The excitement surrounding crowdfunding continues to grow. I've written about it several times, and a lot of questions have been raised by our readers as a result.
Recently one of those readers, Sam Houghton, who also happens to be an attorney focusing on finance-related issues, corporate structuring and ownership transfer at Clark, Campbell & Lancaster, P.A. in Lakeland, Florida, reached out to me to help clarify and explain the important issues surrounding the JOBS Act and it's implications for crowdfunding.
Sam has spoken on the subject numerous times in the past couple of months at events focusing on the new legislation. He rung me up during a rare lapse in his schedule, and I think you'll find his insights valuable.
Our discussion resulted in what I believe is one of the best primers on the reality of the JOBS Act and the likely impact on crowdfunding that I think you'll read anywhere.
Mark: Sam, I've written about the JOBS Act and the implications it will have on the nascent crowdfunding initiatives that are currently being birthed as a result. You've researched and lectured on this extensively, so I wanted to pick your brain a bit on a few things.
Sam: Sure, absolutely. Like most things there are more moving parts than it might appear.
Mark: Of course, and when you throw regulators into the mix it just gets all that much more confusing, as you never know the direction their going to head, but you can almost always count on it being more oversight, not less.
Sam: And especially when you are dealing with crowdfunding, which will be the riskiest unleveraged investment known to man.
Mark: So let's jump in. You put together a great one-page fact sheet on crowdfunding - it's history, the size of the market and the risks. Can you summarize some of that for us?
Sam: Sure. Crowdfunding began as a grass-roots way for fans to raise money for their favorite bands to go on tour. The first crowdfunded venture was Marillion (an English rock band). In 1997 its fans secretly raised $60,000 for the band to tour the US. The band of course loved it, and went on to use the idea a number of other times to do the same thing.
The "crowdsourcing" (which is what raising money is called when investment is not involved) movement made its way into movies and arts (through sites like Artistshare) and is now a real option for businesses to use to raise funds. Businesses raise funds by giving something back to the donor. All sorts of creative rewards are available. What is not available, until the JOBS Act takes effect after the SEC regulations (likely January 1, 2013), is debt or equity in the company. The JOBS Act changed that.
Once the rules are complete, accredited or unaccredited investors can invest directly into these businesses. What this means is that the average American can now invest in a market that was previously unavailable. Private equity investment is no longer limited to the extremely wealthy.
Massolution put together some really excellent data on the market. Their research determined that the 2011 market was $1.47 Billion and growing at a rate of 63% CAGR. They expect the market to nearly double in 2012 to $2.8 Billion. The total world market includes 456 portals (the sites that list the crowdfunding/crowdsourcing projects) as of April 2012. That number is expected to be 536 by the end of the year.
Mark: WOW!! I didn't expect to see a number like that, it's huge!
Sam: It is huge, and of course many will fade away relatively quickly. But there are risks here, and those risks are losing your money. David Rose, CEO of Gust, LLC, stated that 50% of all investments will lose their entire investment. 40% will make a decent return (10-25%). 10% will be a home run (100%+). Every investor is different, but one proper investment strategy might be to use 5% of your income and split it into 10 different investments.
Mark: This is EXACTLY the advice that our friend Doug Casey gives to speculators in general. He talks about the mining and resource business, but it's applicable with any speculative investment.
Sam, the JOBS Act is actually 6 different bills, correct? Which ones pertain to crowdfunding?
Sam: Yes, the JOBS Act is a conglomeration of 6 bills. The crowdfunding bill is H.R. 2930 - "The Entrepreneur Access to Capital Act." The other huge change in private equity is the removal of the ban on solicitation of regulation D offerings (H.R. 2940).
Mark: Let's review that in a bit, but right now tell us why you think crowdfunding such a big deal now?
Sam: That's pretty easy to understand I think...
1) You've invented a new way to fund a business. Prior to this, entrepreneurs borrow money from family members and mortgage their houses to start businesses. Well, neither Uncle Jerry nor your house has a ton of equity at this point, so those options are depressed.
2) The investor pool is multiplied by a factor of 99. Anyone can invest in anyone (with limitations). Prior to the JOBS act, unaccredited investors (you can think of them as the 99%) were (generally speaking) not able to invest in businesses without the issuers facing significant legal hurdles with the SEC. Startups have never before been able to raise money from the general public.
