On February 18, entrepreneur William Pryor successfully raised a £30,000 funding round for his U.K.-based oriental rugs business, Oriental Rugs of Bath. In return for the money, Pryor offered the 36 individuals who invested in Oriental Rugs of Bath a share of the company’s equity, divvying out 10% of the enterprise’s stock in total. This entire transaction took place online through an equity-based crowdfunding platform called Crowdcube.
This type of investing is currently illegal in America — but not for long.
Signed into law by President Obama on April 5, the Jumpstart Our Business Startups (JOBS) Act legalizes crowdfund investing in the United States. When the Securities and Exchange Commission’s nine-month legislative review process concludes, entrepreneurs across the country will be able to solicit and collect investments for their startups and small businesses via the Internet. But is the JOBS Act a beneficial piece of legislation for the average American? The bill’s ardent supporters argue it will democratize finance for the 99 percent and ameliorate the United States’ sputtering economy, while its loudest critics claim it will pave the way for another financial crisis. Whether the JOBS Act improves or depresses the American economy, it will fundamentally alter the country’s business ecosystem. It is, as President Obama called it, a “game-changer.”
OLD CONCEPT, NEW TECHNOLOGY
Although the term “crowdfunding” is relatively new — fundavlog founder Michael Sullivan coined the phrase on August 16, 2006 — the concept of soliciting money from the masses is not. In March 1885, for example, publisher Joseph Pulitzer initiated an open-call fundraising campaign in his newspaper The World. Over a six-month period, Pulitzer raised $100,000 — nearly $2.4 million in today’s dollars — to help finance the Statue of Liberty’s massive pedestal. The campaign appealed to peoples’ emotions — “Every American citizen should feel proud to donate to the Pedestal Fund,” read the advertisement — and offered rewards for those who reached certain donation thresholds (one dollar garnered a six-inch mini-statuette, five dollars a twelve-inch model). Notably, however, most of the 120,000 donations were for less than a single dollar.
There are several striking similarities between Pulitzer’s fundraising campaign and successful crowdfunding campaigns today — the micro-pledge model, the reward structure, the emotional draw — but there’s one major difference, too: the Internet. Because of the web’s global reach, crowdfunded ventures can target much narrower communities than “Americans” — say, webcomic fans or iPhone photographers — and still raise a substantial amount of money.
There are hundreds of crowdfunding sites on the web, each with its own regional or categorical niche, but Kickstarter is undoubtedly the dominant platform, routinely shattering worldwide crowdfunding records. In March, San Francisco-based Double Fine raised $3.3 million through Kickstarter to create a new adventure video game, a benchmark for the crowdfunding industry. That benchmark didn’t last long, however: the Pebble Smartwatch project, which Eric Migicovsky and the Pebble Technology team posted on April 11, currently sits at $7.3 million raised and counting.
The more than 49,300 backers funding the Pebble project won’t receive an equity stake in Migicovsky’s startup Allerta Inc.; instead, those who pledge over $115 essentially pre-order the watch to help finance its production. With the exception of peer-to-peer lending platforms like Prosper and Lending Club, Kickstarter and all other U.S.-based crowdfunding sites operate as “pledge-based” platforms, which means project creators can offer “rewards” as a “thank you” for backers who pledge to contribute a certain amount, but legally, these pledges cannot function as investments. The JOBS Act eliminates that limitation for funding platforms willing to undergo SEC certification, legalizing a crowdfund-investing framework for business ventures in the United States.
CROWDFUND INVESTING: THE FACTS
When the “crowdfunding exemption” portion of the law goes into effect in early 2013, entrepreneurs and business owners will be able to solicit investments online via SEC-certified crowdfunding portals. There are a number of restrictions embedded in this new framework — for companies, funding portals and investors — intended to safeguard investors from fraud and negligence. As discussions between the SEC, Financial Industry Regulatory Authority (FINRA), and crowdfunding industry leaders progress, the remaining ambiguity surrounding the JOBS Act’s jumble of checks and balances — who is responsible for regulating what, when — will continue to dissipate. Here’s what we know right now.
