The SEC Proposed Rules for Crowd Investing!
Nearly two years ago,we lobbied Congress to legalize crowd investing. Senators and Congressmen asked our advice on how to make the legislation work for high-tech startups. We were invited to the White House to watch as President Obama signed the JOBS Act into law on April 5th, 2012. It was incredibly fulfilling to see democracy at work!
And then nothing happened for 18 months.
Until yesterday, when the SEC released 585 pages worth of proposed rules for crowd investing. Talk about fun bedtime reading!
After reading all the rules, it's clear that high-growth startups will not crowdfund as currently proposed.
So now it's time to start lobbying again. The SEC is soliciting comments over the next three months. Let's help make the rules better!
The Good Stuff
Overall, the proposed rules are better then we expected. It's clear that the SEC is not trying to kill crowdfunding via regulatory fiat; the rules are an honest attempt to comply with the intent of Congress. Specifically, we liked:
- Startups can raise unlimited amounts (but only $1m from unaccredited investors per year). Startups will be allowed to fundraise with Reg D Rule 506(c) concurrently with the crowdfunding exemption. There are no integration issues. This means that startups can raise unlimited amounts from accredited investors, while reserving room in their financings for up to $1m from unaccredited investors per year. Without this provision, crowdfunding would have been a non-starter for any company that intended to grow fast.
- No stringent income verification. Investors do not have to upload tax returns or provide other sensitive information to provide evidence of their income. They can self-certify that they are investing less then the maximum annual limit allowed by law. We're very happy about this. If Kickstarter required all their backers to upload tax returns, Kickstarter never would have succeeded.
- The SEC (mostly) understands the Internet. The rules read like the authors have a good understanding of how Kickstarter works. The rules require that the funding portals have a communication channel where the “wisdom of the crowd” can work, which is smart. And everything can be done electronically,even submitting forms to the SEC via XML! (Ok, it's not JSON, but still gotta give 'em credit).
The Bad Stuff
The SEC has thought a lot about how to expand access to capital for small businesses that don't fit the typical profile for venture capital investment. But the SEC hasn't paid enough attention to the other important part of the JOBS Act: democratizing investing so that everyone can have access to opportunities that previously were only available to the rich and well-networked.
That's our mission at Wefunder — to destroy the “insider's club”, so that all Americans can participate in high-quality private investments.
Good startups have plenty of options for raising capital from professional angel investors. Many will go on to raise venture capital. Some of the proposed rules need to be improved in order to make crowdfunding workable for that class of company.
The root of the problem is that the SEC needs more information about how high-growth startups raise financing. They designed the rules primarily for small businesses… and — inadvertently — for poor-quality startups that can't raise funding from the professionals.
Three rules need to be improved so that high-quality startups will crowdfund.
I. Startups should pay $0. Rather, intermediaries should earn their profits in equity, at the same terms as their investors.
The SEC has assumed that funding platforms will use a business model that is unworkable. They assume startups will pay 5-15% of their fundraising round in fees to the intermediary.
That's insane. The best startups are not lacking capital — investors are throwing money at them. They won't pay fees. Only the companies that have no other option will. Do we really want a world where unaccredited investors can only invest in second-tier startups that have no other way to raise funding? Or do we want a world where up to 15% of a financing round is leached off by parasitic finance dudes?
Further, this gives funding platforms bad incentives. How do they make their money? Not by enforcing a high quality standard — for instance, only accepting companies vetted and invested in by professional investors. Instead, to earn revenue, platforms must dramatically increase the volume of companies that are fundraising, regardless of their chances of actual business success. That's a recipe for a lot of investors losing their money. Not good.
At Wefunder, we want to charge startups $0 when they fundraise from unaccredited investors. On a $1,000,000 fundraise, that'll costs about $100,000 less than what the SEC envisions.
The catch? In return for offering our services at nearly no cost, we want Wefunder to receive a financial stake in every company on Wefunder at the same terms as unaccredited investors and proudly disclose this fact. We don't want to pick and choose winners from companies on our platform. We don't want better terms than unaccredited investors. Rather, we want a high quality bar that ensures every company that unaccredited investors have access to has been vetted by professional, highly experienced investors. Our incentives are then perfectly aligned with unaccredited investors; we only make money if they do, at the same rate they do.
We have no problem disclosing that fact; it's key to our brand. That's the best kind of investor protection we can possibly provide.
One problem: the proposed SEC rules prohibit it. The SEC has not followed Congressional intent, which purposely allowed the intermediary itself to own a financial stake. Further, the SEC's decision to unilaterally decide to extend the prohibition to the intermediary directly goes against a Congressional Letter of Record provided to the SEC by a Senator who drafted the legislation, which states:
Excerpt from the Congressional Letter of Record. In addition, intermediaries should be allowed to take an equity stake in offerings. This however, does not mean that intermediaries should be able to choose which offerings to participate in but rather it should be a standard process for any offering that the intermediary facilitates. This will incentivize an intermediary to focus on issuer quality over quantity, providing more vetting for investors and greater alignment of interests. Of course, any equity stakes by the intermediary must be fully and meaningfully disclosed to investors.
Luckily, the SEC is specifically requesting comment on whether they should change this rule. The answer is a resounding yes!
