Strings attached to the JOBS Act may nullify much of its ability to truly help startups – by Bill Hanigan and Mark Wickham.
Congress is in the business of making laws. Some of those laws prove helpful, while others do not help much at all. The recently enacted (and eagerly anticipated) crowdfunding provisions contained in the Jumpstart Our Business Startups Act (JOBS Act), which was signed into law on April 5, may ultimately fall into the latter category. Congress intended to make it easier for startups to raise investment capital over the internet by allowing companies to accept small investments from a relatively large number of investors. That much was expected in any crowdfunding measure passed by Congress. However, the strings attached to crowdfunding offerings, which in our view will add significant costs to raising any substantial amount of capital, might make these offerings unworkable.
As a bit of background, there are only two legal ways to take money from investors in the United States: by registering securities with the SEC through an IPO, or by utilizing an exemption from SEC registration. Registered offerings are time consuming and expensive, and for those reasons are typically not within the realm of possibility for startups. The crowdfunding provisions of the JOBS Act acknowledge this problem by creating a new exemption from registration for crowdfunding offerings. This exemption, as enacted, allows startups to use the internet to raise up to $1 million per year, subject to important restrictions.
Most significantly, startups may not conduct a crowdfunding offering without hiring either a licensed broker or a “funding portal.” A funding portal is a new animal in the law that is not quite equivalent to a stock broker, but is not exactly your buddy Bob and his laptop either. Funding portals must register with the SEC and provide disclosures to investors about the startup that is selling its securities, the terms of the offering, and the accompanying risks to investors. Funding portals must also conduct background checks on the startups’ leaders and significant owners, ensure that individual investors are not investing more than an allowable threshold each year based on their income and net worth, and ensure that investment proceeds are kept in a third-party lock box until some minimum level of capital is collected from investors. Each of these items will involve compliance efforts on behalf of the funding portal in the form of time and expense, at least as long as the portal desires to remain in the good graces of the SEC. These costs will of course be passed along to the startups utilizing the services of the funding portal. Congress effectively pre-empted funding portals from offsetting their costs through other means by prohibiting funding portals from compensating their employees on a commission basis for directing investors to the portal.
The JOBS Act also requires startups to provide a minimum level of credibility or warranty behind their financial statements. For offerings of $100,000 or less, the issuer’s CEO must personally certify the accuracy of the financial statements. For offerings between $100,000 and $500,000, startups must hire accountants to “review” their financial statements, which must then be delivered to the SEC. For offerings greater than $500,000, startups must file fully audited financial statements with the SEC. At each of these thresholds, the accompanying costs to startups increases. Finally, following a crowdfunding offering, startups must annually file financial statements and results of operations with the SEC, which will result in ongoing expenses.
The JOBS Act provides a basic framework for crowdfunding offerings. Within that framework, the SEC will adopt regulations that further clarify how crowdfunding offerings will work. The devil is often in the details, and these regulations will ultimately determine the usefulness of the crowdfunding exemption as envisioned by Congress, and whether further changes to the law are necessary for startups to effectively access capital. These regulations are scheduled to be implemented in January 2013. Until then, startups are functionally without a way to utilize crowdfunding, and it may take them that long to find a cost-effective use for it.
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