Crowdfunding through the JOBS Act: Balancing regulation and cost of compliance
Andrew Kring
The following is a review article of several articles in the field of Financial Management. The specific topic is the opening of crowdfunding as a technique to raise equity as created by the JOBS Act. I hope that it serves both as a summary of recent research as well as an argument against the passage of the JOBS Act in its current form. While this paper is most applicable to Financial Management, it also deals with the passage of a law so some elements of a law review are present.
Abstract
The JOBS Act, signed into law in 2012 but yet to take full effect, changes a number of rules in the financial sector. Of interest in this paper is the creation of a new investment tool: crowdsourced equity funding. Prior to the passage of the JOBS Act, small businesses could not offer equity in exchange for crowdfunding, only rewards such as early access. The JOBS Act opens up crowdsourced equity funding to small businesses looking to raise money in exchange for equity through a network of unaccredited investors. This paper reviews the relevant research and comes to the conclusion that there is not enough regulation in place to protect investors. At the same time, there is too much regulation for the companies seeking to use crowdfunding, resulting in a system that either restricts investment or allows fraud to occur.
Introduction and Thesis
The JOBS Act, signed into law by Congress in 2012 but still yet to come into full effect, contains a bevy of changes to the financial industry. Perhaps most controversial is Title III of the Act, which established a new investment tool: crowdsourced equity funding through non-accredited investors. Crowdsourced equity funding is a new way to raise money that has become more popular as the internet has made it easier to do. It is a process by which a company can exchange small stakes of equity in return for cash from investors through a registered crowdfunding portal. The company keeps the equity exchanges relatively small and seeks a broad pool of investors. Importantly, this exchange occurs before a company’s IPO, which is historically the period in which the vast majority of a company’s value is generated. Prior to the passage of the JOBS Act, only accredited investors, those Americans who have a net worth greater than $1 million or have had an income of at least $200,000 for the last two years and expects to make the same amount this year, could participate in crowdsourced equity funding. Non-accredited investors could take part in crowdfunding, but were not allowed to receive equity in exchange for their cash. Instead, they could only receive special promotions, deals, or bundles of product. Kickstarter is perhaps the best-known crowdfunding portal for non-accredited investors. Now, companies can seek funding from anyone, subject to a series of regulations. These regulations affect three groups: the potential investors, the small business seeking equity, and the portal that connects the business to the investors.
Proponents of crowdsourced equity funding from non-accredited investors believe it has the possibility to democratize investing and allow previously marginalized groups, such as women and African-Americans, to invest their money in the startups and small businesses of their choice. They also believe that it will make it easier for small companies to find funding, which will spur the creation of more small businesses, and, in doing so, creating more jobs. For crowdsourced funding to become a viable investment tool, however, the JOBS Act must strike the right balance between regulation and the cost of compliance.
This paper reviews the relevant and recent research on the impact the regulation will have on the small businesses seeking investors, the investors themselves, and the requisite crowdfunding portals to reach the conclusion that the regulation is both too restrictive and not restrictive enough. That is, complying with the regulations is too costly for companies to do so. At the same time, those looking to invest are not protected enough.
Regulations for Potential Investors
The first group I examine is the potential investors, those Americans who are classified as unaccredited investors. Potential investors are split into two groups: those with an annual income or net worth greater than $100,000 and those with an annual income or net worth less than $100,000. The former is allowed to invest up to the greater of $2,000 or 5% of the investor’s annual income or net worth within a 12-month period. The latter’s allowed investment amount is capped at 10% of the investor’s annual income or net worth but not to exceed $100,000 over the 12 month period (Hazen 2012). Already a problem is encountered with the regulation, as “there is…vagueness on whether net worth includes homeownership, the inclusion of which would push many low-income individuals over the $100,000 amount in net worth” (Martin 2012). Thomas Martin, a law professor at Portland State University, goes on to say in his paper, “The jobs act of 2012: Balancing fundamental security law principles with the demands of the crowd,” that by opening the door to non-accredited investors “fraud appears imminent” (2012). Likewise, Andrew Fink, a law professor at the University Connecticut worries in his paper, “Protecting the crowd and raising capital through the JOBS Act,” that seeking investors through the internet makes fraud easier. He writes that “the impersonal nature of the Internet would seem to call for more rather than less investor protection” (2013). Here, Fink rightfully raises the concern that crowdsourced funding occurs purely on the internet, where fraud is easier to commit due to lack of personal disclosure and identification.
