Still Time to Fix the Fix Crowdfunding Act
One of the cardinal rules of investing is diversification – a critical ingredient for long-term portfolio growth. This rule applies with equal, if not greater, force when investing in “Title III Regulation CF Crowdfunding” securities – open for business since May 2016 – and an important part of the Jumpstart Our Business Startups Act of 2012 (the JOBS Act). For the foreseeable future, companies relying upon Regulation CF will mostly comprise startups and very early stage companies, the riskiest investment class, particularly in view of the annual dollar ceiling of $1 million and the availability of other, less complex securities law exemptions – principally private placements limited to accredited investors.
Diversification inarguably increases the odds of a successful portfolio, as opposed to putting all of your eggs into one basket – regardless of how attractive a single investment may appear. This is particularly true for the riskiest of investments: startups and early stage companies – where there are more things which can – and ultimately will – go wrong – and a total loss is more likely than an investment in a later stage company.
A corollary rule is to invest in things one knows best. And if this is not always possible, especially in this complex and rapidly changing world we live in, relying upon experts can often increase an investor’s odds of success.
Unfortunately, when it comes to Title III investment crowdfunding, the ability to effectively combine both diversification and external expertise is made more difficult by our securities laws, which currently provide no exemption which would allow so-called “special purpose vehicles” – i.e. diversified funds – limited to crowdfunded securities purchased by both accredited and non-accredited investors. Under current law, even a fund which has no non-accredited investors, but more than 100 accredited investors must register, thus limiting the capital pool derived from accredited investors as well.
Though registering the fund is, in theory, a solution, a registered investment company is a highly regulated entity. And with regulation goes costs – which would, of course, increase the cost of doing business and eat into a fund’s returns. This is likely to be especially true in the area of Regulation CF investments, where there is an annual $1 million cap for crowdfunding issuers and, at least in the short term, there will be a shortage of investment-worthy companies sufficient to justify the costs of operating as a fully registered investment company.
Fix Crowdfunding Act (HR 4855)
The Fix Crowdfunding Act, introduced by Congressman Patrick McHenry earlier this year and passed by the House in July 2016, takes a step in the right direction. Unfortunately, due what I perceive as the absence of bi-partisan support, it is a baby step at best toward making Regulation CF a smarter and safer place for investors.
Specifically, HR 4855 affords funds investing in crowdfunded securities an exemption from registering as an investment company, but with provisos. The proviso which is the principal show stopper, in my opinion, is the requirement that the fund hold only securities of a single security – precluding diversification. The Bill also limits eligible securities to companies with a single class of security – in my opinion another unnecessary barrier. Broadening this Bill to allow investment by an unregistered fund in more than one issuer would foster investor diversification – and thus hopefully will be added on in the Senate, where the Bill now resides.
The Role of the Investment Advisor
The Bill also requires that in order to be exempt from registration as an investment company, the fund must be advised by an investment advisor registered under the Investment Advisers Act of 1940. I support this requirement, for a number of reasons, especially in conjunction with a diversified fund.
Though much has been said as to the “wisdom of the crowd,” there are limits on the wisdom of a crowd comprising largely investors inexperienced with early stage, illiquid investments – and the risks peculiar to this investment class. The reality is that most non-accredited investors have no experience whatsoever – their experience being limited mostly to exchange-traded securities, managed funds and ETF’s.
As some investors will learn the hard way, simply picking a successful company in its early stages is not enough to guarantee a profit, or even to see a return of any of the invested capital. Though Regulation CF allows a company to sell a broad range of debt and equity securities, many early stage crowdfunding companies will undoubtedly offer common stock in their initial raise under Regulation CF. The successful ones will often launch multiple, successive rounds under other exemptions as they grow and scale their businesses.
In the real world of SME finance, these subsequent rounds often have preferences over the common stock, including a preferential return over the common stock upon a future “liquidity event” – such as being sold. In addition, initial Regulation CF investors who purchase common stock will typically not receive what is called “anti-dilution” protection – a common provision in early stage investments. Without this protection the early “common” investor is at greater risk of being diluted in value by subsequent financing rounds, without any adjustment to the original purchase price, number of shares or the right to participate in future, often more favorable, financing rounds.
A registered investment advisor, advising a group of Regulation CF investors, will generally understand these risks more readily than the crowd. Moreover, even if a would-be Reg CF investor recognizes this risk, it is unlikely that a single investor will have any ability whatsoever to renegotiate the terms of an investment – making the investment decision in Regulation CF a “take it or leave it” proposition. However, a fund which represents a group of investors, coming with more potential capital, would have more leverage to re-negotiate the terms of a Regulation CF raise to make it more investor-friendly.
The Fix Crowdfunding Act Needs to be (and Should be) Fixed
The ability to form a non-registered fund to invest in Regulation CF securities would go a long way toward protecting investors in these early stage, high-risk investments – but there is one missing ingredient in the Fix Crowdfunding Act: the ability of the fund to diversify – to invest in more than a single crowdfunded company. Also problematic is the Bill’s current limitation on issuers issuing more than one class of security.
Allowing professionally managed funds to diversify would be expected to have the added benefit of enhancing the ability of these funds to attract greater amounts of investor capital to the crowdfunding market. With the ability of a fund represented by a professional adviser to attract more capital this is also a potential benefit to all issuers worthy of investment seeking to hit their target offering amount.
This is not to suggest that all Regulation CF funds ought to be outside the purview of investment company registration entirely. However, this is an issue that can be addressed by limiting the total dollars which the fund could attract before it would be required to register.
Notwithstanding the current state of this Bill, hopefully these few important tweaks can and will be made as the Bill passes through the Senate. The result would be expected to reduce investor risk, increase the odds of a successful investment, and provide a useful vehicle to attract more capital in the aggregate to this new financial market.
[Author’s Note – Though there are many improvements to Title III of the JOBS Act which can, and should, be made, this article only addresses those provisions which remain in the current Bill, HR 4855.]
Samuel S. Guzik, a Senior Contributor to Crowdfund Insider, is a corporate and securities attorney and business advisor with the law firm of Guzik & Associates, with more than 30 years of experience in private practice. Guzik is also former President and Board Chair of the Crowdfunding Professional Association (CfPA) and currently CfPA Legislative & Regulatory Special Counsel. A nationally recognized authority on the JOBS Act, including Regulation D private placements, investment crowdfunding and Regulation A+, he is and an advisor to legislators, researchers and private businesses, including crowdfunding issuers, service providers and platforms, on matters relating to the JOBS Act. As an advocate for small and medium sized business, he has engaged with major stakeholders in the ongoing post-JOBS Act reform, including legislators, industry advocates and federal and state securities regulators. In 2014, some of his speaking engagements have included leading a Crowdfunding Roundtable in Washington, DC sponsored by the U.S. Small Business Administration Office of Advocacy, a panelist at the MIT Sloan School of Business 2014 Crowdfunding Roundtable, and a panelist at a national bar association event which included private practitioners, investor advocates and officials of NASAA. His articles on JOBS Act issues, including two published in the Harvard Law School Forum on Corporate Governance and Financial Regulation, have also served as a basis for post-JOBS Act proposed legislation.