Earlier this year I wrote a series of columns about crowdfunding and the JOBS Act, which was signed into law last April with several goals, one of which was to help startups raise money from ordinary investors. Those columns were about the promise of crowdfunding and the JOBS Act while this one is about what progress has been made so far toward that end. For startups, alas, the news is not entirely good. Crowdfunding looks like it may not be available at all for the smaller, needier companies the law was supposedly designed to serve.
It’s one thing to pass a law and quite another to write rules to carry out that law. Title 3 of the JOBS Act required the U.S. Securities & Exchange Commission (SEC) to write rules for the so-called crowdfunding intermediaries or portals specified by the Act, to choose or create a regulator to monitor those new entities, and to write rules clarifying how deals could be advertised to non-accredited middle class investors.
My research so far suggests that while the rules are coming along toward defining the crowdfunding portals, the SEC is taking a conservative approach that will effectively disenfranchise most startups looking for capital. Specifically it appears the SEC is uncomfortable relying solely on crowdfunding portals to handle the deals and is leaning toward requiring registered broker-dealers be part of each crowd funded transaction.
Involving broker-dealers is not bad in itself, but it will change the nature of the deals, making them larger. There’s another entity to be paid, for one, meaning a lower return for the entrepreneur because of higher costs. Broker-dealers are already involved in private placements that average $700,000. Will they even be willing to look at smaller deals?
On our Startup Tour in 2010 we visited companies that had raised from no money at all up to $70 million, but the median raised was $40,000. If regulated equity crowdfunding requires a portal and a broker-dealer, and broker-dealer fees and revenue expectations are based on $700,000 deals, there is reason to believe they won’t bother at all with $40,000 opportunities.
So typical KickStarter deals won’t naturally transfer to equity crowdfunding and the vast majority of startup founders won’t receive any help at all from the JOBS Act.
There’s worse news still for the crowdfunding portals, themselves. They were created by the JOBS Act as a cheaper alternative to broker-dealers. Yet it looks like crowdfunding under the JOBS Act will require both entities. Actually, that’s not the case, because a broker-dealer can do anything a crowd funding portal can do, so the most logical way for things to proceed is for the broker-dealers to take the business leaving the portals with nothing to do.
But why would anyone want to tart a crowdfunding portal anyway? The way the law is written, no one in their right mind would want to be a portal. They have to bear all the regulatory liability and expense of vetting and educating everybody, but will not have the ability to either solicit business or charge fees. If the current SEC mindset regarding what constitutes “solicitation” is maintained, they won’t even be able to do what run-of-the-mill portals do, which is to act as a platform for the aggregation and exchange of information. This is crazy!
The JOBS Act has inspired many startups, nearly all of them would-be portals, but the trend we’re seeing from the SEC suggests that those portals are likely to fail.
This information I’m sharing comes from attending public meetings, interviewing securities attorneys at the heart of this process, reading SEC comments published to date, and talking directly with the SEC, itself.
The SEC can change direction, of course, but to do so before January is unlikely. And I think they are really trying to do a good job. But remember the SEC is tasked with protecting the public, which they take very seriously. That mandate conflicts with some of the requirements of the JOBS Act, and the result is what we’re seeing.
Based on where things stand today, I expect broker-dealers to take most of the business. I expect the Financial Industry Regulatory Authority (FINRA) to be named the crowdfunding regulator because they already regulate broker-dealers. And I’m not sure the SEC yet has a handle on how to do advertising and solicitation.
There’s a huge irony here that Americans are allowed — encouraged — by government to lose $140 billion per year buying lottery tickets yet the $20 billion startup ecosystem, which actually creates many jobs, is considered too risky.
You can lose all your money on lottery tickets, casino gambling, or even common stocks, yet the JOBS Act limits Americans to investing only a small percentage of their income or net worth.
This is not the fault of the SEC, which is simply trying to implement the law while staying within its broader mandate to protect the public.
Maybe lotteries should be put under the SEC, too.
So the JOBS Act is headed toward disappointment. I expect the average deal size will be around $500,000. This is not bad in itself, but it leaves out in the cold most startups. Or startups can increase their raises to match the revenue requirements of broker-dealers, which means founders will lose control earlier, fewer companies will succeed, and fewer fortunes will be made.
We see this latter trend all the time in venture capital, by the way, where VCs need larger deals to suit their own business models, founders comply, but in doing so they lose their companies. It’s a bad trend and is in part why venture capital returns have dropped in recent years.
Again, this isn’t the fault of the SEC, but what I think will likely happen come January is rules will be issued and crowd funding will go nowhere.
