A new era of entrepreneurship in America began this week, as Title II of the Jumpstart Our Business Startups Act (“JOBS Act”) went into effect on September 23rd. The much ballyhooed act promises to make it easier for startups to obtain funding by allowing them to sell equity shares to the general public with minimal regulatory oversight. Specifically, entrepreneurs can now solicit investors online by utilizing a crowdfunding platform similar to the popular website KickStarter.[i] Does the JOBS Act bring equity financing into the 21st Century, or has Congress forgotten past lessons learned by investors duped by “snake oil salesmen?”[ii]
To be sure, the benefits of the Jobs Act are potentially enormous to entrepreneurs and investors alike. For entrepreneurs, the Act removes barriers to seed capital and allows them to directly solicit thousands of potential investors. “Now that the general solicitation ban is lifted, within a matter of days startups and small businesses can leverage the internet as a marketing tool for their fundraising [. . .] to reach potentially thousands of potential investors. Prior to this, reaching a targeted audience of 20 or more active investors often took 4 to 6 months.”[iii] This ability to utilize the internet to reach a wide-array of investors will help to level the playing field for geographically disadvantaged startups,[iv] and for those systematically disadvantaged for other reasons.[v] Other potential benefits include reduced transaction costs and increased visibility to consumers.
The benefit to investors is similar. The online crowdfunding platform promises to give investors access to a much wider range of investment opportunities by increasing available information and decreasing geographic restrictions.
There are downsides too. Most obviously, decreased regulations and disclosures increases the potential for fraud – willfully misleading investors by mischaracterizing an investment opportunity. Not as obvious is the potential for what I will call “accidental fraud” – misleading investors by unknowingly mischaracterizing an investment opportunity. As the crowdfunding platform opens up the channels of equity funding to less sophisticated business owners, the latter is perhaps the more likely danger for investors. Just as less sophisticated business owners will have greater access to channels of funding, so too will less sophisticated investors. Put simply, unsophisticated investors could be exposing themselves to more risk than they think.[vi] These investors may also have unrealistic expectations for their investments.[vii]
Some safeguards are in place, at least for now. On the investor side, Title II of the Act permits only “accredited investors” to participate in the equity crowd-funding. However, such an investor does not exactly need to be Warren Buffet. An individual needs only to have a net worth exceeding $1 million or an annual income over $200 thousand to be accredited.[viii] While those amounts are far from chump-change, they may not be high enough to prevent overexposure to risk, and they certain don’t guarantee investor sophistication. Moreover, the accreditation restrictions will be removed when Title III of the JOBS Act is implemented sometime next year.
On the startup side, Title II requires entrepreneurs to make reasonable efforts to determine that an investor is accredited. This may include “[r]eviewing copies of any IRS form that reports the income of the purchaser [. . . or] [r]eceiving a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant that such entity or person has taken reasonable steps to verify the purchaser’s accredited status.”[ix] Startups must also file SEC Form D before soliciting funds, ensuring some regulatory oversight.
Reasonable minds can differ on whether the pros of the JOBS Act outweigh its potential cons, and we likely won’t have a clear winner in that debate for years. Whatever ends up happening, it’s an exciting week for startups (and “accredited” investors) across America.
[i] http://www.kickstarter.com. Kickstarter allows entrepreneurs, musicians, and artists to solicit donations from the public to fund their projects. Often, the solicitors offer a finished version of their product in exchange for a donation.
[ii] Laws closely regulating public equity offerings date to the 1930s, and were put in place to “prevent the snake oil salesman from bankrupting the trusting and unassuming grandma,” said Ajay K. Agrawal, a professor of entrepreneurship at the University of Toronto. http://www.nytimes.com/2013/09/23/technology/law-opens-financing-of-start-ups-to-crowds.html?ref=technology&_r=1&&pagewanted=all
[iii] http://www.forbes.com/sites/chancebarnett/2013/09/23/the-crowdfunders-guide-to-general-solicitation-title-ii-of-the-jobs-act/2/
[iv] In other words, it may not be as important for entrepreneurs to relocate to San Francisco, Boston, or New York to receive the investor attention needed to raise adequate capital. In this way, the Act not only increases access to funding, but also decreases barriers to entry for entrepreneurs – particularly those with limited resources or family ties to a specific geographic area.
[v] “Other reasons” may include socio-economic status, age, sex, or race. For example, a 2010 Minority Business Development Agency (MBDA) student concluded that “[t]he average amount of new equity investments in minority-owned firms receiving equity is 43 percent of the average of new equity investments in non-minority-owned firms.” http://www.mbda.gov/node/291
[vii] For equity-based crowdfunding, the challenges could be much greater, particularly because the public is not likely to be used to traditional investment timelines and will expect financial returns quickly. http://www.nytimes.com/2013/09/23/technology/law-opens-financing-of-start-ups-to-crowds.html?ref=technology&_r=1&&pagewanted=all