Crowdfunding and the JOBS Act: How many angel investors will there be at the end of a SEC rulemaking?

By: Terry Colberg

On April 5, 2012, President Obama signed the Jumpstart Our Business Startups Act (the “JOBS Act”)[1], which, among other initiatives to streamline the regulatory restrictions for businesses to raise capital, provided for equity-based crowdfunding in amounts up to $1,000,000. Raising capital for small businesses and startups used to require entrepreneurs to take on personal debt or pitch their ideas to a limited pool of angel investors and venture capital firms. Some small businesses and those with personal projects, like independent filmmakers, want to tap into the vast pool of people on the internet who are not active investors, but who potentially might want to take an equity stake (e.g. part ownership) in a small business or other venture via internet-based crowdfunding portals if they found a company or project they like. Think of equity-based crowdfunding like a miniature initial public offering (“IPO”), but without the prohibitive costs and regulatory hurdles of the traditional IPO process.

Currently, small businesses are only able to secure crowdfunding by soliciting donations or loans and offering “investor rewards”, such as a free unit or copy of the final product, trinkets, or allowing the supporter to have some input on the project’s development, somewhat akin to the model used for public radio or television. The companies and their crowdfunding intermediaries, like Kickstarter[2] and IndieGoGo,[3] cannot yet sell an equity stake to their crowdfunders. Before the JOBS Act, soliciting securities (equity stakes in a company) to the public at large, or general solicitation, was illegal. Restricting the sale of securities to specific channels and to accredited investors was all part of protecting the public from confidence men. The trick to creating a regulatory framework for equity-based crowdfunding will be in balancing the eagerness of entrepreneurs to get their ideas and projects out the public with the need to protect investors against the ever present threat of fraud.

But, until the Securities and Exchange Commission (“SEC”) promulgates new rules on crowdfunding, general solicitation and selling securities to crowdfunders is still unlawful.[4] The JOBS Act mandated that the SEC take the first step to allowing crowdfunding—amending its regulations to allow for general solicitation—within 90 days. The SEC missed that mark, only announcing a thirty-day public comment period for proposed rule amendments on August 29th at an open meeting of the commission[5]. Regardless of these delays, it has yet to be seen whether the SEC can meet the statutory deadline of issuing final rules to regulate crowdfunding brokers and internet portals set for the end of this year.[6] Reuters has pointed out that in addition to the slow process of notice-and-comment rulemaking, the SEC is struggling with the responsibilities placed upon it by the Dodd-Frank Act of 2010.[7] SEC Chairman Mary Schapiro, however, remarked during a hearing before the House Committee on Oversight and Government Reform that she did not “foresee not meeting the deadline.”[8]

All crowdfunding intermediaries wishing to sell securities will need to register with the SEC and the Financial Industry Regulatory Authority (“FINRA”) and create a process to reduce the risk of fraudulent offerings, in addition to making sure that each investor has access to company disclosures and understands that his or her investments involve some measure of risk to some or all of the principle amount.[9] New crowdfunding portals, like EarlyShares[10] and Crowdfunder,[11] are getting a head start in inviting startups to prepare their sales pitches and to garner interest from investors in anticipation of the SEC finishing its rulemaking process in the next few months. Some groups, like the North American Securities Administrators Association (“NASAA”), remain concerned that this “democratization” of venture capital will expose many more investors, especially lay-investors, to the turbulent and risky market of investing in small businesses.[12] Worse, there is an increased potential for fraud. It is one thing to lose a donation to a failed project, losing an investment is another. Jason Best and Sherwood Neiss, two of the major proponents behind the crowdfunding section of the JOBS Act, fired back at NASAA, asserting that the organization’s concerns were based upon examples from the pre-JOBS Act model of investing.[13] Best and Neiss posit that the “strong disinfectant power of social media,” the protective mechanisms that the crowdfunding portals will develop, the upcoming regulations from theSEC, and other safeguards built into the legislation will be effective in curtailing fraud. In the end, it seems that the best recommendation for potential investors in crowdfunded securities will be the same advice that has been doled out to investors of all types in the past: do your due diligence and don’t risk any money you can’t stand to lose.

The growth in crowdfunding stands to dramatically change not only the way that small businesses are funded, but could help change the American economy. While the United States leads all other nations in the number of crowdfunding platforms, equity-based crowdfunding platforms have been multiplying rapidly in Europe.[14] With total crowdfunding for 2011 estimated at nearly $1.5 billion and the total for 2012 predicted to be double that amount,[15] the opening of the next stage in crowdfunding could be a shot in the arm for the U.S. economy, which has been lumbering along since the financial crisis four years ago.