The JOBS Act: a game changer for crowdsourcing?

November 2013 | FEATURE | FINANCE & INVESTMENT

Financier Worldwide Magazine

The implementation of the Jumpstart Our Business Startup (JOBS) Act, heralded as a ‘game changer’ by President Obama, is well underway. On 23 September, Title II of the JOBS Act went into effect, marking a historic day for entrepreneurship and financing in the US.

The Act’s regulations finally allow for general solicitation by companies wishing to raise money, provided that they accept investments only from ‘accredited’ investors. Under the previous regime, small and medium enterprises (SMEs) and startup companies were unable to call on their wider email, networking or social network connections to drum up support and vital investment. Conversations regarding fundraising and investing were limited to accredited investors with a net worth in excess of $1m, or who have an annual income of over $200,000.

With the second title of the JOBS Act coming into effect, the ban on general solicitation has now been lifted. Startups and SMEs who file with the US Securities and Exchange Commission (SEC) are now permitted to solicit both on and offline, provided they disclose their soliciting method to the SEC in more detail within 15 days.

Title III is likely to be implemented in early 2014; this will also be transformative for SMEs and startups. Title III will open investment even further by allowing non-accredited investors to invest in companies. For the first time, businesses will be able to advertise their investment and funding needs in any way they see fit. From billboards to newspapers to television advertisement campaigns, companies can set their own fundraising agenda.

The enactment of the JOBS Act is an exciting development for fundraising entrepreneurs. Private companies and investment crowdfunding platforms such as KickStarter Inc, Indiegogo Inc, and Rock The Post, will undoubtedly see a leap in interest and investment. Previously, crowdfunding was a domain occupied primarily by artists, musicians and specialist tech companies, among others. The enactment of the JOBS Act will change that and ‘equity crowdfunding’ could become the norm. This will allow small businesses to sell stakes in their companies, potentially allowing them to move from startup to success.

As a result of the JOBS Act, the emphasis for investors within crowdfunding itself has shifted. Whereas previous crowdfunding efforts offered patrons small tokens of appreciation for their investment, investors in these new crowdfunding ventures will be looking for financial returns on their initial outlays.

Impact

The advent of the JOBS Act is clearly a significant step for SMEs and startups across the US. Title II in particular has the potential to be truly transformational, although it is still early days. Despite the obvious enthusiasm from the crowdfunding sector, the question remains, will lifting the general solicitation ban truly be a game changer?

For many analysts the decision to enact the JOBS Act ranks as one of the most important developments in, and changes to, US securities law since the 1930s. Wil Schroter, chief executive of online crowdfunding platform Fundable, has gone on record as stating that the Act will be the “single biggest event” for capital formation since the initial public offering (IPO).

The Act stands to be revolutionary for many firms as well the national economy. Crowdfunding could inject much needed stimulation and job growth into the US economy. The end of the ban on general solicitation opens the door for grassroots fundraising via crowdfunding sites as well as across local communities. The liberalisation of solicitation rules will mean that funding will soon be available to innovators and entrepreneurs throughout the US, not just in technology hotspots such as Silicon Valley. Indeed, Titles II and III will open up the investing landscape to people who have never previously had the opportunity to invest. Both Titles of the Act will allow entrepreneurs to cast a far wider net to attract investment dollars. “This is particularly important as the trend within the traditional capital formation business of licensed broker-dealers has been only to conduct larger and larger financings,” says Douglas Ellenoff, a corporate and securities partner at Ellenoff, Grossman & Schole LLP. “Title II doesn’t limit the amount of money which can be raised and doesn’t require a funding portal or broker-dealer to be involved. Title III limits the amount of capital per entrepreneur to be up to a maximum of $1m and must be done through a funding portal which must be regulated by the SEC and the financial industry regulatory authority (FINRA).”

However, not everyone is sure that the Act will be as transformative as has been suggested. Mark Reinstra, a partner at Wilson Sonsini Goodrich & Rosati, is not convinced. “There is a significant amount of angel financing available for start-ups,” he says. “The crowdfunding portion of the JOBS Act requires issuers to comply with rules that will have a chilling effect on an issuer’s desire to engage in crowdfunding. For example, if an issuer raises in excess of $500,000, the issuer must have audited financial statements. The additional costs of compliance will likely outweigh any benefits for those companies raising smaller amounts. Where the JOBS Act could have a significant effect will be for larger transactions where sales of securities will only be to accredited investors. While the SEC has imposed more stringent requirements on verifying that these investors are accredited, I think that over time, this enhanced verification will simply be a tax on the system and will be a cost of raising capital.”

