It is this Thursday and significant info regarding crowdfunding is anticipated. . .
http://www.sec.gov/news/press/2012/2012-194.htm
I will post some thoughts afterwards and would be interested to hear others.
On the eve of the election, I’ve been thinking about how a Romney presidency would impact investment crowdfunding in the U.S. This isn’t a prediction as the odds seem to be that Romney will lose. It isn’t a preference either. It is just interesting to think about because of the timing of the election and pending regulations under Title II and Title III of the JOBS Act. For that matter, it is also interesting to think about how a change from Mary Shapiro as head of the SEC will impact investment crowdfunding regulations, in terms of both substance and timing, even if Obama is reelected. It is widely expected that Shapiro will leave even if Obama wins. However, one would think that a new Obama appointee would keep more of the senior SEC staff in place that dictate internal policy.
What about Romney? There is probably little to no difference on the legislative front. Given that the odds are that Congress will remain divided after the election, with the Democrats retaining the Senate and the Republicans retaining the House, any type of major legislation is unlikely to happen for either candidate. After this election, and in our hyper-partisan times, only a horse trade over the catastrophic financial cliff seems likely. That is not going to include any modifications or fixes to the crowdfunding law.
However, the regulatory landscape could change quite dramatically. The LA Times had an interesting piece on how a Romney driven change in leadership at Treasury and the SEC would potentially water down Dodd Frank based Wall Street reform. For what it is worth, I see this as one of the bigger downsides to a Romney win. Letting the Wall Street foxes back in the henhouse for entities that have systemic risk is scary. But what about the pending crowdfunding regulations? Would piling excessive costs and regulations on Title III crowdfunding transactions be the type of abusive regulations that Romney has been talking about killing? One might guess that the regulations that come out would have a lighter regulatory touch. Would Romney see investment crowdfunding as competitive to his finance cronies and seek to undermine it? Who knows?
The more likely issue is that a wholesale change at the SEC after a Romney win would seem to put in some period of transition on top of an already backlogged agency. It is impossible to predict how any of this shakes out, but it is yet another reason to speculate about just how far off investment crowdfunding really is in the U.S.
When thinking about what is required to make investment crowdfunding work, I get the sense that not many people are thinking enough about what crowdfunding already is and how it got there. This is a problem as regulators are attempting to define the landscape. Maybe it is just an issue of timing, but I sense it is something more here. The timing issue is that pending regulations that the lift the general ban on solicitation are certain to occur before Title III crowdfunding regulations are promulgated. This lifting of the general ban on solicitation has an impact on investment crowdfunding, and enables crowdfunding for accredited investors, but it is certainly not limited to crowdfunding. In fact, some of the more interesting applications of the ability to generally advertise private investment opportunities have nothing to do with the Internet or social networks. After all, just imagine if Y Combinator ran its next class as a reality TV show and at the end of the reality show accredited investors could actually invest in the class of new companies? That is a pretty dramatically different world. However, creating new mechanisms for the same types of companies to get essentially the same type of funding (as to size of the round and size of an individual investment) from essentially the same type of investor, is not crowdfunding to me—it is generally advertised Reg. D investment.
To me, genuine investment crowdfunding is something very different and it has its roots in what crowdfunding as an industry already has become. Crowdfunding drew the attention of lawmakers because large amounts of money was getting contributed to help fund things that have never been privately funded before. No better example exists than Kickstarter’s funding of independent films and music. Genuine crowdfunding is more likely to occur when the Title III regulations are promulgated because Title III investments can be made by anyone who is old enough to enter into a contract. This means that people who cannot easily invest in companies now will be able to do so. It is investment for everyone.
Because anyone can invest and because Title III investments will be capped annually, both for issuers and investors, the investors and the investments are likely to be very different than what is realized by companies receiving outside investment today. A standard Series A round for a tech company will exceed the $1 million annual cap for such a company. While one can contest the propriety of the particular caps, the notion of investor caps helps create the true crowdfunding dynamic of smaller investments and larger numbers of investors. Under Title III, I think mostly about communities funding a local coffee shop as opposed to mini Fred Wilsons looking to invest in the next Twitter.
