Like many others, my interest in the JOBS Act really started with crowdfunding. This is probably because securities law is an imposing tangle of archaic acts, byzantine regulations and repetitive rules. (Securities lawyers commonly say things like “…Rule 506 under Regulation D, promulgated pursuant to Section 4(2) of the ’33 Act…” and expect you to understand/stay awake). Crowdfunding, however, is the hip, internet-based, exciting new thing! It’s like that Kickstarter thing your cousin, the “performance artist”, keeps posting about on Facebook! Everyone is talking about crowdfunding, so it MUST be awesome, right? Well, not so fast: a lot of media coverage and law blogs doesn't mean a law will live up to the hype (I admit my own guilt). So, what impact will Crowdfunding really have once the SEC passes all its rules?
I’m leaning towards not much. First, they have 270 days to enact the rules, but as this guy explains quite well, you really shouldn’t bother writing that down in your calendar: the SEC will be late. More to the point, some think this will be the panacea to our economies ailments, while others expect it to pretty much license fraud. Obama called this a “game changer” and I agree, but - to make a football analogy - this is more like a “two-point conversion” game changer than a “forward pass” game changer. Most start ups will eschew crowdfunding for more traditional fund raising methods.
First, we need to ask: what kind of issuer will use crowdfunding? Not the guys who are looking to ramp up an already humming business, they already have venture capitalist to turn to. And remember that the JOBS Act also amended Reg A (allows a company to sell up to $50 Million in securities with minimal disclosures and no restrictions on advertising) and Sec. 12(g) of the ’34 Act (now companies can have up to 2000 investors without being forced to go public, and employees don’t count towards the limit). One the SEC makes rules on these changes, a company can offer up to $50 Million in stock, advertising however it likes, using a Regulation A circular, provided that it keeps non-accredited investors under 500 and total number of investors under 2000. $50 Million divided by 2000 investors is a mere $25,000 per investor – not an extravagant amount by any means, and this might deepen the venture capital markets. For many more established or promising start ups, this will present a much more appealing opportunity. The “start up” that already has a product and some employees probably won’t resort to crowdfunding.
Crowdfunding is limited to $1,000,000 dollars, gleaned from any number of investors. Issuers (and the funding portals) are prohibited from advertising the offering, beyond director investors to the website (it will be interesting to see whether Facebook and Twitter links will be considered advertising or mere directing). And if the issuer wants to raise over $500,000, it will need to release audited financial statements. That means dropping a few grand on a CPA, on top of the whatever fees the funding portal will charge (and issuers would be remiss to do any of this without an attorney). The transaction costs will be high. If the issuer wants to raise somewhere between $100,000 and $500,000, then the financial statements need only be “reviewed”, which is slightly less pricey. On top of those requirements (and the basics like names of officers and addresses), issuers will need to describe the purpose of the fundraising, a description of the ownership and capital structure of the issuer and file annual reports with the SEC, including financial statements. And, do note, the SEC is empowered to make “any other requirements…for the protection of investors and in the public interest.” That means that the SEC could make any of these requirements more onerous and costly. Again, given that Mary Schapiro and Luis Aguilar have pooh-poohed the concept generally, expect the SEC to add some regulatory meat to the statutory bones.
Normally, a start up gets going using the founder’s own funds, and the money he can beg, borrow or steal from his friends and family, and sometimes they find an “angel investor” – some wealthy person willing to give them a shot in the form of a few thousand dollars. Crowdfunding will be popular among the start ups that can’t find this kind of “seed money”. Younger entrepreneurs, whose friends are all also broke, are more likely to turn to crowdfunding. In addition, crowdfunding will be huge for entrepreneurs living outside of seed-money friendly areas. It will also help individuals with really solid ideas of how to return 20% on the dollar, which isn’t the sort of return that excites many angel investors (think pizza shop in a small town without so much as a Dominos). And, to be frank, it will help the socially awkward types who can’t sell their vision face-to-face.
Crowdfunding isn’t the democratization of equity investment; it’s the democratization of angel investment. Most of us will still be unable to invest in the next Facebook or Google, because they’ll skip crowdfunding altogether. I suspect most crowdfunding offerings will end up being for less than $100,000 (meaning the issuer only needs to provide self-certified financial statements and last year’s tax return, plus the other rules). It will be for just enough to make a prototype or launch a beta version. In other words, just enough to attract a venture capitalist.
For investors, crowdfunding means a lot of chances to lose some money. Some will get to support the next must-have app for your phone, but more will probably invest in a bar or restaurant (an industry famous for failures), or with tech-geeks without a lick of business acumen. I’m okay with this, to be honest. Some will invest for philosophical reasons (support only small/local businesses), others will gamble (better here than a casino), but I think most will do it almost for fun (another venue for those who “dabble” or “play” in the stock market). And there are limits on how much someone can lose. The Act uses “income or net worth” in setting limits, which will allow some retirees with over $100,000 saved to potentially risk the greater of 10% or $20,000. Potential for fraud is restricted by investment limits, the fact that issuers need to use a broker or a funding portal*, and that said fraudsters need to give the SEC their name, address, etc. (generally not a good criminal plan, giving the Feds your personal info). More importantly, the Act requires brokers/funding portals to ask and receive answers from the investors, making sure they understand the risks. I’m pretty sure that no other group of investors have to pass a quiz before they can invest. That’s a lot of work for something that should be understood as allowing the Average Joe to invest $100 in a company a few times a year.
Crowdfunding will be good for the little guy start up. Investors who decide to go into crowdfunding should do so understanding the risks, and should model themselves after angel investors, who often invest in a dozen companies in the hopes that one strikes it big.
Crowdfunding will be fun and exciting, don’t get me wrong, and I intend to invest this way myself. For some, it really will be a game changer, but only if the game is already really, really close.
* This is really an aside: Funding portals and brokers acting as crowdfunding intermediaries will need to register with the SEC and register with an applicable self-regulatory organization. There are already a few nascent organizations coming together to create a funding portal SRO. Thus, these guys will face the type of serious and undoubtedly complex regulations not unlike those that broker-dealers already face. In addition, if a funding portal wants to skip registration as a broker-dealer, it will need to be a member of a national securities association, which means a battery of tests and not-insignificant fees. Most importantly, they will be exposed to all sorts of liabilities, which will make prudent portals wary of shady start-ups. The net effect will mean that a crowdfunding boiler room will have a similiar likelihood of getting caught as any other, only for a lot less potential payout.