Paul H Jossey, founder of thecrowdfundinglawyers.com participated in a panel at DC Startup Week titled Crowdfunding and the Different Models (alternative models for raising capital). The other panelists included Larry Bard, Partner at Shulman Rogers, Katherine Mereand, Program Manager for Innovation & Equitable Development at the DC Department of Small and Local Business Development, and Sara Gibson, CEO at 20 Degrees. Prayas Neupane, Manager at Business Retention and Expansion at the Washington, DC Economic Partnership.
The panel covered various types of crowdfunding models, things to know when starting a crowdfunding campaign, how to best execute a crowdfunding campaign, and how to wrap it up. Jossey, specfically covered equity crowdfunding, including the various legal and practical requirements.
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Crowdfund Capital Advisors has always led the equity crowdfunding (Reg CF) charge. It provides the public free and invaluable data about Reg CF’s promise and growth. It deserves accolades for its leadership.
But last week it released a report and with The Small Business & Entrepreneurship Council that tries to steer Reg CF down a wanton path. The groups argue the federal government, i.e. taxpayers, should co-invest alongside private investors in Reg CF issues. The scheme would involve a $20 billion fund dispersed in tranches of up to $250k. Terms would be “standard,” and issuers would repay the loans, first to private investors, then the government.
As evidence for this program’s need Crowdfund Capital Advisors and SBE Council promote a few factors. First, they expose challenges traditionally underserved entrepreneurs such as minority groups face. (They drive home the point home by analyzing Reg CF issuers by Congressional district). Second, they point to a UK program that could serve as a model. Finally, they declare the pandemic’s hardship makes this program necessary and urgent.
Crowdfund Capital Advisors evidence for more government involvement is unavailing
Several problems arise with programs of this sort from an economic and social utility standpoint. First, it would apparently require participating companies take on multi-source debt. While debt is the right financial route for some Reg CF issuers, they are not the majority. As the 2019 Reg CF report noted, only 27% of issuers chose debt for their financial instrument.
Source: Securities and Exchange Commission
This limits company freedom to choose their own financial instruments and forces it into an ill-suited instrument to enjoy taxpayer largess. The report nudges local investors to the front of the line, if issuer fails, as many of them will, taxpayers get stuck with empty IOUs.
If the issuers need the extra money after a successful Reg CF raise they can use their new capital as collateral. If the market won’t support an extra injection, taxpayers shouldn’t be a backstop.
The government creates zombies
Second this program would prolong the agony of “zombie firms.” Taxpayers will prolong the agony of firms destined to die. In free markets not every idea succeeds, and many entrepreneurs fail once or twice before hitting their stride. The experience of learning what went wrong is invaluable. And doing more with less on short budgets makes a firm scrappy and smart in a way that getting a six-figure wire from Uncle Sam never will. Capitalism cannot succeed if it cannot destroy bad ideas. This axiom is why SEC Chair Jay Clayton calls the US private capital markets “unrivaled and coveted around the globe.”
Third most big portals are already committed to serving underserved communities and nontraditional entrepreneurs. Some write it into their mission. Wefunder’s charter for instance states “Wefunder will help those who are willing to work hard to achieve the American Dream. Everyone deserves access to funding, including immigrants, minorities, and the poor.” Republic adds “Traditionally, female, black, and latinx founders have seen far less venture capital than their white male counterparts. Furthermore, the majority of funded startups come from Silicon Valley and New York with little representation from other cities across the US.”
Reg CF is already a great tool bring capital access to these entrepreneurs. This success will hopefully spark an entrepreneurial cascade of strong companies emerging from these communities and demographics. But the market will (and should) be the ultimate judge of their success.
Fourth, Reg CF is already succeeding. CCA reports 2018-2019 saw a 37% increase in Reg CF investment. And 2020 will top it all. As the report states, “During the last 2 months (July and August 2020) equity and debt crowdfunding delivered the same amount of capital ($48 million) as the first full year (2016-2017) of online fundraising.”