Don’t get me wrong, there will be unconventional companies funded through new rules under Title II enabled 506 rounds as well as some genuine crowdfunding rounds under Title II. There will also be some new Facebooks funded under Title III crowdfunding. However, my on unofficial survey indicates that the bulk of the crowdfunding portal industry is gearing up for Title II “crowdfunding” and is aiming for larger rounds that will not fit under Title III. For portals attempting to be as profitable as possible, that makes some sense. The problem is that if regulators are only speaking to this group, there is no one at the table discussing what is necessary to make genuine crowdfunding work and pointing out what could be accomplished if the JOBS Act concept of a funding portal is actually realized. These Internet investment bankers are not trying to make smaller offerings to companies not now being funded work. They want to be investment bankers, so the cost of being broker-dealers is not particularly significant because larger investment rounds can absorb those costs and the activities they want to conduct require registration anyway.
Hopefully the regulators are thinking of how to make equity rounds as small as $50,0000 viable through funding portals. These micro-rounds would be very enabling for many Main Street businesses because even SBA loans require some equity in the capitalization. That is what genuine crowdfunding is about. The JOBS Act was written with the understanding that this type of round cannot absorb the costs of broker-dealer compliance. Further, this type of funding cannot absorb a burdensome registration or compliance program from FINRA that could be created for funding portals. I hope these issues are getting full consideration by regulators because it really does not appear to me that crowdfunding industry groups really care about making small rounds viable. It is these small rounds that will have tremendous impact for Main Street–like new coffee shops, landscaping businesses, bakeries, organic food stands, fitness centers and florists. In a post recession world, capital is just not available for these businesses. These proprietors no longer have home equity, let alone home equity lines of credit that formerly served to get them started. This is not very interesting if you want to be an internet Goldman Sachs but the economy does not need more of that. We need new investment from new investors and this is what crowdfunding is really about. Even for tech companies, seed rounds like this can have a dramatic impact. That is one thing that Y Combinator and Techstars have already proven–$50,000 can go a long way.
I was excited to attend the Dealflow Media Crowdfunding Conference in San Francisco Monday. However, what I heard about the regulatory process and the anticipated future rules from the SEC and FINRA sounded like most would-be investment portals have already raised the white flag to the regulators and the potential of the industry will not be realized. Portals seem to have concluded that the regulators are going to effectively require them to register as broker-dealers even though the JOBS Act clearly was written to allow the creation of funding portals that do not have to deal with full broker-dealer compliance and costs. I think this capitulation is the wrong approach, is contrary to the legislative intent of Title III of the JOBS Act and effectively kills true crowdfunding before it even begins.
The portal logic is two-fold. Firstly the representatives of portals who have been meeting most with the regulators have determined that FINRA registration for internet portals will be close to as onerous as the requirements that exist for broker-dealers. Having to deal with “80% of a broker-dealer’s obligations,” portals will then get virtually none of the broker-dealer’s licensed benefits. Unlike broker-dealers, the JOBS Act appropriately limits the ability of internet portals to conduct certain activities and receive certain fees that are more commonly associated with broker roles. The portals’ conclusion is apparently that dealing with the remaining 20% of the regulatory burden in order to receive 100% of the broker-dealer “benefits” and fee structures is a trade worth making. I think this reaction imprudently focuses on the benefits of broker-dealer status without fully calculating the associated costs and burdens.
One of the roles that is prohibited to funding portals under the JOBS Act without broker-dealer registration is that of acting as an investment advisor. The second assumption by portals seems to be that the SEC will classify so many things as “investment advice” that no workable portal will be able to operate without being a broker-dealer. Some portals want to give the crowd what is clearly investment advice. If you want to recommend to people how they should invest their money, you are not a funding portal and you certainly should be required to register as a broker-dealer. Again, the JOBS Act was written with that simple logic and precludes funding portals from advising investors.
