By Tom Still
To cut down on fraud during the Great Depression, Washington banned private companies from soliciting investments from the general public. Since then, only relatively wealthy people – those who qualify as “accredited investors” by virtue of income or assets – have been able to buy shares of companies not listed on a public stock exchange.
The passage in early 2012 of the federal JOBS Act – short for Jumpstart Our Business Startups – was intended to change that. Among other things, the JOBS Act embraced “crowdfunding” as a way for privately held companies, usually startups, to raise money from ordinary investors through online fundraising campaigns.
More than 16 months after President Obama signed the JOBS Act, the federal Securities and Exchange Commission is still writing the rules of the game. The reasons for the delay are more complex than a federal agency stiff-arming the president and Congress.
Crowdfunding in the Internet era has largely been a province of artists, causes and special projects that don’t come with an expectation of profit. You might get an awesome T-shirt or a front-row ticket out of your crowdfunding investment, as well as some warm feelings about your involvement, but not a lot more.
Read this commentary in the Milwaukee Journal Sentinel here.
That changed with the advent of “equity crowdfunding,” through which small companies may sell small pieces of their company in return for the cash needed to move it from startup to success. The expectations for investors are very different: Instead of a T-shirt, they look for a return on investment.
The concept was embraced by the JOBS Act, within certain investment limits, but it ran head-long into the SEC’s historic concern about society inventing new ways to swindle grandmothers and other unsuspecting investors.
So, while most of the nation waits for the SEC rules, two states have moved ahead with crowdfunding on their own. Georgia and Kansas have taken the plunge; North Carolina and Washington state are considering similar state-based platforms.
Joining the march, three Wisconsin legislators said this month they will introduce a bill to rewrite Wisconsin’s securities law to allow equity crowdfunding. To get a crowdfunding exemption under the Wisconsin proposal, a company would need to:
– Be a Wisconsin business selling stock to state investors.
– Not raise more than $1 million, or $2 million if the company issuing stock is willing to be audited and make the audit available to investors.
– Not sell more than $5,000 in stock to anyone who is not an accredited investor. Accredited investors have to earn more than $100,000 per year, or $150,000 for married couples, or have a net worth of $750,000 or more. That’s a different standard than set by the SEC.
– Issue the stock through an Internet site registered with the state Department of Financial Institutions; file disclosure statements; and share those disclosure documents with investors.
– Have stock payments held in escrow by a Wisconsin bank.
– Not have offered or sold other stock through the exemption in the past year.
The advantages of the state bill begin with the democratizing of equity investments in private companies. Mom and Pop could invest in mom-and-pop businesses. It also brings money off the sidelines for deals too small or early for angel and venture capitalists to consider. There’s also considerably less regulatory burden on companies that would otherwise need to pursue a private offering exemption under existing federal law. It could become a “farm system” for angel and venture capitalists to keep an eye on emerging companies.
There are some potential pitfalls, as well. The Depression-era mentality about protecting investors from themselves wasn’t entirely Rooseveltian paternalism. People can and do fall victim to fraud – even in public markets.
A proliferation of state rules could create a patchwork quilt of laws that might hamper commerce rather than encourage it. Can a global portal like the Internet truly screen out non-Wisconsin investors if they’re determined to get around it? Upstream investors might shun buying out crowdfunded deals if the list of previous investors is too hard to unravel, which could leave those initial investors stranded.
Perhaps the biggest danger is adverse selection. If the best deals are attracting experienced money from venture capitalists or angel groups, does that mean crowdfunding investors are left to pick from a less desirable pool? Are they seeing second-tier deals?
If so, the gold-rush mentality of crowdfunding could give way to disappointment among an entire class of investors who aren’t accustomed to the stark reality that many startups fail, even when backed with institutional money.
The SEC may be dragging its feet, but Wisconsin should carefully examine all sides of crowdfunding before running too far ahead.