I spent a lovely weekend reading (and re-reading) all 685 pages of the final SEC rules of Title III the Jobs Act. Ah, the joy of memorizing regulations!
We helped Congress pass the JOBS Act back in 2012, to help everyone — no matter how wealthy — invest as little as $100 in startups they love. We’ve been waiting for the SEC to implement the law ever since, so I was eager (to say the least) to read what they finally came up with after three years.
Surprisingly, most of the final changes the SEC made were good. They clearly carefully considered our feedback (Wefunder was cited 72 times in the footnotes of the final rules).
However, by the end of the weekend, I came to an inevitable conclusion: thanks to one last-minute change by the SEC, only small businesses with no ambition to grow will use the JOBS Act.
As a result, normal Americans will continue to be locked out of investing in the high-quality startups that only accredited investors (i.e., the rich) have access too. The SEC has created a system that allows “everyday” investors to only invest in companies that can’t get funding elsewhere from a professional, experienced investor.
It’s up to Congress to overrule the SEC and save Investment Crowdfunding for everyone. We’ll be lobbying hard for passage of a bipartisan bill that takes the noncontroversial aspects of the Investment Crowdfunding Improvement Act introduced in the House by Congressman McHenry.
JOBS Act: The Good, The Bad, and the Ugly
The best surprise is that the SEC reversed its former position, and now allows platforms to be compensated with a financial stake in companies. We’ve always considered this to be critical: well-run platforms will align their incentives with their investors, earning profits only when their investors do, while reducing the costs for cash-poor companies. Otherwise, platforms would be incentivized to list every crappy company that comes along, and parasitically suck out 10–15% of the fundraising round for their up-front fee. We prefer not to be a parasite; we want skin in the game.
This battle was hard to win. Congress originally wrote the legislation to prohibit platforms from taking a stake in companies, but we convinced Senator Brown of our position, and he rose up to argue the case on the Senate floor. Thankfully, Senator Brown had an impact — the finalized JOBS Act allowed the platform to earn a financial stake.
So we were shocked when the SEC then prohibited it on their own initiative two years ago. Thankfully, since then, we, along with many others, changed their mind. The SEC now writes in the final rules:
As commenters further noted, permitting such a financial interest may also help to align the interests of intermediaries and investors, and provide an additional incentive to screen for fraud. We believe at this time the interest of promoting capital formation for small businesses, and developing a workable framework for securities-based crowdfunding, counsels against extending the prohibition on financial interests to the intermediary itself.
Startups cannot accept thousands of direct shareholders— it endangers their follow-on financing as venture capitalists don’t invest in companies with “messy cap tables.”
Crowdfunding platforms for accredited investors (i.e., “rich people”) solved this problem with Special Purpose Funds. These group investors into one fund, managed by the platform, which then invests as one shareholder into the company. The platform also combines the voting power of all small investors and advocates on their behalf when the startup raises follow-on financing from venture capitalists.
Accredited-only platforms like Wefunder and AngelList have delivered over aquarter billion dollars to startups this way over the past two years.
In 2014, we met with a dozen staffers from the SEC, and strongly advocated for this approach, warning them that startups won’t crowdfund otherwise. Unfortunately, the SEC wrote in the final rules:
We are not creating, as suggested by some commenters, an exception to this exclusion for a single purpose fund organized to invest in a single company…. In reaching this determination, we have considered that the primary purpose of Section 4(a)(6), as we understand it, is to facilitate capital formation by early stage companies that might not otherwise have access to capital.
In other words, the SEC interprets the intent of Congress to let “everyday people” only be allowed to invest in companies that can’t possibly raise funding from professional, experienced investors. This is a ludicrous position.
On Wefunder, we are going to feature hundreds of companies, listed side by side, some of which are only going to be available to accredited investors. We list startups like Zenefits (where Wefunder investors currently have a 30,000% unrealized return over two years). Others will be art galleries, coffee shops, and bagel shops. The rich, as accredited investors, will be able to legally invest in the next Zenefits… but thanks to this SEC decision, the rest of us can only invest in the bagel shops.
