Interview: Sherwood Neiss On Crowdfunding’s Future

SherwoodNeiss_HeadshotSherwood Neiss is one of a handful of people credited with the drafting and passage of the JOBS Act, legislation that will soon legalize investment crowdfunding in the United States. He is also one of the principals of crowdfunding consulting and advisory firm Crowdfund Capital Advisors.

I was recently sitting in on a State Department-sponsored web chat with himself and Jessica Jackley of Kiva when I overheard him refer to crowdfunding as “re-regulation.” With the media largely portraying crowdfunding as a deregulatory exercise, I found his characterization fascinating and wanted to give Mr. Neiss a chance to clarify his statement. I also took the opportunity to ask about some of the other common perceptions dominating the national crowdfunding discourse.

5 quick quotes for the TL;DR crowd…

  1. “… the $1M cap on entrepreneurs was put in there because while it would solve the funding void problem it would restrict any potential fraudster from taking off with more than that amount.”
  2. “Deregulation is throwing out the process.  Re-regulation is adapting the process to the times.  Crowdfunding is about bring the securities laws to the Internet Age to allow the SEC to do its job better (investor protection) while allowing capital to form (flow).”
  3. “The only way we will have an efficient marketplace is with companies like this that can help the crowd to dissect information.  Translate it into a form they will understand and build tools to make them smarter investors.  The end result?  We will demand these same tools for the public markets.  And I’d argue that would be a good thing.”
  4. “The majority of businesses that use Crowdfund Investing will be Main Street businesses.  Why do I know this?  Because I was talking to the Western Association of Chambers of Commerce a few weeks ago and after the talk they came up and told me we just solved the number one problem facing all their constituents, where to find capital.  This isn’t about finding the next Facebook (although they will be crowdfunded), it is about letting businesses that exist in communities all across the USA to have access to capital that will keep both them and the jobs they create alive.”
  5. “The SEC should move quickly to get this going.  There is nothing to limit them from making adjustments as they see fit later on.”

The full interview is below.

 

You have some well-known experience raising capital during your time as CFO of FLAVORx. How did the current regulatory environment affect your efforts (positively or negatively) to raise capital for your company?

Prior to the collapse of the financial markets we were operating under the status quo environment of Regulation D and what the banks loans, credit cards and home equity lines afforded us for growth/expansion capital.  I was fortunate enough to have a business that was cash flow positive (mental note – want to raise money, have a cash flow positive company.  Investors will throw money at you).  While the burden of the regulation (hiring lawyers at $50,000 pop to raise $750k) was required, the capital was available.  There also wasn’t any other choice.  You HAD TO find lawyers (time and effort), you had to HIRE them (cost) and you had to follow all the statutory requirements including individual state filings (Blue Sky laws) for each state where you had an investor.  While it was a nuisance, it was the process and neither I nor any of my peers argued with it.  I was able to do 3 rounds of financing and even sold the company in 2007 in the private capital markets.  (Please note, we SOLD, we didn’t IPO.  Many companies just like ours follow our path of growth and strategic sale.  There’s plenty of money to be made for investors in this type of non-ipo strategy). That all changed with the collapse of the financial markets in 2007.  While the burden, cost, etc. were necessary before, now those providers of capital disappeared.  So we (entrepreneurs, aka our nation’s job creators) were left sitting in a room going, “did they just realize that they cut the funding off to the people that are supposed to create the jobs to get us out of this recession?”

Investor protection was considered in everything we did. For instance, the $1M cap on entrepreneurs was put in there because while it would solve the funding void problem it would restrict any potential fraudster from taking off with more than that amount.

What did you experience during that process that led you to become involved in crowdfunding?

It was that shock coupled with my trying to go out and start a company in 2010 after winning a business plan competition that forced me to address this issue head on.  I won the plan and went to all the traditional sources I received capital from before; my bank (don’t loan unless you have 3 years of financials), my home equity (disappeared – i live in Miami and with the crash was 60% underwater on my mortgage), my credit cards (they slashed the credit and raised the interest rates – skip that), my private equity investors (we don’t invest in companies like this – seriously?  you invested in me before?  I thought it was about the people???).  Realizing all the excuses around me, I was venting my frustrations with my entrepreneurial peers Jason Best and Zak Cassady-Dorion.  Turns out they too faced the same problems.  Since we’d collectively probably spent over $250,000 on lawyers raising capital prior to the collapse of the financial markets and read all the documents, we clearly understood the rules.  They just didn’t relate to the internet age.  We were also giving money to entrepreneurs on Kiva and artists on Kickstarter.  Why shouldn’t we be able to use those same dollars to fund jobs in the USA?  From there we sat down and went right to each of the bottlenecks in the 80 year old securities laws.  We drafted the Startup Exemption framework.  Since I testified in front of Congress once before, I was tasked with it again and made the first venture to DC.

 

To what degree was investor protection considered when drafting the Startup Exemption and/or the JOBS Act?

