Move Over JOBS Act: States Are the Real Laboratories for Crowdfunding

Today marks two years since the passage of the JOBS Act—the landmark legislation that was supposed to open up gushers of capital for the nation's small businesses and create jobs. But as the law inches closer to implementation, it's becoming clear to even (or especially) the law's most ardent supporters that it will fall short of those lofty goals. If the SEC's 600 pages of proposed crowdfunding rules are adopted as laid out, the complexities and requirements they entail will likely make it too expensive and onerous for most of the small businesses the law was originally intended to help. 

For example, the SEC estimates that companies raising less than $100,000 could pay up to 15% in legal and other fees. For companies raising $1 million (which requires audited financials), the costs could be as much as $250,000.

As that reality sets in, a number of states impatient to spur job creation and entrepreneurship are crafting laws that allow investment crowdfunding within their own borders. Kansas was the first, with its Invest Kansas Exemption (IKE), followed by Georgia. In late 2013, Wisconsin and Michigan joined in with laws of their own. 

Already this year, Maine, Alabama, Washington, Indiana and Maryland have passed their own mini-JOBS Acts, and many more are likely to follow. Why? Because they see it as pragmatic economic development, a way to strengthen their local economies. 

“I hope that IKE can serve as a model for all fifty states,” one Kansas state regulator told me. (Fittingly, Kansas was the first state in the country to regulate securities, in 1911. The argument—to keep "Kansas money in Kansas" and help local farmers and businesses rather than enriching "New York Stock Exchange speculators and gamblers"—rings as true now as it did then. (See chapter 2 of my book for more on these genesis of the Blue Sky laws) 

Although the state laws vary, generally they allow any business based in the state to raise money from any resident of the state, without all of the red tape and restrictions entailed that come with JOBS Act crowdfunding. In Kansas and Georgia, for example, companies raising money submit a simple one-page form to state regulators, and there are no audited financials required. Unlike the JOBS Act, transactions in those two states don't even need to take place on a portal (although I think portals can provide clear value). 

Because companies are restricted to raising money from residents of their state, intrastate crowdfunding may not appeal to high-flying firms that can attract a national or global audience of investors. But then, those companies typically do not have problems raising capital—unlike thousands of smaller or less sexy businesses that the JOBS Act was expected to boost.

So where does state crowdfunding stand? It's been slow to take off so far, mainly because it is so new and much education needs to be done. In Kansas and Georgia, there have been just a handful of deals so far, and many residents still don't know the laws exist. I'm most impressed with Michigan, which is taking a more hands on approach to promote the Michigan Invest Local Exemption (MILE). The Michigan Municipal League, a well respected organization that represents counties and towns throughout the state, has taken the lead in educating businesses and investors, and has partnered with two crowdfunding platforms- Localstake and Fundrise - to encourage MILE deals. The first Michigan state crowdfunding campaign - for the Tecumseh Brewery - is now live on Localstake. 

I still hold out hope for a workable JOBS Act someday. But, as with so many things these days, states are becoming the true laboratories for crowdfunding. They have an opportunity to show how crowdfunding—or in this case, communityfunding—can be done. 

Me & Patrick McHenry at the Rose Garden signing ceremony April 5, 2012

Crowdfunding: Don't Start Your Engines Just Yet

Crowdfunding has landed with a thud! On Wednesday, the SEC issued 568 pages of proposed rules for Title III of the JOBS Act – aka crowdfunding. Embedded in it were 295 questions for interested parties and the public at large to comment on, ranging from how to calculate the $1 million per year limit on how much issuers can raise (ie. should that be net of fees? should other non-crowdfunded fundraising be included or exempted?) to the economic impact of the proposed rules (question #295). 

SEC commissioners weighed in on the historic moment, proclaiming it a step forward in a "bold experiment" that has "great potential" to unleash capital for the nation's small businesses, but one that will take some time to get right. Others interpreted the voluminous proposal as the SEC kicking the can further down the road while appearing to fulfill its duty to issue rules mandated in the JOBS Act (already more than ten months behind). 

While the details are sorted out, the broad outlines of crowdfunding remain the same: 

- Companies can raise a maximum of $1 million through crowdfunding in a 12-month period
- Investors whose income and net worth are less than $100,000 are limited to $2,000 or 5% of their income, whichever is greater, in aggregate crowdfunding investments over a 12-month period
- Investors whose annual income or net worth is greater than $100,000 may invest up to 10% of their income or net worth, not to exceed $100,000 in a 12-month period
- All crowdfunding transactions must take place on an SEC-registered intermediary - either a broker-dealer or a crowdfunding portal
- These intermediaries must take measures to educate investors and mitigate fraud
- Companies raising money on these platforms must provide basic financial information (the proposed rules require audited financials for offerings greater than $500,000)

So when can we expect mainstream investment crowdfunding to be ready for prime time? 