Startups and businesses offering equities to investors through the JOBS Act’s crowdfunding exemption will be allowed to raise up to $1 million per year. They must reach or exceed their funding target to collect the capital; partial sums will be returned to the original investors. Companies requesting less than $100,000 need their CEO to certify the accuracy of their financial statements; companies seeking to raise between $100,000 and $500,000 must have an accountant verify the accuracy of their financials; and companies seeking to raise over $500,000 are required to file fully-audited financial statements with the SEC. At each threshold, the initial cost of the crowdfunded offering increases — but so does the potential value of the return. All successfully crowdfunded companies must file annual reports with the SEC and their investors that disclose the businesses’ results of operations, financial statements, and other information prescribed by the SEC.
It is highly probable that the SEC will require funding portals to conduct background checks on entrepreneurs hoping to crowdfund a company — but this condition doesn’t actually appear in the JOBS Act text. The SEC may also suggest entrepreneurs maintain a minimum credit score (say, 750) as a prerequisite for crowdfunding a company — but again, this isn’t spelled out in the legislation. The SEC is actively soliciting public comments on its rulemaking process and other regulatory initiatives in regards to the JOBS Act.
The JOBS Act requires equity-based funding portals to provide disclosures to prospective investors about the company selling securities, the terms of the offering, and the risks inherent in the investment. The portals must keep raised funds in an escrow account — in the hands of a trusted third party — as capital amasses (the SEC solidified this condition during a discussion with FINRA and crowdfunding industry leaders on April 20). The platforms are not allowed to offer “investment advice,” but precisely what constitutes “advice” requires additional clarification. After the fundraising process ends, but before a company actually dispenses its shares, the legislation calls for a three-week “cooling off” period during which the funding portal and crowd of investors have time to root out any fraudulent activity. Pledge-based platforms like Kickstarter can continue to operate without SEC oversight provided they stick to “traditional” crowdfunding, as opposed to crowdfund investing.
The JOBS Act includes two tiers of investment restrictions based on investors’ annual income and net worth. If either the annual income or the net worth of an investor is less than $100,000, he can invest up to $2,000 or five percent of his annual income or net worth through crowdfunding platforms — the greater of the limits is the cap. But if an investor’s income or net worth tops $100,000, he can invest up to 10 percent of his annual income or net worth through crowdfunding portals — with a $100,000 total cap for everyone, regardless of total income or net worth.
Although the JOBS Act passed swiftly through Congress with widespread bipartisan support, it is not without its detractors.
“The so-called ‘JOBS Act’ is an extremely anti-consumer, anti-investor, and anti-jobs bill,” said Senator Bernie Sanders (D-VT) in a statement after the Senate passed the bill 73-26. “At best, this bill could make it easier for con artists to defraud seniors out of their entire life savings by convincing them to invest in worthless companies. At worst, this bill has the potential to create the next Enron or Arthur Andersen scandal or an even worse financial crisis.”
In his scathing criticism of the Act, Sanders highlights the two most common arguments against the legislation: the potential for fraudsters to scam unsophisticated investors out of their hard-earned cash, and the prospective dangers of the regulatory relief embedded in the bill.
The potential for crowdfunding fraud greatly concerns securities lawyer Jeffrey Rubin. A partner at international law firm Hogan Levells, Rubin is chair of the federal regulation of securities committee for the business law section of the American Bar Association. When Crowdsourcing.org spoke with Rubin this past Wednesday, he walked us through a hypothetical scenario of what could happen after JOBS Act’s crowdfunding exemption goes into effect in early 2013.
“I could see a promoter who raises $800,000, all of which he pays himself in salary, declares the company not to be viable, pulls the plug and then moves on to another venture,” Rubin told Crowdsourcing.org. “And so then the person goes onto the next venture, and the next one, and the one after that, leaving in his wake a number of investors who will never see their money back.”
If some disgruntled investors were to sue this deceptive fraudster, explained Rubin, it’s not clear that they would be entitled to recovery, because that person likely undertook visible — if intentionally ineffective — efforts to have his startups succeed. He may have rented offices, hired staff members, laid out business plans and so on, suggesting that his companies had some prospects but that they didn’t work out.
