Newswise — An SEC rule change in 2011 intended to protect angel investors has sharply reduced start-up funding for new ventures, according to a new study from the University of Iowa.

Jiajie Xu, assistant professor of finance in the Tippie College of Business, said the rule change meant that angel investors could no longer count the value of their house as an asset in order to be accredited by the SEC. The change has led to several effects……

--The number of potential angel investors was cut by 20% and led to an 11% decrease in the amount of angel investments in the most affected cities.

--The greatest effect has been seen in smaller cities away from the coasts, places that most need angel investors because VCs and investment funds generally pay them less attention.

--The number of patents issued to companies based in the most affected cities dropped in the decade after the rule change, as did retail sales and number of jobs at angel investor-supported businesses.

--Founders have been forced to rely more on SBA loans and second mortgages to finance their start-ups.

Xu said angel investors play an important role in venture funding, as they’re often the initial source of cash to help a founder get their startup off the ground. Most invest small amounts in any single business—she said the typical size is about $10,000, though some can reach into the hundreds of thousands of dollars. Most focus their investments on businesses in the areas where they live.

The SEC made it harder to be accredited in 2011 with the intention of protecting marginal angel investors after the Great Recession in 2008 and 2009 when many lost their primary residence. However, Xu said the agency’s assumption was that angel investors were not very sophisticated and needed the regulator to look out for them.

But she said the agency’s rule change ignores the fact that most angel investment is located in the investor’s immediate geographical area, so they know the neighborhood well and have enough information to know if a business is likely to succeed or fail.

“They’re actually sophisticated investors,” she said. “If they weren’t, they’d have a history of investing in bad firms or dead firms and they don’t. They know the local community and the local demand for a business very well.”

Xu said the affects from the loss of angel investments offsets whatever gains have come from the rule change.

Xu’s study, “Is There a Trade-off between Protecting Investors and Promoting Entrepreneurial Activity? Evidence from Angel Financing” was published in the Journal of Financial and Quantitative Analysis.

Journal Link: Journal of Finance and Quantitative Analysis