Financing’s New Rules Under the JOBS Act

SEC rulemaking is needed before last year’s JOBS Act can be fully implemented. Once it is, who will use this new route to capital?
Financing’s New Rules Under the JOBS Act

In November, Zach Supalla put his Minneapolis company, Spark Devices, on the crowdfunding website Kickstarter. With only a rough prototype in hand, Supalla’s goal was to raise $250,000 to bring his idea to market: a wi-fi–connected lightbulb socket that lets users control the lights in their homes from anywhere using a mobile app. Backers who contributed $25, $49, or more for the cause could count on a T-shirt, a Spark socket, or one of Supalla’s next-gen prototypes in return. Since Kickstarter’s launch in April 2009, more than 34,000 projects have been successfully funded through the site, raising $387 million in financing collectively.

By next November, will the Zach Supallas of the world be able to raise financing by selling shares of stock via crowdfunding?

That’s the intent behind the federal Jumpstart Our Business Startups (JOBS) Act signed into law in April 2012. The legislation has a number of provisions designed to make it easier for companies to receive financing and thereby grow and create jobs. Selling shares to the public without going public is one of them.

As common-sense as this sounds, this provision would radically alter the way startups have been financed since passage of the Securities Act of 1933. Currently, a company that sells stock must register the securities with the Securities and Exchange Commission (SEC) or find an exemption, most commonly through Regulation D, that allows private companies to sell stock to accredited investors—basically, financial institutions and high-net worth individuals. The general public cannot buy such stock.

But how is crowdfunding supposed to work when investors expect a dollar return instead of a T-shirt or a widget? No one really knows yet, including the SEC.

The SEC is still working out the rules for implementing much of the JOBS Act. The rulemaking for the crowdfunding portion of the law was not completed by the December 31 deadline.

“I think the SEC is slightly frozen at this point,” says Tom Martin, a partner at Dorsey & Whitney, LLP, who co-chairs the Minneapolis law firm’s venture capital and emerging companies practice group. For months, the SEC has appeared stuck between a rock and a hard place in its own divided mission: facilitating “capital formation” for companies on the one hand and protecting investors on the other.

“The thought that you can publicly offer securities to unsophisticated, small investors without disclosure is pretty antithetical to securities law basics,” Martin says. “I mean, it really is totally antithetical to the Security and Exchange Commission’s mission.”

This Doesn’t Solve the Liquidity Problem

One way to understand the JOBS Act is to see it in degrees of departure from the past 80 years of securities law.

Parts of the act allow companies to communicate with traditional groups of investors but disclose less to them, a step away from past practice. Parts of it allow communicating with the broad public—a new option—to reach more of the investors who have been historically eligible to buy shares of private companies. That’s another step removed from the norm. The biggest departure is bringing in the general public to participate as investors in private offerings.

Three major segments, or titles, of the law were adopted SEC last April. Three more, including public solicitation and crowdfunding, are waiting for SEC action.

For all the changes the act would bring, it doesn’t solve the problem it needs to, says Doug Ramler, an angel investor and a principal with Gray Plant Mooty who co-chairs the Minneapolis law firm’s entrepreneurial services and technology practices. “To keep the JOBS Act in perspective, we’re looking at the circle of capital flow, and it doesn’t really address the liquidity portion,” Ramler says.

Think of a “capital circle” that’s like the face of a clock, he explains. Entrepreneurs put in money to fund their own ideas at twelve o’clock, friends and family invest at two o’clock, angel investors at four o’clock, venture and strategic investors at six or seven o’clock, maybe with debt financing following that. “Then at ten o’clock, you’re supposed to exit,” selling your company or doing an initial public offering of stock so that everyone in the circle gets a return.

“The problem with the way the system works now . . . is we don’t have those liquidity events,” Ramler says. The JOBS Act may cause shifts within the circle, but it doesn’t do much to complete the circle by making exits easier to achieve. In that sense, he says, it’s like “rearranging the deck chairs on the Titanic.”

Troy Kopischke says something similar from an entrepreneur’s perspective. Kopischke is managing director of Invenshure, LLC, an incubator for technology companies that he and Danny Cunagin founded two years ago, with an affiliated fund made up of individual angel investors. The two are engineers and were the top executives at Steady State Imaging and Logic Product Development, Twin Cities companies that they led to successful exits through sales to GE Healthcare and Micro Dynamics, respectively. “The number-one reason right now why people don’t want to invest in early-stage companies is liquidity,” Kopischke says. He would have liked to see bolder measures in the JOBS Act to make IPOs easier to conduct, or even see the government set up “a trading exchange for private company securities.”

If he could rewrite the new law, “I would have started at the liquidity problem first.”

General Solicitation: ‘The Most Groundbreaking Provision’

“I think people are confused,” Martin says. Not knowing the details of the JOBS Act, they “hear ‘crowdfunding’ and then they start talking about Title II.”

In reality, Title II of the JOBS Act would eliminate a longstanding prohibition on “general solicitation” for private placements.

Most private stock offerings today are done under a rule that lets them bypass registration with the SEC and other disclosure requirements if the issuers forgo communicating about their deal with the general public. Issuers can talk only to high–net worth accredited investors with whom they or their broker-dealers can claim a pre-existing relationship.

That’s what Title II would do away with. It would let a company promote its “private” offering to anyone by any means: at events, in social media, in advertising. A billboard along I-394? Fine. But the company could still take money only from accredited investors.

“[General solicitation] would be a tremendous expansion of a small company’s ability to raise money,” Martin says. While accredited investors are a small subset of the public, there are many of them; these “aren’t tremendously wealthy people anymore,” he says of those with net worth or net income that meets the SEC’s definition. “I think that Title II is the most groundbreaking provision of the act.”