Finally, the connected nature of crowdfunding means that even if fraud is committed in a relatively small number of instances, it could have a large effect. In this vein, Abbey Stemler, an assistant business law professor at Indiana University, states in her paper, “The JOBS Act and crowdfunding: Harnessing the power and money of the masses”, that “as the influence of the Crowd is only impressive in its aggregation, the sum of fraud perpetrated on just a small portion of the Crowd could be damaging to the economy” (2012). That is, committing fraud in a limited number of instances could affect a large number of people due to the interconnectivity of crowdfunding. For example, if a company finds 1,000 investors through crowdfunding but fraudulently deceives 20 investors, all 1,000 investors would be affected.
Regulations for Small Businesses
Regulations also exist for the small businesses seeking to raise money through crowdsourced equity funding, which manages to be too costly to comply with while also not being restrictive enough to prevent fraud. Each company is required to disclose any risk to the investor, and any additional disclosures required by the Securities andExchange Comission (SEC). Furthermore, for companies seeking to raise more than $500,000, audited financial statements are required to be filed with the Securities and Exchange Commission (SEC). Finally, all companies must file separate annual reports with the both SEC and its investors (Hazen 2012). Fink estimates that complying with these regulations will cost companies “between $40,000 and $60,000” (2012) a year. This cost is prohibitive for small businesses and in some cases may be greater than the amount they are seeking to raise. As such, it seems likely that small businesses will explore alternative investment vehicles in order to raise money.
While complying with the regulations is expensive, it is not enough to prevent fraud. Stemler finds that part of the problem is systemic, saying the “SEC’s resources are limited, and the Commission cannot be expected to be effective in the crowdfunding arena—especially considering widely reported enforcement failures involving much larger economic stakes.” (2013). Likewise, Fink finds that the SEC has been “dangerously inefficient at regulating billion dollar transactions and entities” (2012). Both Stemler and Fink raise the same concern: if the SEC cannot properly regulate its biggest, most important, and longest-established industries, then it will not be able to regulate a new, relatively small industry such as crowdsourced equity funding.
Regulations for Crowdfunding Portals
Finally, the portals responsible for connecting investors with the small businesses seeking them are subject to regulations as well. Chiefly, a portal must:
| A. [Ensure that investors] review investor-education information, in accordance with standards established by the Commission, by rule.
B. Positively affirm that the investor understands that the investor is risking the loss of the entire investment, and that the investor could bear such a loss; and C. Answer questions demonstrating— i. an understanding of the level of risk generally applicable to investments in startups, emerging businesses, and small issuers; ii. an understanding of the risk of illiquidity; and iii. an understanding of such other matters as the Commission determines appropriate
|
(Securities and Exchange Commission 2015).
The portals are given a seemingly large amount of responsibility, particularly, the mandate to educate investors through a portal that exists solely on the internet. The responsibility given to portals is particularly troubling because it is unclear “how Congress intends the intermediary to conduct this screening process” (Martin 2012). Without guidelines that are more clearly stated, it is entirely possible for portals to fail to adequately protect investors. Martin worries that portals may simply insert provisions on investor education into its terms and conditions, allowing the portals to claim that they adequately protected investors. These documents are often tens of pages long, written in complex legal language, and as such, they usually go unread. While there is not enough regulation of portals as is, more thoroughly regulating them would cost more money and decrease incentive to run a portal.
Conclusion
In all three parts of the crowdfunding process, the investors, the portals, and the small businesses, there exist problems with the current state of regulation. Investors are not adequately protected. The small businesses themselves are not properly regulated, but the cost to properly regulate them is too high. Finally, the regulations for the portals themselves are too ambiguous to ensure that investors are properly educated and protected. Proponents of crowdfunding are correct; it does have the possibility to democratize investment, create jobs, and empower those who previously could not invest. Unfortunately, these lofty goals and ideals cannot be realized with the law in the in its current state.
Works Cited
Fink, A., (2012). Protecting the Crowd and Raising Capital Through the JOBS Act. Social Science Research Network. http://poseidon01.ssrn.com/delivery.php? Hazen, T., Crowdfunding or Fraudfunding?. North Carolina Law Review, 90, 1735-1770.
Martin, T., The JOBS Act of 2012. Social Science Research Network, 1-34. http://dx.doi.org/10.2139/ssrn.2040953
Securities and Exchange Commission. (2015). SEC adopts rules to permit crowdfunding [press release]. https://www.sec.gov/news/pressrelease/2015-249.html
Stemler, A., (2013). The JOBS Act and Crowdfunding. Business Horizons, 56(3), 271-275.