Why Crowdfunding Is a Failure of the JOBS Act

How Crowdfunding could be fixed under the JOBS Act

Crowdfunding was conceived as a way to help spur job growth by making it easier for small businesses and startups to raise money from public investors. Enacted by Congress in 2012, it wasn’t until 2016 that the SEC adopted the rules and regulations for crowdfunding under the 2012 federal Jumpstart our Business Startups (JOBS) Act.

• The failure: logistics and costs involved as a result of the procedures and regulations imposed by the SEC on companies seeking crowdfunding financing make it a poor choice for small companies, and have resulted in only twelve million dollars raised this year through crowdfunding sites. As presently over-regulated, crowdfunding is a flawed structure for raising money for a new or growing business.
• The remedy: reduce the costs, increase the tax benefits and amounts that can be raised, and make the accounting disclosures and procedures in sync with the amounts allowed to be raised under crowdfunding. These improvements will make crowdfunding the meaningful source of funding for startups and small businesses and the engine for job creation it was meant to be.

I have no issue with limitations regulators chose to place on the amounts one can invest; there is no reason to encourage unsophisticated investors to gamble more than they can afford to lose. Requiring material disclosures has been a part of our system for raising money from investors throughout our lifetimes. But what disclosure is material here, in this smaller milieu, is different from what is required in IPO’s and billion dollar public companies. It is not burdensome to require small companies to disclose management’s backgrounds, proposed use of proceeds, revenue and expense projections, material contracts and risk factors. Requiring expensive financial reporting through independent accountants hasn’t provided protections that are clearly needed and affordable for companies raising far greater amounts than the million dollar crowdfunding limit.

The SEC lost its way on crowdfunding

The absence of a more flexible exit strategy doomed crowdfunding to its presently tiny presence in our capital formation system. We can and must do better if we are to remain the world leader in capital formation.

The regulators erred in failing to provide for a window at which the investor could cash a winning ticket: crowdfunding is gambling – in every gambling forum, be it Las Vegas, any race track, a lottery or the Chicago Options Exchange, bettors (investors) are provided with a reasonably prompt exit strategy for a successful wager.

Crowdfunding not only does not provide a prompt method to cash in, it locks the investment in as a long term investment in the same way as any private placement would – small investors are locked in and will likely have to hold onto their securities for years before cashing in, even if the investment is in a business that succeeds. But most new businesses don’t succeed. That’s why most venture capital professionals make it a practice to spread their bets, investing in a number of startups and early stage businesses.

Crowdfunding can be an engine for creating jobs

The need the regulators missed can be remedied by providing tax advantages and a trading mechanism, with some simple and reasonable protective devices and controls to limit opportunities for fraudulent promoters – such as prohibiting trading by insiders, only allowing the small investors to trade more freely in the small amounts they invested, and only for equity they initially purchased. This could be readily accomplished in a self-policing website established solely to facilitate and monitor sales limited to the crowdfunding investors and to the shares they purchased.

If crowdfunding investors are provided a more reasonable and more timely exit strategy, such as an exit sale website format, or some similar construct, this source of capital can be an important job creating innovation that could improve and promote crowdfunding. As an added plus, placing a low tax rate on sales when investors cash out can create a revenue stream for the government. If tax advantages were provided, such as a tax as low as 5% on the first $2,500 of profit, and an ordinary income deduction on the first $2,500 of loss in any year the loss is taken, these could also serve to stimulate capital formation via crowdfunding.

Ease crowdfunding rules

The President has the opportunity to name new heads of Treasury, of the SEC and key regulators that can do more to stimulate financing of smaller companies. Too many current reporting and financial regulations that are properly applicable to larger established companies have also been imposed on new and growing companies that can ill afford them. Certified financial statements do not provide comparable protections to shareholders of small corporations: they are costly and disproportionately eat into capital needed to grow the business.

I have seen more than one company fail, not because the business wasn’t growing, but because overly burdensome accounting requirements and attendant costs could not be met by small businesses. Regulations intended to protect investors have been material contributors to failures of growing businesses whose shareholders had already put their money into the companies; investors gain no benefit from rigorous and costly post-investment disclosure requirements. SEC requirements that apply to a so-called development stage company (a company with annual revenues of up to a billion dollars) should not be required of companies with revenues of as little as under one million dollars: in many instances the accounting requirements under SEC regulations are the same, regardless of the size of the companies.

Fixing the JOBS Act rules and regulations can be done quickly by the President’s new team. It is a needed fix that can provide rapid job growth opportunities. There is no reason to apply the accounting and reporting rules that are applied to billion dollar businesses to a recently financed, much smaller business. Lumping all companies with revenues of below one billion dollars in the one-size-fits-all category of “development companies,” as the Act does, makes no sense. This is one of the required easy fixes needed under the JOBS Act.

Do you have any questions? Would you like to discuss the matter further? If so, please contact me, Dan Brecher, at 201-806-3364.