The downside for investors, he adds, is that nobody’s acting as a gatekeeper: “All the stuff that’s out on the Internet, you don’t have a clue as to whether it’s real or not.”

“Right now, as I come across deals or members of my network come across deals, I know that they’ve looked at it, and if it were a bad deal, they wouldn’t tell me about it,” Ramler says. “If it’s a bad deal, it still shows up in [a web] portal. There’s not as much of a filter, which is a big concern as an investor.”

The downside for entrepreneurs might be verifying who’s accredited. Today, investors sign a document confirming their own status. Under JOBS, will issuers need to get investors’ tax returns? Personal financial statements? Third-party verification from an accountant? It’s not clear until the SEC writes the rules.

But Kopischke and Ramler both agree with Martin that Title II could be valuable. They say that widely publicizing deals could have the effect of aggregating both the deals and the investors around specific sweet spots, whether it’s a preferred industry, geography, or type or size of offering. In other words, it could make the market more efficient.

“If I came up with a new dental invention, I could go out and publicly talk with dental groups and dentists and try to raise money from them, and that’s actually fantastic,” Kopischke says, “because they’ll understand it right away and understand whether they’d want to buy it or not.”

Ramler has been contacted by web portals that want to work solely with medical device and health care companies. “If you can create a group of investors interested in a particular industry, I think that could work,” he says.

Crowdfunding: Still Distant and Fuzzy

But what about crowdfunding under Title III of the JOBS Act, the kind that would resemble the Kickstarter model?

The SEC hasn’t issued even preliminary rules for public comment yet, as it has for Title II. Once final Title III rules are in place, registered web portals and a governing body for them will still have to be set up. FINRA, the Financial Industry Regulatory Authority, an independent nonprofit regulator of securities firms that is empowered by the federal government, has taken steps to become the needed governing body once the SEC takes its action. But Martin is in no hurry to see Title III take effect, at least not as the act was signed into law.

“Frankly, we should all ask ourselves whether somebody at the poverty line should be investing their hard-earned dollars in an equity investment offered over the Internet. The answer is, maybe that doesn’t make a heck of a lot of sense,” he says.

Title III would allow anyone, even investors of very modest means, to buy privately offered shares of a company, but with significant restrictions on the size of the offering and the size of the investments. Offerings would be capped at $1 million and would have to be made through registered online portals or broker-dealers. Investors with income of less than $100,000 a year could invest no more than $2,000 in crowdfunding deals in any 12-month period. More affluent investors could put in up to 10 percent of their income or net worth, as much as $100,000 in 12 months.

“The market [will be] absolutely enormous if it ever gets established,” Martin says. But because Title III requires so much work and cost for an issuer relative to the few hundred thousand or one million dollars being raised, “I just don’t think it’s going to be used as much as people anticipate.”

DIY offerings are not allowed. Companies will have to provide financials and other disclosures, pay accounting and legal fees to put an offering together, and pay a portal or a broker-dealer to present the offering to investors. Broker-dealer fees are often 10 to 13 percent of the size of the offering today, Martin notes.

Dollars won’t be the only costs. Kopischke, who’s managed company relationships with a handful of angels, says he can’t imagine working with dozens or even hundreds of inexperienced investors. “It’s twofold: the quantity [of investors] they’ll have to be managing, but also the level of sophistication” and number of questions that will result, he says.

Nonaccredited investors—who participate in private offerings today under certain exemptions—are more likely to bring legal challenges if they lose money, Ramler believes: “My experience is that’s where the litigation comes from.”

‘Democratization’ of Capital

“It’s actually not the first million that kills a lot of these companies, it’s the second round,” Kopischke says. The “valley of death,” where companies perish from lack of capital, is between $1 million and $5 million, “so I wish the maximum size offering was larger.”

Still, Kopischke puts himself firmly in the pro-crowdfunding camp: “I would push for it. I really believe in it.”

The wealthy shouldn’t be the only ones who can make this type of investment, he adds. And crowdfunding under JOBS will be a new source of funding for “a lot of great young entrepreneurs who don’t have a proven track record.”

Every company passes through a stage where $1 million is meaningful, Ramler says. Even medical technology companies that ultimately raise tens of millions might need a small round early on to complete their product design. By contrast, “for a start-up technology or web-based company, sometimes half a million dollars is all they need to get to profitability or cash-flow break even.”

It’s not hard to see why crowdfunding under the JOBS Act has taken hold of people’s imaginations and, to varying degrees, their enthusiasm, despite big unknowns and known downsides. On Kickstarter, Zach Supalla’s company raised $52,000 in pledges of support in just a week, almost all of it in increments of $300 or less. However, when Spark Devices didn’t reach it’s goal of $250,000 of support within 30 days, under the rules of Kickstarter, the deal was off.

Crowdfunding could bring more of the “wisdom of crowds” to investing, the idea that the many are smarter than the few, and that collective wisdom will spot the winning deals. But Ramler isn’t so sure about that. Experienced venture capitalists average only about one big win in 10 deals. “Why do we think that Joe down the street has any better insight?” he asks.

Crowdfunding is “the democratization of venture capital,” Ramler says. As such, in equity crowdfunding, the many will share in the losses as well as the rewards.

Maybe the JOBS Act should have included a provision for sending investors T-shirts and widgets. Instead, in many cases they’ll have to be satisfied with the other thing that motivates all those Kickstarter donors. “Getting involved in the process and funding innovation,” Ramler says, “people feel good about that.”