That scenario doesn’t seem realistic to Korstiaan Zandvliet, co-founder and CEO of the Netherlands-based Symbid.com, one of the world’s first equity-based crowdfunding platforms.
“Crowdfunding in itself is an act which is being done on the premise of being transparent,” said Zandvliet. “Of course crowdfunding will attract fraudulent behavior to some extent, but I think it’s very easy to wash out given the very open premise of crowdfunding.”
Even if a con artist manages to rip off a group of naive investors once, Zandvliet argues, there’s little to no chance the fraudster could play the same trick twice. If even just one individual digs up some dirt on an entrepreneur, soon the entire crowd of investors will know.
“This is something we have seen at Symbid, where negative publicity around a proposition basically resulted in a complete walkout of investors,” Zandvliet continued. “It’s really hard to obtain a large sum of capital from a large group of people, so you better have your story straight.”
Symbid, which intends to enter the U.S. crowdfunding market as soon as the JOBS Act is implemented, remains fraud-free after more than a year of operation.
No crowdfunded business — fraudulent or otherwise — will be able to raise a seed round without actively engaging in social networking. A Facebook page and Twitter account won’t do the trick by themselves, though. Faceless startups are fundless startups, insisted Startup Exemption’s Sherwood Neiss. Entrepreneurs who want to successfully crowdfund a company will almost certainly need to engage their personal social networks to spark the initial wave of investments, so crowdfunding con artists will effectively be stealing money from their friends and family.
“I mean, I’m sure that happens all the time,” laughed Neiss, “but again, the principles of crowdfunding entail that you’re doing this from the people that are closest to you.”
During his recent discussion with Crowdsourcing.org, Neiss highlighted an additional barrier to crowdfunding fraud: education. American investors will have to take a test about crowdfund investing before they are allowed to purchase shares through a crowdfunding platform, said Neiss. A brief introduction will provide some background information, then investors must answer questions like: “Do you understand that you should never invest money with someone you don’t know and trust? Do you understand that most startups fail? That you will likely never see your money back? That, if you do, it will likely be a fraction of your investment rather than a factor of your investment? That a return could be very far off? That investing in a wide range of startups is a better strategy than backing just a few?” Unless investors answer “yes” to questions like these, they can’t proceed.
Despite the various safeguards and investor protections adopted by the SEC and funding portals, some amount of fraud will undoubtedly permeate the crowdfunding ecosystem. Combined with the inevitable failure of many of these new startups, the danger to unsophisticated investors is quite high, argue critics like securities lawyer Jeffrey Rubin. But Luke Lang, co-founder of U.K.-based crowdfund investing platform CrowdCube, thinks these fresh-faced investors should be allowed to explore and fund the startup ecosystem despite the risks of fraud and legitimate failure.
“I think the idea that because you’re not a sophisticated investor with high-net worth you’re not responsible enough to manage, invest, and spend your own money is ludicrous and elitist,” declared Lang.
Internet technologies expert Clay Shirky agrees. He thinks allowing average Americans to invest in the previously exclusive startup ecosystem will be educational and, ultimately, beneficial.
“Unsophisticated investors become sophisticated investors by making mistakes,” he said. “I think that the regulatory bias should be in the direction of protecting investors from the downsides of failure, rather than protecting them from entering into the pool in the first place because they might fail.”
After all, argued Shirky, failure is what the crowdfunding portion of the JOBS Act is all about.
“The goal of the JOBS Act is to have more companies fail faster,” Shirky told Crowdsourcing.org. “This isn’t a side effect, this is really the main effect of improving the startup economy: getting more people to try more ideas, which inherently means more failure. But it also means more experience, it means more surprises, it means lower cost. In a way, the criminogenic argument seems to me to get halfway towards what the JOBS Act is actually targeted for in that it recognizes this lowering of the threshold to participation — but [the JOBS Act] also lowers the cost of participation.”
$1 BILLION COMPANIES NEED HELP?
Shirky, clearly bullish on the crowdfunding portion of the JOBS Act, isn’t so optimistic about the regulatory relief embedded in the bill — which, unlike the crowdfunding exemption, went into effect when Obama enacted the legislation earlier this month. When Senator Sanders warned the JOBS Act “has the potential to create the next Enron or Arthur Andersen scandal or an even worse financial crisis,” he was referring to the relaxed SEC requirements for “emerging growth companies.”