3) Issuers can't lose (much). Let's say you make furniture. You want to start another line of chairs. You put a video out on a crowdfunding site showing your chairs and offering a chair and a share in exchange for $100. If people like your chairs, they will give you the money. You've now done market research and pre-sold merchandise - or alternatively, you've been told that your chairs aren't that great - so you don't go to the expense of making them.
Mark: I hate to interrupt, but this is precisely what Michael Joyce did with kickstarting a disruptive technology for 3D printing. He used the Kickstarter platform as a way to validate his thesis and test the market first. It cost him nothing ... it's really very, very smart.
Sam: It has its advantages. So to add to that with my final point:
... 4) The crowd will find the winners. Let's face it, angel groups and VCs might be intelligent, but they're not 18-25 year olds. Bridging on the market research argument in #3 above, the crowds will find more winners than the previous model. 10,000 Americans can't be wrong.
Mark: Sounds like you're describing American Idol meets private equity! (laughs)
Let's define a few terms. You have the Issuers, or companies that want to sell stock to the public; the intermediaries, or portals, broker/dealers, etc. who wish to act as the middle-men; and, finally the investors that want to buy the issuers stock and invest in the offering.
I covered those definitions in my post, "Dissecting Crowdfunding." What can you add to what I discussed therein, regarding the descriptions of the various players that might not be clear or obvious?
Sam: You did a great job describing the players and the process. I thought the article was very informative. I can tell you that there are a couple of items that the regulators are going to be discussing that might not have been obvious from the legislation.
First of all, some are saying that the $100,000 limit on the amount invested might not apply to accredited investors or institutional investors. Instead, those investors might be able to invest as much as they'd like. Secondly, the $1,000,000 cap on annual issuance might only apply to unaccredited investors. If there is more money that can be poured in by accredited investors, why would the SEC want to stop the company from being further funded?
Mark: That's actually really encouraging and exciting Sam! Chris and I speak a lot about how we don't agree with the whole "accredited investor" thing, however it isn't likely to change anytime soon.
I recently spoke to Nick Bhargava, the CEO of Motaavi in my post, "Making Money with Crowdfunding." Nick's company is an intermediary portal. They were actually pretty involved in helping craft the crowdfunding components of the JOBS Act, and actually lobbied in Washington to support the legislation.
They seem to have a very solid understanding of crowdfunding, however I fear there are a lot of others entering the space, or wanting to enter it, who don't have the same understanding. Can you outline some of the likely pitfalls for these "would-be" intermediaries?
Sam: The biggest pitfall is that right now there are no pitfalls. The rules are being discussed right now at the SEC. What makes this an interesting game is that the funding portals are working feverishly to get their sites together for a January 1, 2013 launch, but they are having to make guesses as to the rules. They must guess as to what is required to ensure that the investors aren't investing more per year than they are permitted. They must guess as to the amount of due diligence necessary into the issuer.
Is it their responsibility to be sure they don't allow their investors to invest in a fraud scheme? How much insurance should they buy and what should they insure against? They must guess as to what is allowed in terms of solicitation for investors to come to their site. What can they say about their site and what can they not say? Can they talk about their success rate or is that giving investment advice? Can institutional investors invest more than the $100,000 limit?
3 Big Questions:
1) Can institutional investors invest more than $100,000 per year? If so, the market matures immediately;
2) Whose responsibility is it to ensure individuals don't invest more than they are allowed and how will this be enforced?;
3) What disclosures/anti-fraud measures does the SEC deem appropriate? This will determine the price of the funding portal, which will determine crowdfunding's viability.
Mark: I've asked this question before and gotten various answers. How do you interpret the revenue model for intermediaries? How are they going to make money while staying within the law as it's likely to be interpreted? Are these guys really just going to be "virtual" broker/dealers?
Sam: With over 500 sites already, there will likely be variants. However, there are models out there currently which charge 5-10% of the raise. Some require a higher percentage if the raise does not meet the threshold. They do that because they don't want people to throw out unrealistic numbers or amounts that they don't really need for what they are doing.
According to the JOBS Act, portals can not pay their employees for sales made and the employees can not own any part of the issuers. Portals can not actively solicit for investments. I think the SEC will take the position that this ban on solicitation relates to the solicitation of individual issuers (i.e. "come on down to crowdfundcentralflorida.com and see our deal of the day - the 'IChair.'").