Not so fast. 

Wednesday's proposed rules kick off a 90-day comment period. At the end of the comment period, SEC staffers will study the comments and consider whether to recommend tweaks to the proposed rules to their bosses. Sara Hanks, an attorney and the CEO of CrowdCheck, notes that the end of the comment period does not imply any action on the part of the SEC – in fact, in practice, proposed rules often languish for many months. Given the controversy surrounding crowdfunding and the magnitude of the questions buried in the proposed Title III rules, this recommendation stage is likely to stretch on for at least three months, if not many more.

The next step would be for the SEC commissioners to formally adopt the rules (or reissue rules and start the process all over again, which is considered unlikely). Bottom line: final crowdfunding rules are not likely to be released until six months out, at the earliest. 

Add in some time for FINRA, the industry regulatory body, which must issue its own rules and guidance, and a registration period for crowdfunding portals, and mainstream crowdfunding will not be a reality until mid-2014 at best.

In the meantime, read the proposed rules here, and offer your own (constructive) comments here.

The Real Risk With Crowdfunding

When the JOBS Act was signed into law last April, entrepreneurs were elated, even giddy, at the prospects. They and other supporters saw it as a democratizing force that could unlock new sources of capital for job-creating entrepreneurs, boost the economy and give Wall Street-wary investors a profitable alternative. It was one of those disruptive innovations that comes along once a generation and radically transforms the competitive landscape. It was so potentially revolutionary that pundits and financial pros alike predicted it would put many venture capitalists and banks out of business—in other words, exactly the sort of game-changing opportunity that makes entrepreneurs dream big.  

Well, ten months later, the enthusiasm has cooled. Not for the potential of crowdfunding, but for the realistic chances that it will be enacted anytime soon and in a form that honors the original intent of legislators to ease the bottlenecks that prevent so many entrepreneurs and small business owners from obtaining the capital they need to grow, hire and thrive. The SEC, which was charged with writing the rules that will govern the nascent crowdfunding industry by year-end, has missed that deadline (not surprisingly–the agency is concerned about the potential for fraud and has a lot on its plate already). Most people now believe true investment crowdfunding will not get underway until 2014. At the same time, it appears likely that the rules will require the new crowdfunding portals to be regulated much like conventional broker-dealers—in other words, more Merrill Lynch than eBay, as one observer put it. For better or for worse, crowdfunding may turn out to be a game not for idealistic entrepreneurs but for well-capitalized investment pros. 

As I wrote in my recent feature for the New York Times, despite the uncertainty, the outlines of a new industry are beginning to take shape, and with it a glimpse of what a crowdfunding future might look like: promising young companies able to get funding from people who  believe in them, regardless of those investors' net worth; new jobs being created by the availability of growth capital; and more broadly shared prosperity and economic opportunity. Sure, there is a risk of fraud and loss with crowdfunding. But then, that takes place every day on Wall Street. As Thom Ruhe, vice president for entrepreneurship at the Kauffman Foundation, told me, with the economy stuck in limbo, the bigger risk to the economy is to do nothing at all. 

In Defense of Crowdfunding

Crowdfunding legislation is tantalizingly close to becoming reality—the Senate is expected to pass a version of a bipartisan House bill within days. But a rash of negative publicity threatens to derail this important update to antiquated securities laws that hamper small business capital raising.


The problems stem from the Jump-Start Our Business Start-Ups act—JOBS, for short—a House package that rolled together a number of largely uncontroversial bills aimed at spurring small business capital raising, and added some new ones. JOBS has provoked a fierce outcry from consumer protection groups, regulators and pundits, who evoke alarming images of coke-snorting boiler room operators, Nigerian scammers and pump-and-dump research analysts. It seems this bill will make "Muppets" of all of us.


Let's all take a deep breathe and consider this.


The elements of JOBS sparking the most backlash are provisions that loosen regulations on public and pre-IPO companies, including exempting publicly traded "emerging growth companies" from certain reporting requirements, and letting issuers and financial firms peddle securities to accredited (aka wealthy) investors. Fair criticism. I don't see anyone taking issue with other elements of the bill, like raising the ceiling for Reg A offerings and increasing the number of shareholders (from 500 to 1,000) a private company can have before it is considered public.


The other key element of the package is a crowdfunding bill that had previously passed the House with near unanimous support. Crowdfunding has its share of detractors, for sure. But much of the recent criticism seems to be unfairly tarring crowdfunding and other good elements of JOBS with the same broad brush. In the Times, Floyd Norris declared crowdfunding "a major victory for Wall Street." 


That couldn't be farther from the truth.