SEC Request for Comment, Question 122. Should we permit an intermediary to receive a financial interest in an issuer as compensation for the services that it provides to the issuer? Why or why not? If we were to permit this arrangement, the proposed rules on disclosure requirements for issuers would require the arrangement to be disclosed to investors in the offering material. Are there other conditions that we should require? If so, please identify those conditions and explain.
II. High-growth startups don't want dozens of direct shareholders
High-growth startups can't accept hundreds of shareholders, as venture capitalists are wary of investing in startups with “messy cap tables”, and it can therefore endanger their follow-on financing. No startup wants to take that risk. Our current solution at Wefunder is to aggregate up to 99 accredited investors that invest in a Single-Purpose LLC Fund, which then invests — as one shareholder — into the startup. This increases costs to investors, but it solves the problem. Unfortunately, the JOBS Act prohibits private funds from using crowdfunding. So this solution won't work for unaccredited investors.
As written in a Congressional Letter of Intent provided to the SEC, we propose that the SEC specifically allow funding portals to be the “holder of record” for all crowdfunded securities until the startup is acquired or goes IPO.
Excerpt from the Congressional Letter of Intent. Intermediaries should also be permitted to act as the holder of record for offerings that they facilitate to reduce compliance complexity for issuers and to increase the likelihood of subsequent funding from institutional investors. Providing holder of record services will reduce compliance complexity for issuers and place the burden of managing crowd funded investors on the intermediary. Without this mechanism, issuer capitalization tables may become unwieldy, discouraging subsequent funding from institutional investors.This has the additional benefit of allowing the intermediary to advocate for smaller unsophisticated investors, who individually won't have the power to protect their rights when venture capitalists provide follow-on financing. Finally, it also takes away the concern that highly sensitive information will leak to competitors, as the information rights are held by the intermediary instead of hundreds of investors (of which one will certainly include a competitor).
If we don't solve this problem, the majority of the high-growth startups will not crowdfund. For the few that do, venture capitalists may treat small investors unfairly during follow-on financing.
III. High growth startups need reduced disclosure requirements
Up to the present, we've succeeded in convincing some of the 'hottest' startups in Silicon Valley to fundraise on Wefunder because we've taken away all of the downsides. They don't need the capital, but are intrigued by letting their most passionate customers and users invest alongside their professional investors. So it's an easy “Yeah, sure, ok”.
However, some of the proposed disclosure requirements — many of which are unneeded for an early-stage startup investment decision — would add too much friction to the decision. Crowdfunding on a platform would require about 10x more information than professional angel investors who cut a $25k check after watching a 7 minute pitch during a “demo day” presentation.
We understand and agree that accepting funds from unaccredited investors should require more responsibility. But reducing unnecessary disclosure requirements that are not relevant to early-stage startup investing would be appropriate. Specifically, we propose:
- Exempt startups from being required to provide financials if they have been existence less than 12 months. Instead, require that startups disclose the amount of cash they have in the bank, and their current monthly gross profit or loss — i.e., their 'burn rate'. Full financial statements are not relevant for early-stage investments when it's little more then a team, an idea, and some early prototype. Professional angel investors don't need or want financials from a three-month-old startup. And busy startup founders will not waste their valuable energy or money putting together useless financial statements with lots of zeros. Far more useful is a disclosure of how much cash is in the bank, what the monthly burn rate is, and how much runway the startup has until more capital is required.
- Create a special crowdfunding exemption with reduced disclosure requirements when the total fundraise is <=$100,000 or the individual investments are <=$500. The primary motivation for high-growth startups raising from unaccredited investors is not the capital — which they can easily get from accredited investors — but rather to reward their most passionate users and customers. Reducing the unaccredited fundraising to under $100,000 or under $500 per investor in exchange for reduced disclosures is perfectly acceptable to them. The SEC seems to be open to some of these improvements, based on the requests for comment below.
Relevant SEC Requests for Comment
91. We have the authority to include exceptions to the ongoing reporting requirements in Section 4A(b)(4). Should we consider excepting certain issuers from ongoing reporting obligations (e.g., those raising a certain amount, such as $100,000 or less)? Should any exception always apply or only after a certain number of reports have been filed? Please explain.
51. Should we exempt issuers with no operating history or issuers that have been in existence for fewer than 12 months from the requirement to provide financial statements, as one commenter suggested?202 Why or why not? Specifically,what difficulties would issuers with no operating history or issuers that have been in existence for fewer than 12 months have in providing financial statements? Please explain.
10. Should we adopt rules providing for another crowdfunding exemption with different investment limits (e.g., an exemption with a $250 investment limit and fewer issuer requirements), as one commenter suggested,or apply different requirements with respect to individual investments under a certain amount, such as $500, as another commenter suggested?
80. Should we require ongoing annual reports, as proposed? Why or why not? Should we require ongoing reporting more frequently than annually? Why or why not? If so, how often (e.g., semi-annually or quarterly)?
Where We Go from Here
It's only been a couple days, and 585 pages of regulations is a lot to absorb! If you feel like I've missed something important in my analysis, please let us know. I'd love to hear it.
We're optimistic we can influence the SEC to improve the proposed rules so crowdfunding will actually be useful for high-growth startups. Otherwise, unaccredited investors will only get to invest in opportunities that professional investors turn down… in other words, they get to scrape the bottom of the barrel. And who wants that?
We're going to spend a lot more time thinking about how we can influence the SEC. After we figure that out, I'll write up a much more concise, polished version of this blog post. Stay tuned!