A Green Light for Investment Crowdfunding?

SEC, crowdfunding, Regulation CF
Pierre Vivant's sculpture, Traffic Light Tree in the Docklands, London. Photo Credit: "Traffic Light Tree" by William Warby (https://commons.wikimedia.org/wiki/File:Traffic_Light_Tree.jpg)

SEC, crowdfunding, Regulation CF

There’s big news in the crowdfunding world.  The Securities and Exchange Commission (SEC) announced that they are (finally) voting on final rules Friday that would make investment crowdfunding legal.

Other types of crowdfunding — funding a venture with small amounts of money solicited from a large group of people — have been around for a while.  The biggest crowdfunding site has even seen its name become a verb – as in “we’re Kickstarting our indie film.”  And while one typically thinks of crowdfunding as a creature of the Internet, the concept has a long history.  The Statue of Liberty stands in New York Harbor because of a successful crowdfunding effort, although in those days they called it taking subscriptions for donations, and the campaign was done door-to-door and not, of course, online.

But crowdfunding has been limited legally.  Organizations raising money through crowdfunding, including for-profit corporations, have been restricted in what they can give in exchange for funds provided through online solicitations.  Things like t-shirts have been popular thank-you gifts, while creators of innovative products, like the Pebble Watch, have offered pre-sales of their coveted inventions.

But offering any kind of return on investment, including the opportunity to buy a piece of the company, has been off limits.  That’s because securities offered for sale in the U.S. must be registered with the relevant regulators, including the SEC and any state regulator in the states in which the securities will be offered.  Any offering that deviates from this rule must fall under one of the laws’ exemptions.  For example, there is an exemption that can apply when an issuer sells only to accredited investors (broadly speaking, institutional investors and wealthy individuals).  Until now, there hasn’t been an exemption for crowdfunding.

In 2010, some entrepreneurs began thinking about an exemption for investment crowdfunding.  They wanted to allow regular people to invest small amounts of money either in start-ups or in small businesses, such as a local coffee shop, without requiring the start-up or small business to register with the regulators.  The fact is that registering an offering with the SEC is extremely time-consuming and expensive.  When companies register an offering for the first time — that is, when the company has its initial public offering or IPO — it’s a big deal.  The local coffee shop is not going to do an IPO to raise $100,000 for a renovation; nor is a start-up going to use an IPO to get seed money.

In the wake of the financial crisis, there was broad concern about capital access for small companies.  In early 2012, Congress passed the Jumpstart Our Business Start-ups (JOBS) Act with wide-spread bi-partisan support, passing 390 to 23 in the House and 73 to 26 in the Senate.  Among other provisions, the Act included a new crowdfunding exemption in securities law.  Reactions in some corners of the start-up world could not have been more enthusiastic: investment crowdfunding would “change the world.”  But the new exemption required implementing regulation, and although the Act ordered the SEC to issue rules by the end of 2012, no rules were forthcoming.  In October 2013, the SEC finally issued proposed rules, but those proposed rules sat untouched for two years.

Finally, with Friday’s vote, the SEC will likely finalize the rules, dubbed Regulation CF, making investment crowdfunding legal.

I doubt, however, that the world will change because of Regulation CF.

The problem is that Regulation CF is really not very new.  It’s an exemption built into the regulatory framework created through the Securities Act and Securities Exchange Act in the mid-1930s.  Even though legislators clearly attempted to create a workable exemption in the JOBS Act, the process was fraught with concern about investors losing all their money through risky start-up investments.  The legislation includes limits on how much any one investor can invest in crowdfunding in any given year — ranging from $2,000 or less for lower and middle income investors, to up to $100,000 for people with incomes over $100,000.

Even this limit was deemed insufficient to fully protect retail investors.  So other features of public offerings (those that are registered with the SEC pursuant to an IPO or later offering) were incorporated into the crowdfunding exemption both in the JOBS Act itself and in proposed Regulation CF.  For example, crowdfunding issuers must both make a number of disclosures about the business and its financial status to the SEC (and the public) and make annual disclosures for as long as the crowdfunding securities remain outstanding, or the company goes out of business.  Additionally, under proposed Regulation CF, issuers must follow U.S. Generally Accepted Accounting Principles (GAAP) in preparing their financial statements.  Among other things, GAAP requires accrual-based accounting, but most small businesses use the simpler cash-based accounting method.  There are reasons to use accrual-based accounting for larger businesses, but it’s not clear that financial statements prepared in accordance with GAAP provides much benefit for investors in small businesses.

The crowdfunding exemption, both as it’s written in the JOBS Act and as the SEC proposes implementing it, is built on several assumptions that underlie the federal securities laws.  While some of these assumptions may be appropriate for the kinds of companies the SEC typically regulates — the large public companies — it’s not clear they apply to the small companies the crowdfunding exemption was designed to support.  Crowdfunding is supposed to be a simple process, one that an issuer could navigate without expensive assistance from accountants and lawyers.  Under the proposed rules and underlying legislation as they are currently written, most issuers will likely need help.  With the $1 million cap on how much a company can raise through selling securities through crowdfunding, it’s unlikely that many issuers will find the process worth the expense.

Fortunately, the JOBS Act included other provisions, many of which have already begun to help companies access capital.  There is no reason why investment crowdfunding should not exist; it’s just unlikely that many issuers will find it useful without significant changes to the underlying legislation, something no rules from the SEC can fix.  And investment crowdfunding is almost certainly not going to change the world.