However, the potential problem is that the SEC has previously concluded that just about everything is “investment advice” in other contexts. As I wrote before, what I heard from David Blass, Chief Counsel, S.E.C. Trading and Markets Division, regarding the SEC’s thoughts on some of these issues earlier this year was entirely reasonable. However, if the SEC definition of “investment advice” in the funding portal context includes things as simple as allowing users to search companies based on their sector or even geography, banning sites from mechanically allowing offerings with more user interest to be more visible to other users and precluding portals from denying listing to any potential company, that is a real problem. Some of this is silly. The SEC would do well to hire a UI/UX developer as a consultant. Helping users logically find what they themselves are looking for is sort of the point of web design and it is not really “advice” from the site if it is user directed and organically generated. Listing a “Deal of the Week” is obviously a different matter. If the SEC determines that funding portal “investment advice” is effectively everything required to simply run a workable website or that any discussion with companies as to how their offering can be hosted and structured on the site is investment advice, then there is no such thing as a funding portal under the JOBS Act despite the clear intention of the law to create one.
If either FINRA registration and compliance for funding portals is unreasonably burdensome or the SEC regs are overly broad on investment advice, then yes, all equity portals will be required to register as broker-dealers in order to function and, from what I heard in San Francisco, most portals are resigned to doing just that. If so, true crowdfunding will never be realized in this country and the effort to democratize business finance in this country will remain broken unless and until Congress fixes the SEC and FINRA’s thinking.
The reason crowdfunding is dead if only registered broker-dealers can do it is that it will not be economical for either issuers or portals to conduct Title III transactions. The trend over the last year has been toward new regulations that have saddled broker-dealers with more costly reporting and compliance requirements. Even before these increased costs of business, the pressure on broker-dealer firms has been toward larger transactions as increased costs have made smaller transactions unworkable. Against this backdrop, crowdfunding sites think they can run a business that is cost-effective to issuers and themselves while absorbing the cost of broker-dealer status. Good luck. Broker-dealers know better. Higher regulation and compliance costs may be appropriate for genuine broker-dealer activities but that is precisely why Congress created the notion of funding portals for crowdfunding. Those portals are not intended to have the high cost of compliance and they are not supposed to be doing anything other than hosting offerings in a passive role.
Being a broker-dealer may work in some online applications. AngelList will be able to absorb the costs of broker-dealer compliance because they are geared to do general solicitations with accredited investors. Other broker-dealers with a good retail clientele will be successful doing general solicitations under Title II. I think that approach will be very successful and will be a great resource for companies that most likely would have likely gotten venture or angel backing anyhow. The rounds will be larger and the valuations will be better and that is a good thing for tech companies in Silicon Valley. Accredited investors will invest who may have never invested before and that will increase early stage capital and it is a step toward the better. But make no mistake, this is just a new vehicle for more funding for the same companies that have always been funded–this is not the vehicle to get funding to main street businesses that have never been, and will never be, attractive to the existing private investment model.
If regulations effectively require funding portals to be registered broker-dealers, $1 million dollar capped rounds under Title III don’t make economic sense and true investment crowdfunding is dead. Portals will likely need to charge up to half of the money raised (perhaps more) for smaller offerings in order to offset the huge costs of compliance. Everyday Americans will not be able to participate in early stage finance because portals will not be able to economically conduct suitability determinations for investments of less than $2,000. Even if they wanted to do so, E&O insurers will probably not permit it. Title III protects these investors by placing arbitrary caps on annual investment. It does not create a nanny-state response of asking a broker to determine that a small investment is suitable for that particular investor. Companies that would not have otherwise gotten angel or institutional investment will not have a vehicle through crowdfunding to find it and the dream of democratizing capital finance for Main Street is dead again–all apparently without much of a fight from would-be funding portals.
Dealflow Media has made the audio of the conference available here if you are interested in hearing the panel comments on broker-dealer registration.
Last week I tweeted out a link to a very insightful Law 360 article written by Joseph McLaughlin of Sidley. I simply sent the tweet without posting comment because McLaughlin’s article speaks for itself in a very eloquent way. What I failed to realize is that the Law 360 article is behind a paid registration wall. Sorry about that. If you have a subscription, the article is here. If not, have no worry because McLaughlin has now publicly commented on the SEC’s proposed rule 506 changes designed to implement the JOBS Act’s elimination of the prohibition against general solicitation. You can find his equally insightful letter to the SEC here. If you have any interest in preserving the possibility that the JOBS Act will realize the Congressional intention to open up capital from accredited investors, you should read his letter because the proposed regs may well be an SEC attempt to undermine that legislation.
