[March 2012 Update: The Senate passed a version of the JOBS Act today with the Merkley-Brown Amendment, which includes a number of safeguards for investors: It requires publicly audited financials for companies seeking over $500,000, additional accountability for companies, industry registration for funding portals, scalable investment caps for investors, a three-week waiting period after funding closes (before funds are received) to uncover potential fraud, and disclosure of capital-raising fees. While I remain skeptical about the principles and incentives at play in equity crowdfunding as described below, these additions, well executed, could mitigate many of the most serious concerns I’ve expressed here.]
The verb “to disrupt” in all its forms is rightly popular in the startup world. To many entrepreneurs, few things are as personally satisfying (or as lucrative) as disrupting an entrenched, complacent, monopolistic, inefficient or stagnant market in ways that often empower consumers and producers alike. Consumer Internet and mobile technology businesses continue to be rife with opportunities for disruption.
On March 8, 2012, the U.S. House of Representatives passed the JOBS Act, becoming the subject of much chatter at this year’s South by Southwest Interactive (SXSW) conference that began the following day. This bill is the latest in a series of efforts and initiatives in recent years intended to disrupt the traditional methods and markets for investment in, and capitalization of, emerging growth businesses. Boosters can be found all over the Web proclaiming a nascent equity crowdfunding revolution that will ensure prosperity for entrepreneurs and mom-and-pop investors alike. As a lawyer, advisor, investor, director and co-founder myself, I am an ardent advocate for entrepreneurs, startups, and the individuals and institutions that fund them. Yet I simply can’t support equity crowdfunding in the form authorized by the House bill for reasons I’ll get into below. To cut to the chase, I believe it would lead to disastrous consequences for minimal gain, creating perverse incentives that would enrich the most “ethically challenged” hucksters, deplete the assets of those who can least afford it, while continuing to leave the most attractive investments to financial institutions and high-net-worth individuals—traditionally, venture capital firms and angel investors.
My colleague at Gust Blog, veteran angel investor Bill Payne, has written a series of outstanding posts on the subject already. If you’re new to the subject, I highly recommend reading this post by Bill, which is more balanced than mine, neatly summarizing the pros and cons, risks and benefits. I’d like to supplement his pieces with my own perspective, developed as an in-house and outside lawyer for startups and investors over the past 15 years. In the course of my career, I’ve counseled clients in matters ranging from $10K friends-and-family convertible debt seed financing for new startups to overhauling a Nasdaq 100 company’s financial disclosure controls and securities compliance as Chairman of the Disclosure Committee in the wake of the Sarbanes-Oxley Act of 2002.
First, it’s important to define what we do and don’t mean by “crowdfunding.” There are various ways of collectively funding new initiatives, such as pooling donations to a non-profit entity or facilitating collective sponsorship of creative projects as Kickstarter does. There are also startups funded by a large number of individual angel investors or groups, all of whom meet the criteria for “accredited investors” under current U.S. securities law. Those are all worthy pursuits that fall outside the scope of this discussion.
My definition of the type of equity crowdfunding contemplated by the JOBS Act — more accurately dubbed “crowd investing” — is the making available of equity shares in a for-profit business enterprise for investment in relatively small dollar amounts by a relatively large number of individual investors who do not meet the traditional “accredited investor” criteria.