Investment platforms and investors

Although there will undoubtedly be some differences of opinion regarding the level of impact that the JOBS Act will have on the investment community, there can be little doubt that investment platforms themselves will be affected by Titles II and III.

Since the adoption of the Titles, new investment platforms have been launched across the US. Existing platforms have also begun to undergo changes, rolling out new public images. Licensed broker-dealers, with whom non broker dealer platforms must strike up partnerships in order to legally sell securities, and companies that offer accredited investor status verification services, are also beginning to launch or extend their existing services to reflect the scale of the changes being experienced in the investment landscape.

The changes to the investment outlook brought about by the Act will see new and existing investment platforms pushed to the forefront of economic vitality, job creation, and innovation. However it is entirely possible that certain investment platforms will struggle to adapt to the new regulations. As Mr Reinstra notes, “platforms that are serving accredited investors, such as AngelList, will thrive under this regulatory environment. Those platforms that cater to retail investors will struggle with the regulatory burden.” For investors, however, the impact will hopefully be much more positive. As a result of the Act there should be “more opportunities for accredited investors and more opportunities to lose money for retail investors,” states Mr Reinstra.

However, despite the optimism felt by investors and investment platforms nationwide, there will be some crucial lessons which will need to be learnt quickly. “Both Title II and Title III re-introduce deal flow back to investors that have otherwise been prohibited by the rules or industry dynamics,” explains Mr Ellenoff. “But, and I emphasise ‘but’, investors need to learn and appreciate all of the various differences in the rules, the websites and deal flow, since some websites will be broker-dealers and others won’t, some will curate their deals prior to posting on the websites and some won’t, some will only take commissions and others performance based compensation – caveat emptor.”

Alternative investment vehicles

Under the Act, the same general solicitation exemptions have also been lifted for alternative investment vehicles such as hedge funds and private equity funds. Accordingly, the Act will also be beneficial to the hedge fund industry. The Act will increase the potential investor base as well as increasing net flows into the sector. With the restrictions on hedge fund and private equity marketing campaigns now lifted, those firms that can effectively implement new marketing strategies will have a clear advantage over their competitors. Alternative investment funds will now be able to advertise their latest funds in different markets than in the past; this should help to entice new investors and capital into the industry.

The relationship between crowdfunding platforms and angel investors, venture capital and private equity funds can be mutually beneficial. There is much to gain from embracing crowdfunding for traditional alternative investment vehicles. Although they will undoubtedly need to adapt to the new paradigm, it is unlikely that crowdfunding will truly usurp alternative investment funds.

The future of the JOBS Act

Clearly the Act will be a transformative piece of legislation. It will help to set the stage for a great deal of grassroots fundraising, be it via online crowdfunding sites, through alternative investment funds or via local community organisations. No matter the starting point, in the long term this investment will help innovators and entrepreneurs everywhere to gain access to the capital they so desperately need to drive innovation and economic growth. Mr Ellenoff agrees. “As a general proposition, we believe that crowd finance, broadly speaking, will spur meaningful innovation and entrepreneurial activity that benefits all of the countries that permit such activity, create jobs and empower groups of people that have been precluded from both raising capital and investing,” he says.

Under the auspices of the JOBS Act it is clear that crowdfunding will play a large role in helping small businesses to raise capital. However, the Act may leave unsophisticated and inexperienced investors exposed to fraud. Instances of fraud will continue to be a major concern, particularly for online funding platforms which have been used previously for money laundering purposes and for advertising fraudulent projects.

The US Senate has attempted to combat any potential fraud that may arise from crowdfunding by requiring issuers to use intermediaries registered with the SEC as brokers or funding portals. These intermediaries are required to provide information to investors to mitigate the potential for fraud, and ensure that investors and issuers satisfy all requirements set forth by the SEC.

The Act will see crowdfunding move in a variety of directions, including instances of fraud, predicts Mr Reinstra. “There will be whole cottage industries that spring up,” he says. “There will be a number of high profile failures and some outright fraud in the early days. After things have settled down, the SEC will provide more clarity and more flexibility toward capital raising for smaller companies.”

Undoubtedly, the JOBS Act has shaken up the investment landscape on many fronts, yet it may take a number of years to truly determine whether or not it will be a true game changer. Regardless, for investors, funding platforms and alternative investment funds alike, the coming months will be a steep learning curve.

Richard Summerfield