As proposed, Rule 506(c) would require companies to take “reasonable steps” to verify that investors are accredited investors. That seems harmless enough on its face. However, the rule does not provide any clarity on what such “reasonable steps” should be. Therefore, companies cannot have any assurance that the steps they have taken are sufficient in the circumstances. Furthermore, even if they were “reasonable,” there is no assurance that a disgruntled investor will not sue just to cause a problem or blackmail the company with the prospect of bad publicity and large legal expenses. McLaughlin persuasively suggests that all this uncertainty is not likely an accident but represents an intentional effort to circumvent provisions of the JOBS Act that the SEC actively argued against. This could be the first evidence that the SEC has an agenda to impose its own will over the clear legislative intent of the JOBS Act. Stay tuned.
Please see my guest blog post on the website of America’s strongest service industry franchisor, The Dwyer Group:
The JOBS Act and pending regulatory rules will dictate what investment-based crowdfunding portals are required to do as part of the due diligence associated with listing an issuing company on their site. Similarly, those rules will eventually dictate what portals will not be permitted to do (like providing buy-side investment advice to the crowd) in connection with these offerings. In between what is specifically required and what is specifically prohibited there will likely remain a huge ocean when crowdfunding legally begins. Some portals are clearly seeking to position themselves as not only an investment portal for purposes of the hosting of crowdfunding securities offerings, but also as a “one stop” service provider for issuers and, seemingly, the crowd alike. That includes advising issuers on investor relations and communications, financial reporting, accounting and an endless range of contemplated services. The range of services contemplated by the portals also seems to include services for purchasers of crowdfunding securities such as facilitating secondary sales of those securities. It is an understandable goal, for both paternalistic and pure business reasons, for investment portals to consider offering a range of services beyond simply listing crowdfunding issuances but I am not sure that the conflicts and risks have been properly thought through. This is a real mine field.
Many of those involved in the crowdfunding movement feel a paternalistic desire to do whatever possible to make investment crowdfunding “work.” This is a laudable goal. There is also an underlying bias that seems to believe that issuers who use crowdfunding portals will generally lack sophistication and will be in need of many ongoing services in order to comply with regulatory rules as well as the expectations of what could be a huge number of investors. The paternalistic instinct kicks in when investment portals to try to also provide those services. Many people in the industry also see these ancillary services as a source of revenue. I think crowdfunding portals need to be very careful in this area. There are other companies moving to fill the void in these areas (such as Crowdfunding Roadmap) and my instinct is that investment portals would be wise to stay away and let these firms provide those services.
Providing perspective on investor communications, regulatory compliance and similar services after the issuance of securities is fraught with potential conflicts and requires extensive sophistication in matters of corporate finance. The issues are so numerous that they are well beyond the scope of a single blog post. There are not many analogies that I know of but the London Stock Exchange has the interesting concept of a “nominated advisor” or “NOMAD” that relates to AIM companies whereby a private organization accepts a quasi-regulatory ongoing role for issuers. It is not uncommon for the investment bank that represents the issuer in the AIM listing to maintain a continuing role with the company as its NOMAD. The NOMAD has obligations to advise the company on compliance with the AIM listing rules as well as investor matters. This is not unlike some of the roles contemplated by would-be crowdfunding investment portals but some of the multiple roles contemplated by crowdfunding portals would be specifically prohibited even under the NOMAD concept.
Because I was general counsel for several years to several AIM listed companies, I’ve seen the effectiveness and the pros and cons of this concept. Importantly, the NOMAD is subject to an approval process by the London Stock Exchange, specific rules and obligations to the Exchange as well as disciplinary proceedings if they do not properly perform their regulatory responsibilities. Will crowdfunding portals have the internal sophistication and experience identifying these many conflicts and issues? Will they understand the underlying business of the issuer sufficiently to guide them on the relevant disclosure issues? Will the SEC or FINRA require them to have this internal expertise? Will portals expose themselves to liability for information disclosed or not disclosed to investors? Will investment portals be implicitly providing investment advice to the crowd with respect to secondary sales? Will it be permitted or advisable for crowdfunding portals to provide ongoing services to the issuer while attempting to facilitate secondary sales by purchasers? These are just a few of the traps for unwary portals.
