnings here for, for those of us that are a little newer to this. Can you tell us a little bit more about your experience at #Hub, founding #Hub, sort of it’s progression?

David: Yeah, yeah for sure. So #Hub started like many other Angel groups in that a few people got together and decided to pool their knowledge and their funds to, to look at companies. We found out very quickly that we wanted to put more structure around our, our angel group. We were putting a lot of time and effort into it. We were producing, you know, 50 page Due Diligence reports on, on these companies, and recommending investments. And so we, we really felt like the best path for us was to form a structured fund. And we did that in 2001. We’re currently investing Hub fund 5. And that’s really turned out to be an excellent mechanism for us. It’s, it’s a way to ensure the longevity of the group. We charge a small management fee which is not unlike any annual fee that a network might charge it’s members. But we do charge a carry off of the profit. And, and this has worked out well for us in that, you know, the early days of the venture capital world were really focussed on the carry rather than the management fee. And, and because our funds are relatively small, typically less than $6 million, then the management fee really doesn’t do much more than cover my phone or my car. And it’s really the carry that motivates us. And, and that’s really a good way to structure a group. And there are also benefits to the members. They instantly buy into a portfolio of companies. We’re all invested in the same companies. We have money in good times and bad and we can reserve money to follow, which is an important investment strategy for us. So I think all in all it’s, it’s a good mechanism for, for both the management and for the, the underlying members of, of our fund.

Nick: Got it. So you’ve got the core fund. And then, do you allow the angels in the group to sidecar onto individual investments?

David: They do, they do, but they don’t run that money through the fund as it were. They make those cheques out directly to the company. But they do ride on the coattails of, of the terms we’ve negotiated and the ongoing governance they we have in the company. So it’s a good way to buy into a little piece of every company and, and as you wish load up on one or more. And, and I would say that on average each of our members co-invest in one or two of the portfolio companies. We have a couple of family offices in our group who co-invest in every single one just because they want to have greater exposure to those companies.

Nick: Got it. And you know, we’ve been fortunate here on the program to have both #John Huston and #Christopher Mirabile on the program. I know that you’re a Chair Emeritus of course of the #ACA. And I was wondering if you could talk a little bit about that story, how you got involved and ultimately became, became the Chairman?

David: Yeah, for sure. So I’ve been very active in the, in the New England region. We have a, a unique ecosystem that encourages us to get together and share and syndicate deals more than it does to encourage us to compete. And so a few of us, #Christopher Mirabile, #Ham Lord, who is #Christopher’s partner at #Launchpad, #Jean Hammond, who is an uber angel here in the local ecosystem, and #James Geshwiler, the initial Chairman of the #Angel Capital Association. So the, the core of us have really tried to increase the number of angels in our ecosystem and the quality of angel investing. And so we, we’ve organized a series of syndication meetings. We have two every year where all of the New England angel groups come and, and participate in, in those events. And we have a couple of education events during the year where we encourage people contemplating becoming an angel to, to come and learn from those that have been doing it for a while. And I think largely because of the activities that we’ve been doing in New England, I was tapped to, to join the #ACA board about this seven years ago, played an active role in the syndication committee and ultimately became the number two seat next to a very good colleague that runs an Angel Group in Pennsylvania, #Catherine Mott. And the way that things work in the #ACA, if you are the Deputy Chair for, for two years, you become the Chair. And I was able to take on that responsibility actually for 3 years up until last year when #Christopher took it over. And I think the #ACA is a great organization. It’s doing the important work of bringing people that ere typically more individual investors together rather than not. And as you can see in many of the public policy activities that are, are facing us now, we really need to have a lot of a voice. We’ve, we’ve been a very private set of investors and a very private asset class. But if you look at it compared to the venture capital community for example, it’s, it’s been largely on par up until recently. And, and we’re talking on the order of $25 billion, but we’ve really never had any type of lobbying activity in, in VC up until I became the Chair.

Nick: Right, right. And there’s tremendous amounts of activity in sort of the public policy arena for, for angels right now. So I think it’s an opportune time to be discussing this. Can we start off by talking a little bit about why public policy issues are such an important consideration for angels?

David: Yeah.You know, angels as I, as I mentioned have really been quiet and private. There are no intermediaries. There are no brokers, you know. Up until the #ACA started cranking up our activities there have been no sort of events. And we’ve been very low on the radar screen. And, and one of the reasons for that is that we really have not had any fraud in our space. And I attribute that to, to people making direct investments into other people. And, and so we’ve got this sort of lack of history of, of things that would bring notoriety to us. Unfortunately there are some, some changes in the public policy space, many of which are, are well intentioned but not necessarily appropriately executed. And those are the things that, that we’ve been focussing on. And we’ve done a good job of cranking up our activities. We have a grassroots public policy committee that one of my colleagues runs. And we’ve essentially have mapped out all of the members of Congress and what committees they’re on that have an impact on, on what’s being legislated or regulated in the Angel space. And we ask people in those states to, to reach out and educate their, their particular members of Congress. I’m in DC as is the Executive Director, #Marianne Hudson. Basically once a quarter, we’ve hired a very professional lobbyist group #Eris, E-r-i-s. And they’ve helped us gain a lot of connections with, with people that are in important positions. And interestingly enough, both members of Congress and members of the SEC have been very open and willing to, to meet with us and listen to us and speak at our events. So I think we’ve, we’ve done a good job of, of increasing the level of, of, of knowledge about angel investing in Washington DC.