An “emerging growth company” (EGC), a new classification created by the JOBS Act, is defined as a business with $1 billion or less in annual revenue. The JOBS Act provides these emerging growth companies a five-year “on-ramp” to the public reporting stage, phasing in various SEC reporting and compliance requirements for companies in a position to go public.
To qualify for EGC status, companies must have gone public not more than five years ago, floated no more than $700 million in stock, and issued no more than $1 billion in debt during a three-year period. EGC status is (slightly) retroactive: companies that went public after December 8, 2011, can qualify for the exemption. Foreign companies can qualify, too.
The cost of SEC compliance for smaller companies is proportionally higher than for large, established companies, so in theory, this exemption will balance the scales by removing some of the burden on these companies — and, hopefully, entice them to go public. But numerous critics, including SEC Chairwoman Mary Schapiro, argue that the $1 billion limit is far too generous.
“While I share in the view that it is important to reduce the impediments to smaller businesses conducting initial public offerings in the United States, the definition of ‘emerging growth company’ is so broad that it would eliminate important investor protections in even very large companies,” said Schapiro in a March 13 letter to Congress. “A lower annual revenue threshold would pose less risk to investors and would more appropriately focus benefits provided by the new provisions on those smaller businesses that are the engine of growth for our economy and whose IPOs the bill is seeking to encourage.”
Securities lawyer Jeffrey Rubin agrees with Schapiro, citing $100 million in annual revenue as a more reasonable limit for emerging growth companies. Given that the $1 billion limit already enacted, however, Rubin thinks a number of the exemptions may prove perilous, potentially eliminating valuable trend information for investors and engendering dangerously close relationships between research analysts and investment bankers, among other concerns. In spite of those fears, Rubin thinks the emerging growth company status could still be a valuable addition to the JOBS Act if it achieves its desired aim.
“If the availability of emerging growth company status encourages companies to do IPOs and brings more companies into the public capital markets, people will ultimately consider it to be a good thing,” he said.
The JOBS Act is an enormously complex piece of legislation. We have yet to even mention the raised shareholder threshold (from 500 to 2,000) or the altered ceiling for “Regulation A” offerings (from $5 million to $50 million). All of this will play into the Act’s massive — and quite diverse — ramifications on America’s business ecosystem.
When all is said and done, will the JOBS Act actually create jobs? Most likely, yes. The deluge of startups in the coming years, a fraction of which will be successful, will create a plethora of opportunities for individuals who were previously unemployed or unsatisfied with their current positions. Many investors will lose their money, due in part to fraud but overwhelmingly because of legitimate failure. Like every other financial market, those who hedge their bets across a broad portfolio of investments will protect themselves from both. There is some danger that the crowd will overvalue startups perfectly capable of receiving funding from other venues, but the number of profitable startups that wouldn’t have received funding in any other ecosystem should more than negate the perils of overvaluation. Provided that the SEC is able to enforce the limitations laid out in the Act with some modicum of success, the benefits of crowdfund investing appear to outweigh the drawbacks.
The JOBS Act’s other components — chiefly, the reporting and accounting exemptions provided to emerging growth companies — complicate matters significantly. Given the $1 billion limit, it will likely allow mid-size to large companies to operate far more opaquely than is healthy for the business environment. Market participants, like the investment bank helping a company go public, may drive these businesses to provide additional information and disclosures not mandated by the JOBS Act. Throughout financial history, however, one thing is abundantly clear: markets do not effectively self-regulate. If these businesses can post sizeable short-term gains by avoiding disclosures key to sufficient investor protections, they very likely will. If this occurs, it will be harmful to the businesses and their investors in the long term. Whether emerging growth company status will cause the intended surge in IPOs — which would (at least partially) counteract the lack of transparency — is largely up in the air.
So, given these contradictory factors, will the JOBS Act be a net positive for the American economy? As much as we hate the cliché, only time will tell. We do know one thing for sure, though: it will certainly be interesting to watch.