Investor protection was considered in everything we did.  For instance, the $1 million cap on entrepreneurs was put in there because while it would solve the funding void problem it would restrict any potential fraudster from taking off with more than that amount.  The all or nothing cap was put in there to deter fraudsters from trying because they knew they’d have to hit 100% of their funding target or no money would hit their greedy hands.  The background check was mandated because isn’t it obvious that we should weed out bad actors up front (turns out we were the first ones to put such a thing in legislation).  The caps on investors were put in there to protect them from going over their heads, and the investor education was put in there so people would be forced to understand the risks they were taking.  Yes, we thought “you don’t have to take an education class when you buy a lottery ticket or when you land in Vegas, but the world looks at investments differently and so should we.”  Everything from disclosures to SEC registered websites were considered as investor protection mechanisms.

 

Investment crowdfunding has largely been characterized as deregulation in the media, and to be fair there are certain rules and requirements that will be loosened to make crowdfunding possible. However, this week you referred to a process of “re-regulation” in the implementation of crowdfunding. Can you expand on what you meant?

Deregulation is throwing out the process.  Re-regulation is adapting the process to the times.  Crowdfunding is about bringing the securities laws to the Internet Age to allow the SEC to do its job better (investor protection) while allowing capital to form (flow).  We don’t get rid of disclosures.  We mandate that they are there and uploaded on SEC-registered websites.  This forces a digital footprint so that if anything goes wrong we can go back and look at the documents and easily find who is responsible.  Re-regulation is the process of forcing the transaction which was taking place behind closed doors before to take place on SEC-registered platforms so we can see who is asking for money, how much, who is funding them and if they hit their funding target.  All of this information was unknown before.  Finally the SEC can/will know what is happening in the private capital markets.  Knowing what is happening will force transparency.  Re-regulation is requiring entrepreneurs to take an investor education component prior to investing.  Re-regulation is mandating audits for raises over $500k (never existed before).  Re-regulation is forcing a background check prior to anyone investing.  Re-regulation is allowing technology (social media) to do what it does naturally (topple dictatorial governments) in a process that is opaque (capital formation).  It is about allowing the crowd via social media to pick apart an entrepreneur, their business, their revenue model and their valuation in a public forum prior to investing.  There is nothing more transparent than social media coupled with capital formation.  Try pulling the wool over 1,000 eyes and you will get busted.

 

There are numerous private companies queued up whose business models are based on an effort to improve investor education, disclosure and transparency around crowdfunding offerings. How important do you think this ecosystem of service providers will be to the health of the crowdfunding industry?

It is part of the backbone of the ecosystem.  The only way we will have an efficient marketplace is with companies like this that can help the crowd to dissect information.  Translate it into a form they will understand and build tools to make them smarter investors.  The end result?  We will demand these same tools for the public markets.  And I’d argue that would be a good thing.

There is nothing more transparent than social media coupled with capital formation.  Try pulling the wool over 1,000 eyes and you will get busted.

There seems to be a prevailing assumption that investment crowdfunding will be dominated by startups and early-stage companies with little to no history on the books. This has been at the root of much of the concern about investor protection. Do you think startups will dominate investment crowdfunding?

Absolutely not.  The majority of businesses that use Crowdfund Investing will be Main Street businesses.  Why do I know this?  Because I was talking to the Western Association of Chambers of Commerce a few weeks ago and after the talk they came up and told me we just solved the number one problem facing all their constituents, where to find capital.  This isn’t about finding the next Facebook (although they will be crowdfunded), it is about letting businesses that exist in communities all across the USA have access to capital that will keep both them and the jobs they create alive.  Startups will play a role but you will see them come out of universities, tech centers, incubators and the like.  VCs will force startups to prove there is customer validation for their product prior to them getting involved by forcing those companies to crowdfund, because they know their vested interest in the funded company is the same as those customers who decide to put their money where their mouth is and pony up a few dollar to invest in the company at its early stage.

 

To what extent do you expect a need to iterate on crowdfunding’s rules? Are you concerned about the SEC’s ability to respond quickly to an evolving marketplace?

I believe the legislation is very baked and that the rules don’t need to be complicated.  We provided limits, caps, actual details about disclosures, etc.  The SEC should move quickly to get this going.  There is nothing to limit them from making adjustments as they see fit later on.

 

I’ve written in the past that crowdfunding stakeholders such as yourself have perhaps the most to lose in crowdfunding’s worse case scenario. What is your confidence level when it comes to crowdfunding’s eventual success as a means of capital formation?

I sincerely believe we are on a global movement.  Why?  Because we are now engaged as partners with the US State Department to promote crowdfunding as a policy to promote entrepreneurship because that creates jobs, and we’ve been engaged by the World Bank to help them understand how developing nations can leapfrog developed nations (just like they did with the phone by going right to mobile phones) by implementing regional crowdfunding ecosystems. This isn’t new. Crowdfund investing is friends and family financing. All we’ve done is applied technology to facilitate the transaction.  To say it will fail is to say that we don’t have faith in humans. And I just don’t believe that.

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