New Money: How the JOBS Act reshapes crowdfunding

By Jason Graf , written on March 13, 2014

From The News Desk

As the Securities and Exchange Commission (SEC) continues to move forward with the implementation of Titles II and III of the Jumpstart Our Business Startups (JOBS) Act, new provisions have opened advertising and investment opportunities to completely new channels. This is causing the startup landscape to order to match people with resources and opportunities in previously unattainable ways.

Unfortunately, while Titles II and III of the JOBS Act are a good step forward the law will actually hamstring crowdfunded start-ups by limiting their options for raising capital outside of traditional, ineffective routes.

The new provisions from the JOBS Act were designed to open up new business markets to start-ups and entrepreneurs. Previously, general solicitation and advertising, through social media channels or email, for instance, fell outside the scope of legal practices.

The concept is tricky and a little convoluted. Business startups have always been able to raise money from accredited investors. Title II simply legalized general solicitation, the act of publicly raising money, a practice outlawed since the 1930s. For crowdfunding, the provision is a tentative step toward legitimization as a money-raising mechanism for any startup. It allows these young, prospective companies to advertise via social media, email, a sign on a street corner – anywhere, really – as long as the funds are invested through a crowdfunding portal.

The catch, and, therefore, the main reason startups have been unable to effectively utilize Title II, is that these small businesses are required to verify each individual accredited investor. To even begin legally soliciting investments, startups are required to file all of the paperwork with the SEC, brokers and dealers. Pushing this paperwork through is expensive – too expensive for a fledgling company – and so it gives the big boys, the ones who can afford it (think large, private corporations and hedge funds) the pick of the investor litter. If this all sounds suspiciously similar to how things were before Title II, that’s because it is.

In theory, Title II opens up completely new avenues for generating investment leads. In reality, the provision places an extra financial burden on these budding companies. Because Title II places the burden of investor affirmation on the startup, the companies are responsible for auditing the investors to ensure they haven’t surpassed individual investment limits. These audits are expensive, and the process effectively creates new knots that the provision should have untied.

Additionally, it is difficult to imagine any accredited, private investor being willing to turn over the necessary financial information that Title II requires for verification. And really, why would they when they can simply continue to use the old investing models, through private channels, that do not require public disclosure?

That's the issue with Title II. With Title III, which the SEC adopted on the heels of the government shutdown, there exist other problems. As the realities of Title II begin to set in, Title III looks increasingly like step toward amelioration, although it still has its flaws. It provides start-ups with another option for raising capital: the unaccredited investor.

While Title II legalized general solicitation, a coup for new, small businesses, it still limited the type of investor. Title III takes into account the possibilities of allowing unaccredited investors (anyone whose net worth is less than $1 million and who earns less than $200,000 annually) to join the investment fun. For crowdfunding, when coupled with the legalization of general solicitation, this means a small business could start a fundraising campaign on, say, Facebook, and friends, relatives or other interested parties, regardless of income level, could invest.

The new rules would cap any company's fundraising potential through crowdfunding to $1 million every 12 months. This may seem like a paltry sum compared to the figures garnered by start-ups with notable public success stories. But considering that $1 million, gathered from non-accredited investors, wasn’t even an option before, it could be a game-changer for crowdfunded start-ups.

Via crowdfunding, non-accredited investors can put in $2,000 and five percent of their annual income if they make less than $100,000 a year. From 2008 to 2012 the median household income was a little more than $53,000, according to the U.S. Census Bureau. Rounded up to $55,000 for good measure, the average person would be legally allowed to invest about $4,750. With crowdfunding capital limits capped at $1 million, it would take 211 investors to reach that relatively low threshold, a noticeable difference from the days when only 35 non-accredited investors were allowed to toss their money into the pool.

With that said, Title III still does little to reduce the amount of red tape for small businesses, such as the financial reporting requirements. Due to the complexity of the exemptions and structure provision, it still costs small businesses not only time, but money as well, as they dig through the piles of compliance requirements. And should an accredited investor decide to invest under Title III, the investment would be capped at $100,000, rather than the unlimited amount allowed under Title II.

Now, we absolutely need to open the market to non-accredited investors. Democratizing the process is the next step for startups and potential investors alike. Title II opened solicitation and advertising to the online world and with the new reach this affords, it makes sense to allow this new demographic to provide funds for startup companies previously unavailable to the non-accredited investors.

Unfortunately, the sheer scale of the process behind bringing these investors into the fold, as set forth by Title III, is simply not worth it for any company serious about fundraising. Why spend both time and money for a limited return with extra liability when accredited investors with far greater capital can be solicited with less risk and much stronger potential?

It's a shame that the JOBS Act does little or nothing for small business and startups in the immediate future. The bill was the “Entrepreneurs Right to Capital Act” not the “Entrepreneurs Right to Marketing Act.” It'll help big business and hedge funds, but do little to assist those who need the money the most.

[Illustration by Hallie Bateman for Pando]