Nick: #David, from more of a, a 30,000 foot view, is there a way that you structure out or frame out the different categories of issues within the, the public policy spectrum?

David: Yeah, I mean, we, we obviously have prioritized a set of issues that we think are short term critically important. We’ve also got a list of what I would call existential threats to angel investing that are a little bit longer term. But we’re, we’re obviously spending most of our time on the, the key issues that are facing angels today. And they’re ones that people probably know a little bit about. But I’d be happy to talk in some depth about each.

Nick: Great. And so what are some of the, those top priorities for the #ACA?

David: So let me pick out three. One, is the capital gains exemption for small business investments is something that, that our group is taking advantage of. Another constitutes a couple of issues around the Jobs Act. And the last and perhaps one of the bigger threats is the accredited investor definition. So let me start at the top. We all I think you know want to make sure that we try to minimize the amount of taxes that we pay. As, as angel investors, the more money in our wallets, the more we tend to put into startup companies. And there is a qualified small business tax benefit. Or any, any investor who invests in a company, if it’s a seed corporation, holds that equity for 5 years. And then if that company has an exit, there’s a 100% capital gain exemption from that exit. It’s called Section 1202. And it’s part of the, the American Taxpayer Relief Act. And it’s, a big percentage of exemption has changed off and on throughout the last 5 or 6 years. It didn’t just go through the tax extenders. And so for 2015 and beyond, it’s a 100% exemption and it does require that, that, that you hold that investment for 5 years. And there is an important precedent to set in your term sheet or, or otherwise upfront, such that when you get to the point of, of seeking the exemption you’ve got a little bit of paperwork that backs up that the company is indeed subject to QSBS treatment.

Nick: Is that, is that just related to it being a seed corp or, or what sort of other language needs to be there to sort of affirm the fact that it was QSBS at the time of investment?

David: Yeah, the, the seed corp is the, is the primary issue as is the holding period. Now we, we’ve been lobbying that, that Section 1202 be tweaked in the future in, in two ways. One, to have the investment holding period be reduced from 5 years to 2 or 3. And the other is to allow LLCs to, to participate in that. I, I suspect that we might get the, the number of holding years reduced. But I’m, I’m less optimistic about the LLCs because you’re getting the, the, the pass-through losses with an LLC early in the company’s life. And to then get the benefit on the back end is maybe trying to get your cake and eat it too.

Nick: Yeah. So I haven’t hit my 5 year holding period yet but I think when #Dave Berkus was on the program he said that if you invest with a convertible then the clock starts when the conversion occurs as opposed to when the initial investment occurs.  Is that

David: yeah

Nick: still the case?

David: Yeah. Yeah, unfortunately it’s got to be in a class of stock that qualifies. And a deck is not a class of stock. So that’s one important thing. As, as a structured fund though, there is an interesting pass-through to funds. So whether or not it’s an individual investment or one done through a fund, it still qualifies as QSBS. And, and we’ve taken advantage of this several times in the last couple of years. And there’s nothing better than getting a little bit of tax exemption from a big hit

Nick: Sure. Great. Anything else on capital gains? Or would you like to

David: You know, capital gains are so

Nick: talk a little more about

David: you know, one, one that hits the wall. I would say, the, the Jobs Act has a couple of, of items that are, are in some some ways good and bad. So general solicitation, general solicitation is one important aspect of the Jobs Act. But the definitions haven’t been particularly clear about what does constitute general solicitation. So for example, the HALOS Act, which has, has made it through the House and is going to the Senate, basically exempts a, a business plan contest and other similar types of, of venues as exempt from general solicitation. So general solicitation basically means an entrepreneur can shout from the rooftops, tweet, go online, have a radio show, and we’re taking advertisement out about their, about raising capital for their company. But then they’re, they are then subject to a particularly special type of filing, they need to verify the accreditation of investors. And a lot of angels don’t want to kind of go through that, that rigmarole. And technically when the general solicitation of the Jobs Act came out, a business plan contest or Demo Day would have been considered general solicitation because they were likely unaccredited people in the crowd. And the HALOS Act sort of takes that off the table. You know, business plan contests and Demo Days are things that we as angels have been doing for decades. That’s one of the ways that we generate deal flow, that’s one of the ways that we support the ecosystem by being judges and, and giving feedback and mentors. So in pulling that off the table it, it sort of, sort of takes a little bit of, of a sharp edge off of general solicitation. And then the, and accompanying that the verification of accreditation status, one of the things that the ACA has established is something called the Existing Angel Group. Which means that by virtue of, of your membership and existing angel group, you are meeting the requirements of verification. So you don’t have to submit a letter from your accountant or your broker or another mechanism for establishing your verification. If you’re a member of, of an EAG, and all organizations that belong to the ACA have the opportunity to, to gain that level of certification through the ACA, then you don’t have to, to worry about tax returns and, and letters from accountants or brokers.