I do, however, believe that the SEC will allow those funding portals to advertise. If I were to guess at an average revenue model, it would be to take 7% of the raise or $5,000, whichever is greater. Some, including Senator Scott Brown, are calling for the ability for funding portals to invest in the issuers. So some funding portals could perhaps require a certain amount of equity for each raise.
Mark: Let's talk about the obvious and less obvious risks for issuers.
Some of our readers are familiar with the more typical types of offerings ... Reg D 506, a 505 or 504 exemption, and S1 registrations. How does crowdfunding differ from the Reg D 506, which is the most predominant for funding a private offering?
Sam: Issuers cannot advertise the offering. They can point people to the funding portal but they can not actively advertise. The rules will likely clarify this, but what this means is that while they can point people to the funding portal via a Facebook post, they can not in the same Facebook post say "I am starting a business that I expect to make $100,000 EBITDA in the first year and I need your help to make it happen." Splitting hairs to be sure.
Mark: The biggest risk is regulatory in my opinion. Issuers will have a lot of rules to follow, although they won't be new to some, they will be to others who may be funding a company for the first time. It's probably a miscalculation for them to think this is easy and they can just start offering securities to whoever they want to, correct?
It seems that some issuers might want to focus on the new Reg D advertising and rule changes, and going that route instead of messing around with crowdfunding. Am I wrong there?
Sam: If the SEC is involved, it is not going to be "easy," but it has to be easier than Reg D. Again, we won't know the ease of use until the SEC issues its rules - and perhaps not until they've interpreted those rules. If crowdfunding is not easy, it will not survive.
With crowdfunding, you are dealing with much smaller amounts than your typical Reg D offering. You are only permitted to raise $1 Million annually via crowdfunding. The crowdfunding market is a completely different animal - it is a group of 200 people from 20 different states paying $200 each to help start a brewery in exchange for a case of beer and .1% ownership. If that brewery becomes a $10MM enterprise, then their $200 is now worth (on paper) $10,000. And the investments will come from anybody - including unaccredited investors.
Reg D offerings are typically $5 Million plus. And if you are attempting to solicit your Reg D offering, you'd better be sure your investors are accredited, because the new law requires that issuers take reasonable steps to ensure that all investors are accredited if you plan to solicit your Reg D filing.
Mark: Something not so obvious that was brought to my attention is the negative perceptions that might be created if an issuer used crowdfunding, and then wanted to work with a traditional VC or IB, or even a more traditional broker/dealer.
Some are of the opinion that those issuers would find a cold reception when and if they chose to do a larger raise and needed the help of these more "traditional" institutions, thereby stranding them in a sense. What's your opinion?
Sam: That is a great problem for an issuer to have and one they would not have had if crowdfunding were not in place. If crowdfunding weren't in place, all they'd have is an idea. If the VC or banker is interested in the company, they will find a way to solve the problem.
The issuer can solve this problem at the outset if it would like to - just put together a stockholders agreement that permits the owner to buy the crowdfunded shares at its option for a set price. What the issuer can get away with is the question - should the option purchase price be 10x the investor's original investment, 20x, 100x? Or you could put a clause in that forces the crowdfunded shares to sell when the founder decides to sell. Those are two options, but the sky is the limit (and the SEC).
If the issuer chose not to cover himself (either because the market would have said no or because he just failed to do so), then you have this issue - if an investor comes in and buys the company (and does not buy out the crowdfunders), then what reporting requirements will that (now very well funded) company have? Will it continue to have to comply with the same crowdfunding reporting requirements? Because that could turn off some investors. They don't want their competitors having access to that information.
Mark: The regulators use language like this: "Provide such disclosures as the SEC deems appropriate." That kind of thing is so purposefully vague as to just make me think this whole thing is a hornets nest. Are my fears overblown, or could this turn out really badly for those intermediaries and issuers who jump the gun willy-nilly?
Sam: You are right that the SEC has huge rulemaking authority in this process. What the SEC "deems as appropriate" will be set forth in the rules, which are scheduled to be completed by January 1. A lot of people think that the rules will not be finished by then. I don't think they can afford to drag it out much further than that, because crowdfunding is already gaining significant traction.
I happen to believe that crowdfunding will be a part of the election campaign - Obama will use it to tout his record as pro-business and Romney will warn against over-regulation. If it gets that exposure, then the SEC better not be late with its homework.
