Washington is a funny town. Good ideas get turned into bills which then get analyzed, compromised and bastardized into laws that the rest of us have to live with. Example: what’s a camel? Answer: a horse created by committee. Nowhere is this more evident than in the JOBS Act.
The equity crowdfunding idea that spawned Title III of the JOBS Act was a noble idea: let the wisdom of the crowd decide who to invest in. What the legislators and regulators have done to that noble idea, however, shouldn’t happen to a dog. Equity crowdfunding is a lassaiz faire notion in an age of regulation that gained enough steam to pass the Republican controlled House. The Democratic controlled Senate, predictably, then added a series of investor protections. As if that wasn’t bad enough, the SEC has been tasked with sitting on the point of the spear, as it were, and adding implementing regulations that will allow retail investment while restricting retail investment. I don’t blame them for dragging their feet.
By way of background, Title II allows a US company to raise up to $1 million in a 12 month period by selling stock on a portal, through an intermediary, to any number of accredited and non accredited (i.e. rich and not so rich) investors provided that certain requirements are met. The investors are limited in how much they can invest, depending on their net worth and annual income, and the scheme is designed for small bets – $1,000 to $10,000 per investor. Ideally, the law would give the little guys out in the internet ether an opportunity to invest in Startup America just like the Super Angels of Silicon Valley. As enacted, the law relies on disclosure to protect investors instead of crowdsourced wisdom, and that is its fundamental and fatal flaw.
On October 23, the SEC proposed regulations implementing Title III of the JOBS Act. The SEC action includes extensive requests for comments (295 questions), so there may be substantial movement before we have final rules.
At is conclusion, I am not sure there is much that the SEC can or will do to salvage this noble experiment. It may be that Congress has to go back to the drawing board and come up with a workable structure, like some less conflicted states have done. Or it may be that the technology and business models have to catch up with the law as it is currently written. Here are the challenges.
First, the costs of an equity crowdfund offering may be prohibitively high given the requirement of CPA – reviewed or audited financial statements, the requirement of extensive information filings with the SEC, the requirement to use an intermediary, the requirement to verify an investor’s qualification to invest (if the regs require it), and the high standard and risk of liability for material misstatements. In addition, contrary to popular wishes, advertising is not permitted. An investor can scan a portal, but that is about it.
I am hopeful that the final regs will assist. I am also hopeful that creative business models and new technologies will solve many of the problems that the Senate created when it added the investor protections. For example, I have talked to accountants who believe they can reduce the costs of reviews and audits for early stage startups to a point where a crowdfund company is not dead in the water from the start. Some entrepreneurs will drive down the costs of legal compliance, disclosure and due diligence through artificial intelligence technologies, interactive query programs and easy to use interfaces.
Other problems are simply going to require legislative fixes. For example, promoter liability for material misstatements means that more companies will get sued more often, thus driving up the costs of D&O insurance and legal compliance (if you can find a lawyer at all who wants to touch it). The law has to change to deal with the cost of that risk. Similarly, only a law change can completely address reducing the costs of using intermediaries and obtaining audited statements. Only a law change can allow advertising so that a company can get some exposure for all its trouble.
In sum, the law has to go back to deferring to the wisdom of the crowd, or not bother at all. The King is Dead.
That’s enough about Title III. The real news in equity crowdfunding is in Title II, which allows a company to advertise the sale of its securities IF it takes investment only from accredited investors. The idea makes sense – accredited investors can be assumed to be able to protect themselves from the dangers of advertisers. Again, what started as a good idea has, for all practical purposes, been gutted by the SEC. The rules that allow accredited-only advertised investments (known as 506(c)) require a company to “verify” that its investors are in fact accredited. This means asking for tax returns, or financials, or bank statements or third party certifications or stuff that no one wants to ask for. As a point in case, since the 506(c) rules became effective, there have been very few 506(c) websites. In fact, many of the websites that were developed and have been lying in wait for the 506(c) rules have instead opted to do old fashioned non-advertised accredited only investments. In a way, nothing has changed except the delivery mechanism.
Interestingly, this major development in crowdfunding has had nothing to do with the JOBS Act and has had everything to do with technology and a couple of SEC No Action letters. First, the no action letters established, quite simply, that you don’t have to be a registered broker dealer to take a carry (i.e. a percentage of the gain from the sale of an investment) in a pooled investment vehicle. Simply put, this means that the people who used to take finders’ fees on the front end for finding investments will now take a percentage of the gain on the back end when the investment is sold and the SEC says that this is just fine. Well, not exactly “just fine” but that fact alone will not cause the finder or intermediary or whatever to have to register as a BD (they still have to comply with the laws relating to investment advisors). Just between you and me, these letters only clarify what everyone was doing anyway; however, in an amazing incident of Jungian synchronicity (google it) a million light bulbs seemed to have illuminated over the heads of a million former “finders” who are now rushing to form their one-off special purpose syndicated pooled investment website vehicles for 506(b) investments. How will we know who is good at it? The Crowd Will Decide.
The market, or the crowd, promises to punish the finders who are finding dogs and richly reward the ones who know what they are doing by tying their comp to carry (just like a VC) and ensuring an early demise for lack of a “track record.” Already, the bigger players are quietly anticipating yet another “death of the VC model” given their reach into heretofore unreachable companies – and they can do it with large online communities. It is the triumph of the crowd at last, and the JOBS Act did not have one little thing to do with it.
Time will tell whether this new model lives up to expectations and whether Washington ever catches up with the market and the technology. In the meantime, I will hang out at the hearings and listen, comment and blog as the legislators and regulators continue to solve a problem that no longer exists.
Long Live the King.