Nick: Got it. You’re too good, #David. You’re taking, taking a bunch of my later questions here. So

David: Let me, let me steal one more from you then

Nick: Alright

David: The accredited investor definition is an interesting topic in that under Dodd-Frank, the SEC must review the accredited investor definition every 4 years. And interestingly enough, 2014 was that year, and that year came and went as did 2015. So the SEC has really been a bit tardy on commenting on, on what should happen to the accredited investor definition. And for those who don’t know, there are financial thresholds that determine whether or not you’re accredited. There’s an income threshold of 200K or 300 including your spouse or a one million net worth threshold that’s excluding the value of your primary residence but not any other residences. So those levels of wealth and income have been the measures of accreditation for 30 years. And when this was raised in 2014, some members of the SEC in sort of a stroke of you know blindness suggested that maybe those levels, those thresholds should be increased by the consumer price index or some other metric inflation since the beginning of time. And that would have effectively doubled both of them and would have made about 60% of angels in the United States including me unaccredited. And so we, we spent a huge amount of time lobbying the SEC and getting members of Congress to do that as well. Basically making the point that of the 400,000 people that are angel investors in the United States, the last thing you want to do is cut that number in half because they’re starting small companies or facilitation to start up small companies. And if you look at the labor statistics, small companies have basically provided over 90% of the net new jobs in our economy over the last 20 years. So we’re a job creator. And the discussion went from gosh don’t increase it to let’s actually expand it. And so what the SEC is now talking about is keeping the levels of wealth and income roughly the same, although in the future those might go up according to the CPI, but adding a measure of sophistication. So for example, if you have an advanced degree or have served on the Board of a private company or some other set of measures of sophistication that you could become accredited even if you don’t meet the thresholds of wealth and income. And we, we think that’s an enlightened view, and we’re hoping that that regulation comes down the pipe soon in, in the near future.

Nick: Yeah it would be quite a shock to the ecosystem if they have the number of total angels putting money into deals with one of these, these updates to the accreditation definition. So

David: And, and it just, it just doesn’t make any sense, you know. I think the SEC is worried about fraud. And as I mentioned on the outset, one of the, the interesting aspects of the angel ecosystem is that there really is a lack of fraud. And so there’s no reason to, to you know, make an issue out of something that doesn’t exist. And I think we’ve done a reasonably good job of convincing the SEC that, that fraud is, is not likely to, to come into our industry, you know, at least in, in the near future. But there certainly are some, some other issues like unaccredited crowd funding that pose some potential existential threats to us I believe.

Nick: Got it. So that was like the third priority issue having to do with accreditation and the accredited investor definition. The first one you talked about was capital gains, which has to do with the PATH Act. And the second one you talked about was sort of this general solicitation, which is

David: Right

Nick: you mentioned it’s the HALOS Act or the Demo Day Bill. Can we go a little deeper on that? So what exactly does that allow? Because you know, I go to some Demo Days and the startups pitch and they say here’s how much I’m raising, here’s the valuation. And then I go to other Demo Days where they don’t speak a word of it because I think they’re worried about soliciting. You know, what does it stipulate and, and what’s now allowed as of the, the Bill passing on May 2nd?

David: Well, I think that when the SEC adopts a regulation and puts penalties behind it, then people particularly lawyers that work with, with schools and incubators and accelerators want to be very cautious not to put a company in jeopardy and/or any of the angels participating. And so many of the Demo Days have stipulated to those that are presenting that they should not consider this a solicitation event, they should not put terms. And some have even cautioned not to put financials up because they suggest the company will need capital in the future, which is mind boggling because they all do by definition, it’s a 100% necessary. So I think people have or appropriately have been cautious. Now the HALOS Act really does a good job of defining Demo Days and other business plan contests, as not focused entirely on fund raising. And even though the HALOS Act has gone through the House, there still is another step for it to go through the Senate before it gets passed. So we’re, we’re not out of the woods yet. So I would still encourage those who are organizing Demo Days and business plan contests to, to be cautious, not treat them as a solicitation event, and have the companies be very careful about soliciting the audience. And obviously if you excite an audience about what the product is and the size of that market place and the quality of the, of the management team, and there are accredited investors in the audience then they should feel comfortable as they always do in approaching the company afterwards to follow up. And then, then it can maintain it’s, the private aspect of the solicitation rather than a general solicitation.

Nick: Right. Yeah, recently I was noticing one of the more vocal investors out west was using Periscope to stream a Demo Day, a live Demo Day. And while it was nice to be able to view it, I was also a little nervous for him and for the Demo Day itself that he’s, he’s streaming this out and making it more of a, a general public event as opposed to, you know, more of a private Demo Day with investors.