Friday, October 25, 2013

A Solution to a Non-Problem: The JOBS Act Crowd-Funded Initiative

A Solution to a Non-Problem: The JOBS Act Crowd-Funded Initiative

Over the years, I’ve learned that if the same anecdote is used over and over again to support a particular policy initiative, you ought to be worried.  A couple of days ago the SEC proposed rules to allow crowd funding of small investments from ordinary investors.  The idea is to allow would-be entrepreneurs to solicit unsophisticated investors via an Internet portal.  This proposal is at the heart of the Jumpstart Our Business Startup (JOBS) Act.  The SEC’s rules are long overdue because the agency has been trying to figure out how they are going to combat fraud.
Real Estate Manager (2002)
Many of the articles written about Title III of the JOBS Act[1] and the SEC rules have cited the same anecdote over and over again.  Pebble, a company developing a digital watch, raised $10 million from crowd-funded contributions.  This anecdote and the $830 million raised by Kickstarter for 50,000 projects are repeatedly cited as support for this initiative.  The idea is to replicate Kickstarter on a massive scale by opening up the opportunity to invest in a startup business to just about any investor.   

In the investment world, the crowd-funding concept is built on a questionable but popular assumption.  Politicians and policymakers continually make the case that there is a shortage of capital for would-be entrepreneurs.  If these entrepreneurs could just get their hands on a small amount of capital, we’d be able to unlock all sorts of new economic opportunities.

There’s no question that attracting small amounts of start up capital is very difficult.  However, it ought to be.   Developing a new product or service is fraught with risk, and simply throwing money at ideas is no way to build a company.  As far as I can tell, there are a plethora of small funds, angel investors, and high net worth folks ceaselessly looking for the next good idea.  As a result, I believe that most of the good ideas eventually find funding. 

I know a lot of people haven’t been able to fund their business plans even after knocking on countless doors.  These folks truly believe in their ideas and they are convinced that they will be the next Mark Zuckerberg.   Politicians and policymakers aren’t going to quash the dreams of their constituents, so they’re forever looking to solve the supposed capital shortage problem.  You’d think that venture capitalists would warn government officials that capital isn’t the missing ingredient.  However, there’s no reason for the VC community to thwart initiatives such as crowd funding.  It doesn’t represent any kind of competitive threat to even the smallest venture fund.  Moreover, if a couple of decent companies emerge, the VCs can easily swoop in, provide the next round of capital, and squeeze out the initial unsophisticated investors.

It is all too easy to be called an entrepreneur.  All someone has to do is adopt the moniker.  In fact, the great majority of people harboring a dream or a business plan aren’t entrepreneurs in the first place.  In my experience as an investor in startups, I found that most of the people who came forward with business ideas weren’t entrepreneurs.  These people were extremely brave in running up large balances on their credit cards.  However, setting out on one’s own doesn’t make someone an entrepreneur. 

I have no doubt that the SEC rules will generate more than a handful of successful companies.  The rules will undoubtedly foster all kinds of crowd funding platforms that will connect potential businesses to retail cash.  The law of large numbers guarantees that there will be some winners.  Of course, Powerball produces big winners as well.  And much like Powerball, the only consistent winners will be the businesses running the platforms.

The SEC delayed proposing rules because they were trying to put in protections to reduce the amount of fraud associated with crowd funding.  The SEC has no choice but to implement this program because Congress enacted it.  However, fraud will be a small part of the problem.  The overwhelming majority of small investors who invest through a crowd-funding platform are going to lose their entire investment.  This is one idea that is overwhelmingly supported by Republicans and Democrats.  The problem is that the idea is fatally flawed.

[1] Here are the key provisions of the JOBS Act:
·       A company can raise a maximum of $1 million via crowd-funded offerings over a 12-month period.
·       Investors can invest up to $2,000 or 5% of their annual income of net worth; whichever is greater, over a 12-month period (if either their net worth or annual income is below $100,000).
·       Investment companies would be ineligible to use crowd funding.
·       Securities purchased via crowd funding cannot be resold for one year, except back to the issuer.
·       Issuers would be required to submit certain information to the SEC, including about the company's financial condition, which would be publicly available. Issuers also would be required to file annual reports with the SEC.
·      Intermediaries would be required to provide certain investor education information, and take measures to reduce the risk of fraud.

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