In my opinion, the NOMAD system is far from ideal. It is difficult to have any single entity to fill the roles of investment bankers and regulatory watchdog contemplated by the AIM rules. The chinese wall procedures are questionable. Crowdfunding portals are planning on even more varied and conflicting roles than that of the NOMAD. The intention of the JOBS Act is that investment portals will be passive when it comes to the marketing of any particular issuer’s securities. This makes tremendous sense. Does providing investor relations services after the first crowdfunding offering prohibit that portal from hosting a second offering by the same issuer because of the nature of the implicit “advice” they provide in their IR role? Will there be a disciplinary system for crowdfunding portals that act negligently? It will be interesting to see how the various regulatory groups deal with these issues and conflicts. From my perspective, investment portals attempting to be all things to all parties and fighting for every available nickel is a very risky proposition. I welcome the thoughts of others.
Some would-be equity-based crowdfunding portals intend to permit listing companies do only a single form of offering. Whether that is common stock, preferred, debt or what have you, this strategy is not likely to work in the real world for issuing companies. Crowdfunding investment portals will need to permit issuing companies to be much more innovative in structuring offerings than a “one-size fits all” approach if the portals intend to be remotely relevant.
Last month I attended a Q&A with the group from the SEC charged with writing the regulations for internet portals operating equity-based crowdfunding platforms. I was extremely impressed by David Blass, Chief Counsel, S.E.C. Trading and Markets Division, and his team members who are charged with drafting these regulations. I was less impressed by the questions that came from the audience. One such attendee represented a would-be investment portal and asked Mr. Blass several leading questions suggesting that the SEC should, by regulation, require a certain structure of the investment for crowdfunding investments. The attendee had a very specific notion of what that form would be. Mr. Blass, speaking for himself and not the SEC, politely disagreed. Mr. Blass consistently provided the same answer to different forms of the same “question.” Specifically, he noted that the SEC should not be concerned with the many forms that the structure of an offering can take. He stated that the SEC should be focused on making sure that the structure chosen is adequately and properly disclosed to those to whom the offering is made. In other words, if issuing companies make the structure complex, they better find a way to adequately describe what people are getting and how it works.
Not only is Mr. Blass’ position entirely sensical, the crowdfunding exemption needs this flexibility to be relevant in the world of corporate finance. The reality is that corporate finance is extremely complex and is dependent upon the specific business, the nature of the business model, the stage of the business, the level of technical and other risks and the nature of the use of proceeds. In some situations, common stock will make sense. In other situations, the risk might be a debt risk with an equity kicker. In still other businesses, a project finance structure may be more appropriate. If portals do not understand these different circumstances, they will quickly find themselves irrelevant amongst their peers in the industry. Further, if investment portals require listing companies to use a single form of offering, very few companies will use that platform. Portals have a strong interest in having paternalistic instincts toward investors. Portals need to be comfortable that the form of an offering listed on their site is properly disclosed. It is not going to be simple. Portals should understand that in advance–the SEC is not going to be able to dumb this down to a “one-size fits all” mandate.
As I interact with players in the investment crowdfunding arena, I am starting to hear some consensus opinions from crowdfunding portals and would-be crowdfunding portals that seem me to be unlikely. For what it is worth, I think these are myths that will turn out to be mostly untrue.
Myth One: Crowdfunding Platforms will play a Primary Role in the Success of any Offering
I don’t think this is likely to any strong degree. Keep in mind that investment crowdfunding platforms are not permitted to market specific offerings. They will only be allowed to direct attention directly to their platform generally. Similarly, investment portals cannot offer investment advice to potential investors. Like donation-based crowdfunding has taught us, success is usually won or lost based on the individual efforts of the project owners themselves. Getting the word out about the offering is going to be the responsibility of the issuer. Sure, some sites will aggregate lots of general traffic and that will be an advantage but the work is going to need to be done by the issuing companies–regardless of which platform they use. However, if you cannot market and push your project, you will not get your offering funded–whether the offering is on a high traffic site or not. Because investment crowdfunding will be “all or nothing,” getting less than your goal means you get nothing at all. Crowdfunding sites will quickly learn that they are not the most important component of the success or failure of investment offerings.