Crowdfunding, as most people by now know, is a fundraising model where lots of small sums are aggregated from lots of people. Think Kickstarter.com, Kiva.org, and President Obama's initial presidential campaign. Crowdfunding legislation would move that model into the investment sphere, so  entrepreneurs could tap into their social networks to raise capital, and allow those investors to share in the profits. It's Kickstarter with a financial return. 


Under existing rules—rules that were crafted in the 1930s, in the age of ticker tape and telegraphs—that is illegal. Private companies may only raise money from accredited investors. If they want to reach out to their customers, their friends and family, their neighbors or social networks—a perfectly natural impulse—they must hire lawyers and accountants to guide them through a registration process and produce a bulky prospectus that hardly anyone reads. This process can easily cost $1 million or more—making it a non-starter for small firms that only need $10,000 or $100,000 or even a million.


These small firms are shut off from a huge pool of potential capital, at a time when bank lending and seed funding is down dramatically. And ordinary Americans are unable to invest in companies that they know and love and support.


Having spent the past two years talking to small businesses and investors, I can tell you that people want to invest this way. They would like to put their money in companies that they know, that are part of their community, or doing things they believe in. Just look at the success of Kickstarter, which has raised tens of millions of dollars in contributions for creative ventures. The site logged $1.6 million in pledges in a single day this week.


Before it shut down last month under pressure from regulators, ProFounder.com—a crowdfunding platform cofounded by a founder of Kiva—helped dozens of small businesses raise money from friends and family. This kind of capital is supportive, nurturing capital. It's the antithesis of vulture capital or "ripping the eyeballs out" of Muppets.   


In fact, crowdfunding presents a badly needed alternative to Wall Street-style investing. Just as Kickstarter allows independent artists to bypass the traditional gatekeepers like record studios and publishers to get their works produced, crowdfunding can help entrepreneurs with good ideas or promising growth potential get funding that is not forthcoming from banks or VCs. Millions of Americans have moved their money out of big banks to credit unions and community banks; many may want to do the same with some of their investment dollars.  


Yes, there is risk. Investors could lose money or be victims of fraud—just as they can in the stock market. Most of the proposed crowdfunding bills limit the amount that individuals can invest in a crowdfunded venture—the highest allowable amount among the bills is (the lesser of) $10,000 or 10% of their annual income—so the amount any one investor could lose would be limited. (In comparison, there is no limit to what they can lose in the stock market or at the casino, for that matter). The amount a company can raise is also limited, to $1 million (or $2 million with additional disclosure).


It is the risk of fraud that has most critics' knickers in a knot. Without a doubt, hucksters will ooze out of the ether. But there are commonsense measures included in the crowdfunding bills that can address the risk. For example, the Senate bills require companies to go through a crowdfunding intermediary to raise funds. The intermediaries (the equivalent of a Kickstarter or eBay) must register with the SEC. And they must hold funds in escrow until the money is released to the company raising it. In addition, state regulators can prosecute any offenders if someone manages to pull off a fraud.


The crowdfunding intermediaries will also perform a basic level of vetting of the companies they list on  their sites, such as background checks of principals and the like. And let's not underestimate the power of  hundreds or thousands of people dissecting a business plan and crowd-vetting an idea or a company. The Internet brings a new level of transparency to investing, in ways that the framers of the 1930s securities laws could never have imagined. In fact, crowdfunding has the potential to be more transparent than many other investments we can routinely make. Do you know what's in your emerging market mutual fund, or what the hidden fees are, for example? Do you really know what is going on inside that blue-chip bank whose stock you own? (Here's a hint)


Crowdfunding has been taking place for nearly two years in the UK without a hitch, funding hundreds of local businesses. Luke Lang, a cofounder of Crowdcube.com, which has raised more than £2.5 million in equity capital for more than a dozen companies since it launched a little over a year ago, fully expects some companies to fail; that comes with the territory. But so far there has not been a whiff of fraud. Likewise, on Funding Circle.com, British investors have lent more than £23 million to about 600 local businesses in the less than two years, with nary a Nigerian scammer or boiler room creep. 


The bottom line is, the financial system is broken. Small businesses—which create the majority of jobs, contribute half of private GDP and provide the biggest economic boost for their communities—are going begging for capital. Investor protections are predicated on the public markets, yet those markets are closed to 80% of the companies that need them, according to a report by Grant Thornton (pdf here). Small firms are simply priced out. The median IPO size has risen from $10 million 20 years ago to roughly $140 million today. 


We need alternatives. Done sensibly, with the right precautions built in, crowdfunding could unleash a new wave of innovation and job growth. The potential rewards vastly outweigh the risks. I hope Congress and the pundits will separate this issue from some of the more problematic proposals in the JOBS package.