The SEC should step back and let Reg CF flourish
More government involvement is not what Reg CF needs. The SEC has finally become comfortable enough after four years to propose increasing the offer limit from $1.07 to $5M, allow ‘testing the waters,’ and remove accredited-investor caps. This is the right direction, but the regulators should remove more restraints to equity crowdfunding. As I argue in an upcoming law review article, Fixing the JOBS Act and Inviting our Tokenized World, the Need for Congressional Action, Congress should copy the private-ordered New Zealand model researched by Professor Andrew Schwartz.
Schwartz showed in an SEC Comment letter how New Zealand copied our own Reg CF but removed many of the restraints currently facing US entrepreneurs. Through gatekeepers and syndication, New Zealand keeps costs low whilst protecting against fraud. Larger lead investors and portals perform due diligence. Big investors put their money on the line and retail investors then join. Reputational awareness keeps portals from accepting subpar issuers. Entrepreneurs face no advertising restrictions or lengthy disclosure documents and investors face no limits.
This model has worked well providing exponentially more opportunities for investors when scaled for economy.
The central focus of regulatory enforcement by the SEC and FINRA should be the oversight of intermediaries, not issuers or offerings, as per the New Zealand model. The intermediaries should exercise direct oversight of the issuers, and the regulators should ensure that the intermediaries have proper practices and procedures in place for doing so.
Crowdfund Capital Advisors is a great resource with a bad idea
Crowdfund Capital Advisors is an invaluable resource for equity crowdfunding. And their intentions are certainly noble. But their bias toward more government involvement is not the way. The government already interferes in the economy in enough terrible ways. It should not straddle the nation’s entrepreneurs with its overbearing presence.
To much fanfare, the Securities and Exchange Commission (SEC) recently expanded the Accredited Investor (AI) definition. Individuals can now qualify as AIs via sophistication criteria and not just hard monetary limits. This change will increase the AI pool for startups and small businesses seeking investment. But it mainly affects Reg D offerings—by far the largest private exemption—which offers a binary: AIs can invest, non-AIs can’t.
Reg D’s dominance of the private markets is clear. In 2019 Reg D 506(b) issuers raised almost $1.5 billion. It dwarfs other exemptions like Reg A+, Reg CF, and Reg D 506(c) (similar to Reg D 506(b) except it allows general solicitation).
But how the new definition affects equity crowdfunding (Reg CF) is more complex. The short answer for now, is, it doesn’t. Because Reg CF already allows anyone to invest, more AIs are irrelevant. But it could matter soon, if the Commissioners approve the March 2020 proposals from last year’s Concept Release. For now, however, the hash Congress and the SEC made of Reg CF’s individual investor limits prevents the AI expansion from having impact.
Congress’s Reg CF individual investor limit exemplified bad drafting.
[T]he aggregate amount sold to any investor by an issuer, including any amount sold in reliance on the exemption provided under this paragraph during the 12- month period preceding the date of such transaction, does not exceed— ‘‘(i) the greater of $2,000 or 5 percent of the annual income or net worth of such investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; and ‘‘(ii) 10 percent of the annual income or net worth of such investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000
Like most statutes this passage shows how lawmakers should not write laws. Congress could have defined a hard limit adjusted for inflation for non-AIs and no limit for AIs. Instead, Congress divided the Reg CF limit into four categories: (i) 5% of annual income; (ii) 5% of net worth; (iii) 10% of annual income; and (iv) 10% of net worth. Then it added a floor, $2,000 and a ceiling, $100,000.
It gets “better.” Congress failed to specify when each limit applies. Part one states, “if either annual income or net worth is less than $100,000 and part two states “if either the annual income or net worth . . . is equal to or more than $100,000.” So which is it? If someone’s income was $150,000 and net worth was zero, he would qualify for both brackets. And once in the bracket which limit applies, annual income or net worth? In the previous example if placed in the 5% bracket the limit would either be $2000 or $7,500.
The SEC interpreted Congressional ambiguity in the worst possible way
Congress tasked the SEC with writing the Reg CF rules and cleaning up its textual mess. In its typically chary way, the SEC chose the worst possible interpretation. First it declared investors must meet the $100,000 threshold for both income and net worth for the 10% bracket. Second it chose the lesser of income or net worth once placed in either bracket. Thus, is the previous example the rules limited the $150,000 salaried person with no net worth to $2,000.