Myth Two: Software is a an Important Differentiator for Crowdfunding Portals
With many internet companies, proprietary software is a must (either actually or because institutional investors perceive it to be that way). Many crowdfunding sites are spending large amounts of money on the creation of software that will meet the requirements of the JOBS Act, the SEC and FINRA (when all of those requirements are known). I am surprised that all of these sites are duplicating efforts and expense–at least as to the back-end development work. Software is not really going to be the critical factor for these platforms. It is all likely to be the same at the end of the day. No offense to my developer friends, but back-end software is not going to drive this train. Front end developers and designers may find more appealing UI/UX–but that is where the money should be spent. Veteran back-end developers like Mike Pence at Hayduke Labs understand this component. That is understandable because Mike has seen it all as the lead developer on Kickstarter before anybody ever heard of Kickstarter. He is coordinating efforts to develop a back-end solution collaboratively amongst various crowdfunding platforms. Likewise, white label solutions will come forward and those that spend too much too early will likely look foolish in retrospect. Collaboration is probably in everybody’s best interest.
Myth Three: Large Numbers of Crowdfunding Portals will Consolidate Quickly After Investing Begins
Maybe this is a reason for some of the lack of cooperation amongst portals. This one also strikes me as bit of wishful thinking by would-be portals. Crowdfunding is not like many other internet businesses. Everyone will not join the “Facebook of investment crowdfunding.” In this manner, I expect investment crowdfunding will be like traditional investment banking. Sure, there will be some “bulge bracket” platforms that emerge. However, there will still be an abundance of platforms. Some platforms will be niche or geographically specific. Some will simply be boutique. Investment crowdfunding will be an ocean and not a pond and there will be room for all types of platforms to be successful.
I’m interested in the views of others on these topics.
Taking Shots at a Legend
America loves to tear down a hero and we are seeing this play out yet again surrounding the liquidation of Curt Schilling’s 38 Studios. Schilling, one of the most dominant and clutch pitchers in the history of baseball, started 38 Studios in order to self-publish a massively multiplayer online game, or “MMOG.” I’ll confess that before Curt Schilling started talking about his MMOG, I did not know that the game category existed. In fact, I was fairly amazed that one of the greatest athletes of our generation was sort of a fancy Dungeons & Dragons geek. As it turns out, MMOG’s are huge business but it apparently takes over a hundred million dollars to build one. After spending much of his personal money, other investment and a whole lot of state government-backed debt, 38 Studios fell short of its goal and filed bankruptcy. 38 Studios’ management believes that they were close when the music stopped.
Crowdfund the Balance
Crowdfunding has already been hugely successful in the gaming industry. Games that have no tangible start have raised millions. I suggest that bankruptcy trustee Jeffrey Burtch try to crowdfund the balance needed to get Copernicus started. If there are really the waiting users that 38 Studios suggests, why not start a crowdfunding campaign to prove that? Give backers a reward consisting of a few months of free fees. This would be better for the company than the standard deal where the game is given away in perpetuity. Even backers receiving rewards will eventually be paying customers. If the users are really there, this effective pre-sale of the product will lure other financial backers to bid on the assets and help with the funding. Do it as a huge “all or nothing” campaign–say, $40,000,000. If 38 Studios management is right, there are hundreds of millions of dollars in user fees for the taking. Some of those users will take a flyer and back the project. If you do not reach the goal, no harm/no foul. By the way Mr. Burtch, negotiate a reduced fee from Kickstarter when you enter the deal or use another site. This would make trustee Jeffrey Burtch a hero in staid bankruptcy circles and could return money to the State of Rhode Island.
By the Way, Lay Off Curt Schilling
As an aside, lay off of Curt Schilling. He took millions of dollars of his own money (reported as much as $50 million) and tried to build a company. Most well paid athletes blow their wealth on parties, fast cars and strippers only a few years after retirement. Curt Schilling hired employees and built a company that was attractive enough to Rhode Island to steal it away from Massachusetts. Many of those employees are high-end coders. Some of those high-end coders will stay in Rhode Island and will build other high-tech businesses. Rhode Island’s taxpayer money went chiefly to the salaries that drew the talent there–not to manufacturing equipment with no other purpose (see Solyndra’s use of proceeds in contrast). I think crowdfunding might be able to save this investment, but, in any event, Schilling’s company has and will pay dividends for Rhode Island.
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