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JOBS Act Legalizes Crowdfunding for Startups

JOBS Act Legalizes Crowdfunding for Startups

The Jumpstart Our Business Startups Act (aka JOBS Act) was signed into law by President Obama on April 5, 2012 with overwhelming bipartisan support. The Act is intended to encourage funding for small businesses by making it easier for certain small businesses to comply with securities regulations (or bypass certain regulations entirely.) Title III of the Act, known as Crowdfunding, amends Section 4 of the Securities Act to create a new exemption for offerings of “crowdfunded” securities. It will exempt issuers from the requirements of Section 5 of the Act when they offer and sell $1 million or less in securities, don’t exceed certain thresholds and meet certain other conditions. The bill allows startup companies to  turn to online investors to raise much-sought-after startup capital — similar to how websites such as Kickstarter let users raise money for films, books, or other projects. Furthermore, the investors can be non-accredited investors (your everyday Jon and Jane Smith – an accredited investor can roughly be translated as “a wealthy person with money to burn”). Essentially, the JOBS Act allows websites to help everyday investors contribute small amounts of capital to for-profit business projects that they read about online. This allows projects that might otherwise have difficulty finding big time investors to raise money more quickly and efficiently.

Since the law has been passed, there has been a lot of discussion and debate about the effects of crowdfunding and whether and how it will help up startup businesses and potential investors.

Crowdfunding Pros and Cons

Ryan Caldbeck, the CEO for crowdfunding website CircleUp, cites multiple reasons that crowdfunding is positive for investors. First, he argues that it significantly reduces costs. Transaction costs for items such as legal due diligence, equity document preparation, background checks, finders’ fees, and more can run into the high six figures on an equity investment of just a few million dollars. Well-run crowdfunding platforms don’t have these high costs for investors, as they standardize legal documents, background checks, and costs that would otherwise make it prohibitively expensive for an individual to invest in a few deals per year. Caldbeck also maintains that crowdfunding helps companies efficiently manage and leverage their investors for maximum value. Crowdfunding helps with networking, as it gives startup companies the opportunity to bring in additional contacts, advice, and, eventually, investors.

However, the measure has not received support. Matt Taibbi, a political blogger for Rolling Stone, claims that the JOBS Act basically legalizes fraud in the stock market. By loosening a whole range of reporting requirements and expanding stock investment beyond accredited investors, and by giving official sanction to Iinternet-based fundraising activity, Taibbi argues that the Act will invite people to cheat the system. He predicts a rash of sham startups looking to swindle small investors out of their money.

The Huffington Post’s Tim Berry is similarly concerned whether the safeguards put in place within the Act to stop fraud will actually work. Startup businesses are required to disclose certain items of information in order to better inform investors. However, Berry’s concern is that these new “Average Joe” investors will treat the disclosures like most of us treat the “I Agree” button in a software license agreement, arguing that unaccredited investors won’t bother to read the information fully in front of them before they choose to invest in a company. Furthermore, if the safeguards against fraud do not work, the entire Act’s purpose has been defeated, in that it will not ultimately create more startups or more jobs. Finally, the considerable risk of novice investors getting burned by bad investment choices could end up having a negative impact on all the crowdfunding that the Act is intended to generate.

Another concern is that because there is the potential of hundreds of shareholders investing in one company, too many shareholders could result in a complex capital structure that could discourage venture-capital firms from making later investments. Venture-capital firms often help companies to grow or stay afloat in times of need. Deterring VC firms from investing might hurt an emerging company in the long run.

Ultimately, many of these potential issues will fall upon the Securities and Exchange Commission. The crowdfunding exemption in the Act gives the SEC a lot of leeway to create standards through its rulemaking process. The Act requires the SEC to adopt implementing rules within 270 days of the law’s enactment. It remains to be seen how the SEC will guide the development of corporate crowdfunding.

Some Tips for Companies Interested in Crowdfunding

A few pieces of advice for businesses interested in using new websites to secure crowdfunding:

  • Take the time to research and do your homework. It is important to know who you working with.
  • Pay attention to the website’s management team and the investors involved the site. The more knowledge you have about the people running the site, the more trustworthy the site.
  • Gain knowledge on the safeguards implemented that will help you and the investors. Do you feel safe and comfortable with the safeguards through this platform? Do you truly understand them?
  • Make sure the site creates transparency for both you and the investors. Transparency gives the investors the information to make a good decision for themselves, which will lead to attracting higher quality investors, which is better for you.

I’ll be writing more about this process as it develops, and I welcome any thoughts or input about this new era in startup investment.

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