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.