Growth Companies

Send in the Crowds

Title III of the JOBS Act — securities-based crowdfunding — goes into effect today. But there's a danger that it could be 'smothered at birth by re...
Send in the Crowds

Title III of the Jumpstart Our Business Startups Act (the crowdfunding exemption) finally goes into effect in the United States today, May 16. But don’t expect a rush of small businesses seeking to tap non-accredited investors for seed funding and other kinds of financing. At least, that’s what the experts are saying.

Crowdfunding is a method of allowing entrepreneurs to access capital via the internet without registration from a large number of small investors, many of whom may be non-accredited.

“Monday is likely to be much like any other Monday, except it’s the debut of an eagerly awaited event, Title III of the Jobs Act,” said Denise Valentine, a senior research analyst at Aite Group. “Prior to this [rule], only accredited investors could hold equity in small companies and startups, but today, everyone can.”

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With securities-based crowdfunding, the kind permitted as of May 16, a company can raise up to $1 million every 12 months. Crowdfunding has been a very hot topic for the four years since the JOBS Act passed into law, explained David Hooper in CFO’s latest edition of Square-Off. Lately, however, the excitement has worn off.

So much so that the consensus seems to be that crowdfunding will start “most likely with a whimper more than a bang,” said James P. Dowd, managing director of North Capital, in an email to CFO.

“We are not expecting an opening of floodgates on Monday,” he added.

As Hooper, an attorney at Barnes & Thornburg, explained in early May, “There has been substantial frustration with the final regulations which provide more, not [fewer], restrictions on capital raising. The attractiveness of the crowdfunding concept was that it was going to be an efficient and streamlined way to raise capital, mostly free from regulatory constraints that pose barriers to many companies — particularly early-stage companies — from raising meaningful capital.”

As CFO describes in its JOBS Act explainer, the rule requires all companies that use crowdfunding to file financial statements for the last two fiscal years (or less, if the firm launched more recently). The rules require companies to submit audited financial statements for offerings of more than $500,000. Smaller offerings would need to be certified by an independent public accountant or the company’s CFO, depending on how much money the company raises. In addition, offerings have to take place through an online portal hosted by a registered broker-dealer, like North Capital.

Criticism of the setup is coming from two camps, says North Capital’s Dowd, and those camps have divergent interests. “On the one side, you have crowdfunding service providers who would like to see a frictionless market: few restrictions, no requirement to bring in outside accountants or law firms, high fundraising limits, all issuer types,” Dowd says. “On the other side are those who are more concerned about investor protection (including the regulators): they are more concerned about due diligence, screening for fraud and bad actors, [and] ensuring that unsophisticated investors do not get over-extended.”

For the record, Dowd doesn’t think the regulations are too onerous, relative to other regulation of financial firms.

“Of course we would always welcome less regulation, but in the scheme of things we don’t believe that there is anything crazy in the crowdfuding rules,” Dowd wrote. “Moreover, our experience is that the regulators seem attuned to the concern that Title III could be smothered at birth by red tape (which is what happened to old Reg A and Small Company Offering Registration financings). In short, I believe the regulators are appropriately focused on investor protection — it’s an important concern and some of the portals would do well to pay more attention to it.”

“Everybody has gripes,” says Aite Group’s Valentine, but “the fact is people need to know what they are investing in, whether its $50,000 or $250,000; it’s money [the investor] worked very hard for and there have to be requirements about disclosure: what the company is, what it does, and what it intends to do with [investors’] money.”

Still, some believe Congress could have done a better job with Title III.

As Brian Korn, a corporate and securities attorney formerly Pepper Hamilton and now at Manatt Phelps & Phillips pointed out in our JOBS Act explainer, by filing annual reports with the SEC, companies that participate in crowdfunding “are taking public-offering-style liability on misstatements in any of their disclosures.”

Many companies would be better off sticking with accredited investors, he said.

“If you went to a private placement in lieu of crowdfunding, you would not have to file with the SEC, you would not have to use a funding portal or broker/dealer, and you could offer and raise an unlimited amount of money. For most IPOs, the legal fees are at least $500,000 to $1 million. To prepare a disclosure statement that adequately protects any business in a crowdfunding round, you’re talking about at least $50,000 to $100,000.”

There are already numerous discussions in Congress about how to improve the JOBS Act, and, specifically, the crowdfunding rules. According to Hooper, there are specific changes that would make the offering type more attractive. In particular, he said, the per-investor and per-offering caps should be raised, and the funding intermediary requirement (which is very costly for issuers) should be eliminated.

But don’t expect any swift changes to the regulations. It may just take time for issuer and investors to get used to the setup. “It will be a slow process of education and awareness, but crowdfunding will enable firms to reach another level of potential investors which could theoretically open more wallets and result in more funding and investment opportunities for small investors,” said Valentine.

“The [peer-to-peer] market took 10 years to evolve,” she added. “The [crowdfunding] portals are well positioned to provide support [to companies.] The infrastructure pieces are there. It’s just getting everyone on board.”

Even with the overall dampened enthusiasm, Dowd says North Capital has a solid and growing pipeline of prospective crowdfunding issuers.

“I personally am convinced that regulation crowdfunding will begin to play an important role in capital formation,” Dowd said.

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