At that point there’s the possibility that Congress will take another look at the legislation, make it clearer and more reasonable, and the SEC might take another shot at the rules. But there’s no guarantee any of that will happen.
These things have a way of just being forgotten in Congress when there are philandering generals to be scolded.
This may be a case where the cart is in front of the horse. It sounds like the SEC is designing the rules in a way similar to the rules used with large banks, investment firms, and large companies. Startup firms as you correctly notes are SMALL. Their money needs are usually modest. I suspect they would be best served by a system designed to work at the local level.
If I knew about a startup with a good idea in my hometown, I’d be tempted to invest in them. Would I invest in a small firm 500 miles away? Probably not. As an investor what I would want is access to information that would lead me to firms needed investor in my community. I would want some rules on how the manage their money and report their finances. I would want some rules defining my rights and responsibilities as an investor, and their rights and responsibilities as a borrower. I like the idea of a broker or clearing house to handle the money. Why can’t it be a local bank? Whenever there is a tragedy in a community their is often a process set up for people to donate money to help. A local bank sets up an account and will accept the money. They will provide the accountability needed by the IRS’s rules on charities. Would this not be a better way to handle crowd funding?
Since this is all part of the JOBS act, I’ll assume it’s about creating employment opertunities by goosing small business activity (although it could have something to do with a Steve Jobs memorial).
If you want more of an activity, you reward people for doing it. If you want less of an activity, you punish people for doing it. As much as we would all like everyone to feel good about paying taxes, it is seen by most as a punishment, at least when you get about 17% or so.
If the government really wanted a cheap and easy way to put people to work it could just put a tax credit, or even direct payout, for every employee hired. That way the highest expense of any company, employees, could be offset by a tax break or some sort of paid internship program (that is almost certain to be abused). Instead, we continue to see payroll taxes, mandates for health insurance, and minimum wage laws that discourage putting butts in chairs.
Bob,
How about a tax credit for an investor who invests (or loans) moderate sums to startups? The investor would have certain limits on the amount of funds allowed per startup and on an annual basis. An accredited investor would have higher limits.
There would be certain rules imposed on the startups, but nothing like those imposed by the SEC. Where the investor has personal access to the startup, these rules on the startup should be minimal.
If the startup is successful, the investor gets both the tax credit and the agreed upon return on the investment or loan. If the startup fails, the investor gets only the tax credit.
” But remember the SEC is tasked with protecting the public, which they take very seriously. ” (COUGH)
Ask a certain Harry Markopoulas for HIS opinion: http://en.wikipedia.org/wiki/Harry_Markopolos
An ad on the front page of iCringly is redirecting me to some other site when I use my iPhone.
Perhaps you’re not holding it correctly. 🙂
Wait…
70,000,000 top and average of 40,000. That’s a lot of under 1000$ companies. Ie no funding at all. Not even themselves.
That is exactly the point! Can the system being developed by the SEC even work for firms in the $20,000 size or smaller? If it can not serve the small startups, then it may not work as hoped.
$70 million was by far an outlier and $40K was the median.
s/want to tart a/want to start a/
I’d have sent this directly to Bob, but his Cloudflare tool prevented it.
“…remember the SEC is tasked with protecting the public, which they take very seriously…”
Really? So seriously they allowed Lehman Brothers and Goldman-Sachs?
I guess even the SEC could not fight the political pressure to “make housing affordable”.
If “the government” would get over it’s silly fantasy that it can “fix” anything… we might all be better off.
FINRA is funded by dues & fees from the B/Ds they oversee. they will likely be overseeing the crowdfunding portals. while they are mandated to “protect” the consumer… they are also interested in protecting B/Ds biz. Crowdfunding portals – done right, would absolutely take biz away from traditional B/Ds… hence the feet dragging
Sounds like the Broker/Dealers are regulating the way in which the portals will steal their business. What could go wrong with that?
Not the fault of the SEC? They’ve just proven yet again, that they are the captive of Wall Street, not the regulator of it. This smacks of special-interest lobbying up the wazoo to ensure traditional broker-dealers get in on the business. I can easily see this going the way of the RIAA’s ear;ly approach to online music sales.
No. The SEC didn’t write the law but the law specifically orders them to write the regulations to enforce the law. That would be easy except they are simultaneously bound by other laws written mainly in the 1930s. It’s not an easy job.
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[…] the innovation in the name of “safety” and essentially turn it into the status quo. See JOBS Act crowdfunding is unlikely to help most startups by Robert Cringely, a technology writer I’ve cited […]
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