The Obama JOBS Act and crowdfunding: bright promises, likely failure - Bring Me The News

The Obama JOBS Act and crowdfunding: bright promises, likely failure

President Obama signed the Jumpstart Our Business Startups (JOBS) Act into law, on April 5. According to the President and bipartisan lawmakers who supported it, its passage makes it easier for small companies and startups to go public and raise capital by changing a variety of the regulations around raising money. I don't think this is going to work ...
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By John Alexander

President Obama signed the Jumpstart Our Business Startups (JOBS) Act into law, on April 5. According to the President and bipartisan lawmakers who supported it, its passage makes it easier for small companies and startups to go public and raise capital by changing a variety of the regulations around raising money.

These changes include:

- Crowdfunding
- Permitting solicitation of new investors and advertising of the fundraising
- Raising the threshold for mandatory registration as a public company to 2,000 shareholders
- Facilitating initial public offerings with less or delayed regulation
- Increasing the size of Regulation A offerings from $5 million to $50 million

Many local lawfirms are offering primers on Crowdfunding to support the anticipation of this new tool for raising money. I have surveyed independent reviews as well as my own opinions which are consolidated here.

The bad news is that Crowdfunding is designed to attract unsophisticated investors, raises the risk and opens door to more fraud than convention forms of funding.

Although Crowdfunding has attracted significant and favorable press, like many actions taken by the government, the “law of unintended consequences” is very much present with many aspects of this feature.

Companies can raise $1 million from an unlimited number of investors so long as the offering is made through a qualified broker-dealer or a “funding web-portal” or Issuer.

It seems unlikely that many legitimate Issuers would find it financially attractive to raise more than $1 million in small investment amounts from a large number of investors, then bear the costs of managing the large shareholder base on an ongoing basis, and also being subject to SEC oversight and new private rights of action.

This is especially true when compared with an Issuer’s ability to engage instead in a Regulation D offering to accredited investors, which permits general advertising without SEC review of substantive disclosure or a private right of action for negligent misrepresentation. Unfortunately, it is already being predicted that many fraudulent offerings will be conducted under the pretext that they comply with Crowdfunding terms.

I can foresee the old stock seller boiler-room where tiers of agents pitch “have I got a deal for you!” Or talking naïve investors into “trading up” to other securities.

Non-accredited investors

Investors do not have to be “accredited” to CrowdFund and such investments are limited to:

-- The greater of $2,000 or 5% of the investor’s annual income, if the investor’s annual income or net worth is less than $100,000; or

-- 10% of the investor’s annual income or net worth (but subject to a $100,000 investment cap), if the investor’s annual income or net worth is at least $100,000.

Accredited investors are those who, among other things, have net worth greater than $1M, and annual income greater than $300,000 if married ($200k if single).

Accredited investors are supposed to be sophisticated enough to understand the risk these types of investments, knowledgeable enough to do their homework, and worse case, can also afford to lose the investment – as so often happens.

The relaxation of the accredited investor standard brings the typically unsophisticated investors into the highly speculative business of investing in risky ventures. It is worth noting that an angel investor has a better chance to make money at the blackjack table than in any individual early-stage deal where 1 winner out of 10 is good performance.

Non-accredited investors can be a nightmare for a CEO if they represent a significant number of shareholders. It was for me in a company that I was hired to first turn around and then run.

Unsophisticated investors often have expectations of an early-stage deal because they don’t fully understand the risk of or time required to take a company from concept to profitability. Because of both this naivety and likelihood that they put too much of their savings into a venture deal, they have a high need for information and handholding.

The wise investor puts less than 5% of his savings into these venture-type deals but the math doesn’t work for investors at these income and net worth levels. Overall, such investors typically have expectations for timing and the probability of liquidity event (making money) that does not fit the reality of this type of investment.

Less Regulation

Crowdfunding securities are “covered securities” for state securities law purposes preempted by the federal securities laws. Though removing this layer of regulation may be good news for brokers, and CEOs without other options, but many state securities regulators have been particularly upset given the potential for fraud in Crowdfunding offerings.

Information

The offering must provide a description of the purpose and use of the funding, disclose potential risks of the investment, and outline steps the Issuer must take “to reduce the risk of fraud.”

The SEC and investors must be provided with information about the officers, directors and 20% shareholders, and investors must answer questions demonstrating an ability to understand the risks involved. Depending upon the size of the offering, the Issuer must provide a range of unaudited, reviewed or audited financial statements. But this is less than a sophisticated venture or angel fund investor receives in diligence.

More importantly, without the clout of significant capital to invest, Crowdfunders are not guaranteed additional information, market-rate terms, or an ability to negotiate terms to make the deal market-rate and investor-friendly if it is not. It is likely to be a “take it or leave it” deal so only the most unsophisticated will play.

I can see where a first time CEO, or founder, who is unwilling to do the homework and preparation necessary to attract accredited investors, may wish to utilize Crowdfunding. But I see little value for these unaccredited investors outside of the ego associated with “getting into a deal.”

My concern is that Crowdfunders will make the same mistakes first time individual angels make: not being permitted or incapable of doing adequate diligence and no ability to leverage their investment to create favorable or even market-rate terms that protect them in this and subsequent rounds.

And because of the lack of the check and balance a lead investor brings, deal pricing will likely go up - further increasing the risk. Like buying a house as a money-making investment, knowing that one day it has to be sold to realize the value, most deals make money by buying at a good price rather than selling at a ultra-premium.

Given that one of the government’s primary roles is regulation and protection: this law seems to create more opportunity for fraud, increased cost, and decreased quality of companies raising money rather than facilitating raising capital for worthy emerging companies. The only saving grace is that the SEC has 9 months to create regulations.

Crowdfunders. or Fools, enter where Angels fear to tread.

John J. Alexander is President of Business Development Advisors, Founder and Chair of the Twin Cities Angels, and business author of the Angel Investment Tax Credit. Email him at: John@BusDevAdvisors.com

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