Mark: Either candidates argument, under that scenario, would be pro-crowdfunding for sure.
How about the investors themselves. We have a lot of accredited and high-net worth readers. However we also have a lot of folks who aren't there yet, although working hard! For the non-accredited investor that wants to participate in crowdfunding, what are the "rules?"
Sam: Anyone can participate in crowdfunding, regardless of whether you are an accredited investor. There are limits, though, based on your income and net worth.
Mark: You mention in your presentation that Angel Networks are likely to see an incredible uptick in the amount of deal flow coming their way. It's going to make the job of separating the wheat from the chaff all that much more difficult.
Sam: Some people see it differently. Some think that crowdfunding will take deals away from angels. I think the opposite. I think that all angels should be patrolling the funding portals for deals and potentially make unsolicited offers to entrepreneurs based on what they see on the funding portals.
Mark: Hmmmm, interesting angle!
Sam: Remember, there is new money coming to the market. The pie is getting bigger. As far as the wheat and chaff, I don't think you'll see any significant increase in chaff (compared with wheat). You might have more deal flow, which means you'll have more deals (more wheat and chaff). How much grain you are willing to process is up to you.
Lets keep going with this analogy ... It may be that this crowdfunding thing provides you with a fancy new combine (I think that is what separates the ... ) because the 10,000 Americans can help you be more certain about a winner. Remember, however, that other angels and the issuer itself will have the same combine, so you need to be faster with your combine or pick the right field. OK, I think we've killed the analogy.
Mark: No, that was great stuff Sam.
What about fraud. I've been in the public markets for a bit, and I've seen all kinds of scams perpetrated on naive investors. I can foresee crowdfunding as a way for some really crappy issuers and all-out fraudsters to extract cash from more than a few greedy and eager "investors".
What are the obvious risks in your opinion? What about the less obvious ones?
Sam: Fraud exists in every market, be it public, private, or flea. Massolution reports that fraud in the U.K. (where equity crowdfunding is legal) is between 2-4%, so not very material. The concern with crowdfunding fraud is that it could happen to someone with literally no money left in the bank. His last $2,000 could be taken. In reality, the chances of that happening are about as likely as him being robbed for the same amount during the next year. Look, its a math problem. For every incremental increase in regulation, fraud goes down and so does wealth creation.
Mark: No arguments there! I'm not overly enthusiastic about regulation. Especially because it obviously doesn't work. Where were the regulators for the decades that Maddoff was defrauding his investors? Where were they on Enron? Where were they on MF Global? Where were they with the unfolding CDS debacle with JP Morgan? Where will they be when the next shoe drops?
Despite my feelings, they will continue to exist and become more and more powerful as things disintegrate (which we believe they will). So my question is, how do you see this playing out, from a regulatory perspective? It would seem the regulators will have some pressure to balance the potential positives of job creation, free-flow of capital, etc. with their instinctual desire to make those same things as difficult as possible..?
Sam: While I agree with you that regulation can kill great intentions, and it has, I believe there is certainly a place for it. To say that regulation doesn't work because bad things still happen assumes that the regulation did nothing. In reality, there may have been 100 more Maddoffs that would have made their way to the newspapers without any regulations whatsoever. In fact, there would be a much lower level of trust in the system without any regulations.
The SEC has a job that is unenviable (and unfunded, by the way). You are very correct - it is certainly a balancing act. Lets hope their decisions are based on the proper motive of extracting the greatest benefit out of this piece of legislation, rather than whitewashing the bill into non-existence. I would encourage you and your readers to write letters to the SEC about these rules that are being written (they are in the comment period right now). The SEC, by law, has to post your letter for the public to see.
Mark: We may just do that... We do sometimes "pick" on regulation herein, but I do respect the job these guys do and the intention. Unfortunately sometimes the best intentions go awry. I really do hope they get it right on crowdfunding, it's crucial to America's competitiveness and the fostering of the culture that made the country great to begin with.
Thanks Samuel, it's been very helpful.
Samuel: Thank you, Mark.
If you have questions on crowdfunding, the JOBS Act or anything that you feel is related, please feel free to post comments below.
This is an important topic, and one which I know strums the heart strings of a lot of our readers, especially the ones who aren't yet accredited but are eager to get into private equity in some way.
"Make things as simple as possible, but not simpler." - Albert Einstein