There’s nothing wrong with a bagel shop — I might want to invest in one in my neighborhood. But I also deserve the same right to invest even $100 in high-growth startups… the same right the wealthy enjoy.
It gets worse.
Why? The SEC snuck in a disastrous, last-minute detail, that was not in the proposed rules. According to the final rules, if a company has over 500 unaccredited shareholders (as would certainly happen in a crowdfunding campaign) and over $25 million in assets, they will be forced to go public
Let’s say the owner of that bagel shop has dreams and ambition: they want a chain of bagel shops one day! Then the owner can’t risk crowdfunding.
If our hypothetical bagel shop does very well, and expands to a dozen locations, that poor business owner can be forced to be a public company. No informed, sane business owner would take that risk.
Congress exempted crowdfunded securities from requiring a company to go public. The JOBS Act states:
The Commission shall, by rule, exempt, conditionally or unconditionally, securities acquired pursuant to an offering made under section 4(6) of the Securities Act of 1933 from the provisions of this subsection.
Unfortunately, Congress gave the option to the the SEC to exempt “conditionally”, and they jumped on it at the last minute. Again, we see a misunderstanding of the intent of Congress, when they write:
We believe that the condition of total assets not exceeding $25 million will result in phasing out the Section 12(g) exemption once companies grow and expand their shareholder base and is consistent with the intent behind Title III of the JOBS Act, which was enacted to facilitate smaller company capital formation.
What this really means is that ambitious companies cannot and will not crowdfund. No company who dreams of more—of perhaps one day opening five more restaurants — can take the risk of being forced to go public.
Adverse selection at its finest. “Everyday” people can invest only in companies that have no ambition to expand, rejected by professionals.
Next Step: Back to Congress
To their credit, the SEC was especially concerned with delivering capital to small businesses who can’t raise money elsewhere. There is a indeed a funding problem for local businesses and the potential for crowdfunding to bridge that gap is exciting.
But the rules, as they are written, are toxic to startups and the ambitious. No company that intends to grow can use crowdfunding until Congress fixes it.
The Investment Crowdfunding Improvement Act
Thankfully, Congress already has a head start. Congressman McHenry, the driving force behind the original crowdfunding legislation, has drafted theInvestment Crowdfunding Improvement Act.
This bill explicitly exempts crowdfunded shareholders from potentially being forced to go public, even if they have more than $25m in assets:
EXCLUSION OF CROWDFUNDING INVESTORS FROM SHAREHOLDER CAP…. For purposes of this subsection, securities originally issued in transactions described under section 4(a)(6) of the Securities Act of 1933 shall neither be deemed to be nor counted towards the definition of `held of record’.’.
The new version of this legislation also allows a Single Purpose Fund:
TREATMENT OF CROWDFUNDING INVESTMENT COMPANIES. — Section 3(c) of the Investment Company Act of 1940 (15 U.S.C. 80a–3(c)) is amended by adding at the end the following: ‘(15) Any person substantially all of whose business is confined to investing, holding, managing, or administering in securities purchased in a transaction made in reliance on section 4(a)(6) of the Securities Act of 1933. ‘(16) Any person that offers or sells securities solely in reliance on the exemption provided under section 4(a)(6) of the Securities Act of 1933, substantially all of the activities of which consist of managing or holding securities of a single issuer.’.
There are a host of other improvements, but these two alone will allow startups to crowdfund without putting their business at risk.
We founded Wefunder to democratize investing so everyone can have access to opportunities previously reserved for the wealthy and well-networked. Everyone deserves the right to invest as little as $100 in the startups they believe in. We’ve spent four years of our life on this quest, in the face of huge regulatory uncertainty.
Now it’s up to Congress. Again.
Nick Tommarello is CEO and co-founder of investment crowdfunding platform WeFunder. Launched in 2012, WeFunder has helped to fund more than 75 startups with over $10 million in investment. Nick received his MBA from Babson. He holds Series 65 and is an alumni of Y Combinator and Techstars. Nick has designed and coded applications with hundreds of thousands of users.