The Commission originally proposed the greater of standard but changed course because of the supposed greater equity crowdfunding risks:
We recognize that this change from the proposed rules could place constraints on capital formation. Nevertheless, we believe that the investment limits in the final rules appropriately take into consideration the need to give issuers access to capital while minimizing an investor’s exposure to risk in a crowdfunding transaction.
Importantly, the Commission also declined to exempt AIs from the formula. This distinguished Reg CF from Reg D and Reg A+ where accredited investors face no caps.
Equity crowdfunding continues to flourish despite bad drafting and regulatory hurdles
[T]he equity crowdfunding market . . . has largely been underwhelming expectations despite significant deregulation to allow individual investors all along the financial spectrum to participate. Instead of a booming marketplace, equity crowdfunding has remained a niche market with fundraising falling well below the statutory caps and issuer-generated maximum targets for their offerings.
The AGs don’t mention the Commission-led barriers placed in Reg CF’s path, including confusing investment limits. Nonetheless after a slow start Reg CF has gained substantial ground in the past two years. According to Crowdfund Capital Advisors Reg CF investment jumped 37% between 2018 and 2019.
Equity Crowdfunding portals are having a record year
Further massive Reg CF portals SeedInvest and Wefunder have reported their best months ever in 2020. And despite endless handwringing from regulators, academics, and nonprofits, Reg CF has not experienced predicted fraud and high-risk speculative investments. The Commission admits as much in its 2019 review of the exemption’s performance:
During the considered period, there were few instances of legal proceedings (involving FINRA or the Commission) referencing Regulation Crowdfunding, so we cannot infer a systematic relation between any particular characteristics of the offerings and the incidence of such legal actions. In particular, a search of publicly available information in the Commission’s litigation releases has not identified civil complaints or administrative proceedings filed against Regulation Crowdfunding issuers or intermediaries. We have, however, identified four actions initiated by FINRA against a funding portal member that involved alleged violations of Regulation Crowdfunding or FINRA rules.
The Proposed Rules along with the expanded AI definition will improve equity crowdfunding
Equity crowdfunding seems poised to become a “booming marketplace” with the expanse of time and more favorable rules. Four years after a decidedly jaundiced Commission wrote Reg CF’s rules it has finally proposed improvements. One proposal seeks to correct its individual investment-limit mistakes. First it has proposed switching to the originally proposed “greater of” standard. Also, it has finally proposed lifting the caps for AIs. Assuming the Commission adopts the proposals as is, more equity crowdfunding investors will be free to invest without limits. This will further enhance Reg CF’s attractiveness to issuers and investors alike inching it toward the “booming marketplace” of state AG dreams.
Neighborhood Sun, the innovative Maryland company revolutionizing the solar industry has now crossed $300k in investments from 336 investors in its equity-crowdfunding campaign. If you’re interested in investing or learning more about this fast-growing company, checkout their Wefunder investment page: https://wefunder.com/neighborhood.sun
Equity crowdfunding keeps gaining on other forms of capital raising despite (or perhaps because of) capital-raising headwinds. The pandemic, economic uncertainty, and the tumult of an approaching election has gripped America with anxiety.
July was the highest month of investor commitments at $23.2 million. The next closest month was October 2019 with $18.5 million. (See chart below)
June and May of this year were the third and fourth highest months of commitments.
The first quarter of this fiscal year saw more commitments than the entire first year of Regulation Crowdfunding.
Proposed SEC rule changes could help equity crowdfunding gain traction
Equity crowdfunding will likely keep gaining even under prolonged uncertainty. In March, the Securities and Exchange Commissionproposed several changes to Regulation Crowdfunding that will increase use. As I explain in an upcoming law review article, the proposed measures fall short of the best possible Commission fixes. But, if enacted as is, it would improve the equity crowdfunding landscape for entrepreneurs and small businesses.
For now, as many people spend lots of time home-ridden, some are looking for investment opportunities. In equity crowdfunding, everything is transacted over the internet and potential investors can view financial and legal documents and query founders before investing. The equity crowdfunding ride is only just beginning.
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