Australia's '20/12 rule' is stifling angel investment and any chance of younger generations backing startups

When the topic of regulations that need to change to increase angel investment in Australia, an excuse that often comes up is:

“Retail investors aren’t prevented from investing in startups, there’s the 20/12 rule!”

Well let me tell you why that’s largely unhelpful.

I recently spoke with someone who told me they were looking to set up a syndicate to help young people invest in startups.

As an under 30s himself, he had already invested in 10+ companies to date alongside Sequoia, a16z, Y Combinator, Elon Musk, and SoftBank.

He told me he got started early and wanted to create a syndicate structure to allow other new investors get access to deals alongside him, and most importantly learn about angel investing.

These weren’t just random moms and dads he wanted to bring in, these are people who were already interested and involved in the startup ecosystem.

Fantastic idea right? Get the next generation of angels interested in investing early, while providing a relatively safe vehicle and the education to gain confidence.

The biggest barrier he said was that most of these people would not qualify as sophisticated investors and they don’t have the ability or appetite to invest directly.

He asked me:

“The problem is that these investors want the benefits of investing collectively with their contacts – to pool capital together and meet the minimum cheque size set by the startup or to diversify their investment portfolio by making more smaller investments. Can we get a lawyer to set up a trust to make this happen?”

My answer to him is this:

Yes, lot’s of angel investors pool their cash and expertise together to form syndicates like this for exactly those reasons.

The barriers to investment syndicates

However, the legal landscape to do this has some pretty large (and unfortunate) caveats:

You can’t promote or recommend your trust as an investment to other people (ie you can’t provide ‘financial product advice’).
The investment decisions and trust must be controlled by all the investors (ie. you’re not running an investment service for them).
You can’t take any fees or cost recoveries for your role in the investment (ie. you’re not running an investment business).

If you can work your trust under these (and other) rules, then great!

If not, then every participant needs to qualify as a ‘wholesale investor’ and the 20/12 rule does not apply (and you may also need to get an AFSL to support your investment trust).

It may sound crazy, but the result is that retail investors may be able to invest directly under the 20/12 rule (if they invest the startup’s minimum cheque size), but it can be really difficult for them to manage risk by pooling their investments together with others.

Let’s see how this works in practice. Let’s say that you and 9 friends decide to pool your money.

If you each put in $50,000 per year, that’s $500,000. That could go a long way, say 20 investments of $25,000 each. That’s a pretty great portfolio! If however, you each only put in $5,000, that would be $50,000 total to invest per year, meaning only 2 startups at $25k, maybe 4 if you’re sophisticated & stretch it.

Assuming you want to invest in at least 10 startups to diversify your returns (and increase your chances of backing a big exit), you may need to pool at least $250,000 ($25k from 10 investors).

Unfortunately, this is where it all falls over.

What you need to do to comply

If you need 10 people to put in at least $25,000 each to get at least $250,000 to be able to make at least 10 investments to create a diverse portfolio; you would probably want to get their commitments ahead of time to ensure that the capital will be there when you call it… and you would probably need a contract in place with fee arrangements to cover costs…. and you may need to share details of your investment mandate to potential investors to ensure they are comfortable… and if that occurs then this might be considered providing financial product advice to retail investors.

Or if you decided to go ‘low-doc’, and not put any agreements in place until a startup is identified, and rather just “mention” the deal to them each time, then somewhere after the 3rd or 4th “casual” mention of this “startup I’m investing in” to all of your 9 friends…. your little club starts to look a lot like ‘arranging’ to invest in financial products.

The sad truth of our federal financial system is that the system simply doesn’t work at scale. The rules push retail investors into making fewer, larger and more risky investments on their own, rather than allowing them to reduce risk by working together with others. It wasn’t an oversight, they designed it like that on purpose.

They are terrified that this angel investor that has experience and early access is going to swindle their 12 friends out of their hard earned money, and they would much rather that money go into places with more certain outcomes (like cryptocurrency).

THIS is why the 20/12 rule is largely unhelpful in driving smart money into early-early-stage startups and building a strong support system for them.

It totally misses the commercial reality of startup investing, and the natural tendency of Angels to manage risk and invest in groups.

My question to you all is this, why exactly are we preventing the next generation of angel investors from entering the market?