Legal crowdfunding is coming, as I explained in the first part of this series. Thanks to the Jumpstart Our Business Startups (JOBS) Act, investors big and small will soon have new ways to buy shares in startups and other small companies. This should be very good for growing companies and for the economy overall, but there’s peril for individual investors from scammers likely to be operating in the early days of this new law.
Most concerns hearken back to the Banking Act of 1933, enacted to bring order and regulation to the banking industry during the Great Depression. It was the collapse of the banking industry, not the stock market crash, that did most of the damage during the Depression. Also called the Glass-Steagall Act, it established federal insurance for bank deposits, keeping banks in the savings business and out of investing, leaving the trading to stock brokers and investment banks, which were not allowed to take deposits. Glass-Steagall along with the Securities Act of 1933 and the Securities Exchange Act of 1934 established a regulatory structure that many people thought worked well until 1999 when parts of Glass-Steagall were repealed by the Gramm-Leach-Bliley Act. Sorry for all the legislative history, folks, but you can’t tell the players without a program.
I am not at all sure that we can fully blame the financial bust of 2008 on the repeal of Glass-Steagall, since a lot of bank shenanigans started before that 1999 repeal. Still there’s a place for financial regulations and the protection of smaller investors and the JOBS Act might well open up a number of problem areas even for the best-intentioned entrepreneurs.
Let me give you an example. This week IndieGoGo, a crowdfund originally intended to support makers of independent (non-studio) films, raised $15 million to expand operations under the JOBS Act. That’s good, right? But a cold breeze is simultaneously rushing through the Indy film community as filmmakers — who have always had to raise money in dribs and drabs — deal with the possible reality that under the JOBS Act they’ll have to reveal possible risk factors to their investors as the SEC requires presently of larger companies.
The old trend was to pitch your movie. The new trend might be pitch your movie then explain how the money — every cent — could be easily lost if anyone dies in the making of the film, if anyone sues for almost any reason, if the weather is too bad, if the star walks out, if, if, if… Hey, this is hard work!
But it won’t be hard for everyone because in the early days of crowdfunding some people will get away with underestimating risks, overselling equity like in The Producers, etc. This is the fear being spread — that crowdfunding will bring out the crooks and the con men.
Of course it will, but then so did the transit of Venus this week. Crooks and con men will always be with us.
What’s misunderstood in this is how much we weren’t being protected under the old rules. I am a so-called Qualified or Accredited Investor and have for many years invested in startups as an angel. This is based on my income and/or net worth and is supposed to mean that I have enough money to survive a bad investment or two and am sophisticated enough to be responsible for my own bad decisions. A key point of the JOBS Act is that it removes this requirement allowing anyone to invest in startups.
Now here’s the important part: no entrepreneur, company, fund, or government agency has ever asked me to prove that I have what it takes to be an accredited investor. In my experience, which is pretty broad, this primary requirement that keeps little people from being involved in private equity is based entirely on the honor system.
If we look at how the current system is run, then, all those little guys who have been feeling excluded could have probably been included if only they’d pushed harder.
Frankly, I was operating as a qualified investor long before anyone even asked me the question — before I even knew the requirement existed. It’s possible, too, that in some of those early days I may not even have been qualified, not that it mattered to me in my glorious ignorance.
Just as Citibank owned Smith Barney before it was theoretically allowed, so too lots of startup investors may have been making and losing money in violation of rules they didn’t even know existed.
What’s changed with the JOBS Act and crowdfunding is that what was happening all along is now going mainstream. And going mainstream means that there will be more abuses and more little investors affected, good and bad.
The trick to making this more good than bad is in how the system is designed. And by that I don’t mean how the regulations are written. We can’t rely on the politicians to fix everything because they tend to be self-important dolts. Fortunately there’s a lot we can do ourselves to make crowdfunding a huge success.
And that’s what I’ll cover in the third and final part of this series, tomorrow.