Equity Crowdfunding Rules Stalled at SEC
To make the leap from theory to reality, crowdfunding will require the core elements of entrepreneurial spirit: a tolerance for risk and an urgency to execute on a great idea.
Sadly, both of those qualities are in short supply in Washington, D.C.
While the U.S. government slid under its New Year deadline to avert the fiscal cliff, it blew right past its milestone calling for a comprehensive set of rules to control crowdfunding, where small firms sell equity stakes without having to go through the expensive registration traditionally required by regulators.
In theory, everyday investors will be able to buy a piece of a future Facebook without a pile of venture capital and a slick office in Silicon Valley.
And entrepreneurs with a great idea will be able to get capital when angels are hard to come by and banks are loath to lend.
The market need for greater capital access for startups has not abated. In the past four years, almost half of small businesses have not been able to secure as much capital as they would have liked and 38 percent had loans and lines of credit either reduced or revoked, according to a May survey of businesses with fewer than 500 employees by the National Small Business Association.
For example, BrainThrob Laboratories Inc., a startup with a software-based service to streamline corporate recruiting, hasn't been able to secure $1 million to hire staff to sell its product and teach clients how to use it. The venture-capital community has been receptive, according to founder Erin DeSpain, but keeps asking for the market validation, such as growing sales -- plans which BrainThrob can't afford at the moment.
"What I really like about the crowdfunding concept is that the people who are investors in your business are possibly the same people who are customers in your business," says DeSpain, whose company is based on the outskirts of Richmond, Va. "The fact that you can put your money in something that you really believe in is evidence to me of how capitalism should work."
So when will entrepreneurs like DeSpain be able to sell startup stock? Probably not until the second half of this year or early 2014, according to the cadre of policy and crowdfunding experts interviewed for this piece.
Although President Obama signed the JOBS Act and its crowdfunding provisions in April, the SEC needs to finalize rules to govern roughly 20 different aspects of the nascent market. And the SEC, at the moment, is making the House of Representatives look like a paragon of efficiency.
In part because of recent defections at a number of high posts -- including the exit of SEC Chairman Mary Schapiro -- the commission has yet to hammer out about one-third of the details called for in the 2010 Dodd-Frank financial reform law. It also hasn't made much progress on an earlier provision of the JOBS Act, which allows startups and small businesses to advertise investment opportunities to corporations and wealthy individuals.
"It seems like everything is at a standstill," said a congressional aide familiar with the legislation. "And every month that goes by, the final measures get pushed 60 days in the future."
The good news is that the SEC staff has largely completed the background work on the law. But progress could be scarce until a fifth commissioner is instated to break the party split on the current four-member commission.
And don't forget there will be a 90-day public comment period on any proposed rules before the final measures are crafted and put to a vote.
If incoming SEC Chairman Elisse Walter plans to move forward on crowdfunding before a fifth commissioner is named, there could be some kind of action in the first quarter, according to industry sources. But there's currently no consensus on when to expect the next step.
The devil, as they say, will be in the details. Here's what's in play for each group of stakeholders.
- Entrepreneurs: The law calls for third-party audits of firms looking to raise more than $500,000. Entrepreneurs like DeSpain argue that such accounting reviews would burn up to 15 percent of any money raised.
- Intermediaries: The companies -- or "portals" -- facilitating crowdfunded offerings won't have to be certified broker-dealers, but they will be regulated nonetheless.
"You're going to have unsophisticated investors and unsophisticated issuers, so you're going to need the portals to be the grown-ups in the room," said Barbara Roper, director of investor protection for the Consumer Federation of America, which was opposed to the legislation from the start.
Crowdfunding middlemen, which may include such firms as Indiegogo, Kickstarter and RocketHub, will have to show regulators that they can protect investor information, do background checks on those holding more than a 20 percent stake in any issuer and ensure that potential investors understand the risks of buying a tiny stake in a tiny company.
Finally, the JOBS law has set guidelines on how much people can invest based on their annual income and net worth. The job of making sure investors don't put too much skin in the game is likely to fall to intermediaries.
- Investors: In addition to fixed investment levels, regulators will also have to decide how -- or if -- investors receive shareholder rights. Consumer advocates are already airing a range of potential governance sticky spots -- from equity dilution to exits.
Meanwhile, Sherwood Neiss, founder of Crowdfund Capital Advisors and a major force behind the JOBS Act, said intermediaries might run out of capital before the market structure is in place. And entrepreneurs frustrated with the wait are turning to alternatives like peer-to-peer lending and royalty-based financing deals.
"Crowdfunding can only prevail if the SEC lets it," Neiss said.