On the April afternoon when President Obama signed the JOBS Act into law, the only thing brighter than the weather in D.C. was the hope that the legislation would open up new doors for businesses. “Because of this bill, startups and small business will now have access to a big, new pool of potential investors -- namely, the American people,” the president had said at the time. “For the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in.” Democrats and Republicans had come together, across the aisle, to support the law. You might have expected Mark Zuckerberg to come from stage left blowing bubbles.
That was April of 2012. More than two and a half years later, entrepreneurs are still unable to take advantage of one of the most attractive -- and controversial -- parts of the law: the provision that would allow them to raise money by selling equity in their companies to anyone in America.
For the last 80 years, since the last major securities law was passed in the U.S., equity crowdfunding has only been legal for professional, accredited investors -- those that meet certain wealth requirements. Title 3 of the JOBS Act made equity crowdfunding legal for everyday Americans, but the rules for its implementation have been mired in regulatory purgatory for years now.
Related: The JOBS Act: What You Need To Know
After countless delays and missed deadlines, the Securities and Exchange Commission claims those rules will be ready by October of this year. But even as the SEC marches dutifully along, key stakeholders and legislators have already moved on. That’s because the JOBS Act that was inked by Obama on that sunny April afternoon had an Achilles’ heel on every leg. Idealistic and mighty, the law was written with too many errors to be reparable.
And so a Frankenstein-style JOBS Act 2.0 is waiting in the wings. It has some of the provisions of the first bill, some elements of previous versions of the bill that never made it to Obama’s desk in 2012, and some new elements. If passed, it would replace the first version.
The SEC declined to comment on this second-generation JOBS Act.
A look into the bowels of regulatory purgatory.
The idea of making equity crowdfunding legal for everyday Americans -- while lofty, sunny, and noble -- is a nightmare to manage. Quagmires abound: How much responsibility should Americans have for making their own investments? What is the role of the government in protecting Americans from losing their hard-earned cash from savvy fraudsters selling snake oil wrapped in a bow as a startup dream?
Writing the legislation for equity crowdfunding in the U.S. quickly became a memorandum on individual freedoms and government responsibility. As a result, the version of the JOBS Act that actually passed Congress contains stipulations that try to protect Americans against themselves.
Protection is reasonable and good. But prevention is not protection. And the first JOBS Act is written with regulations that criss-cross each other, both tying up entrepreneurs and handcuffing crowdfunding portals. It was virtually dead on arrival.
“If we let the JOBS Act be the way it was, it would be a horrendously un-functional piece of legislature that would have potentially gone live with overbearing regulations from the SEC, with even more wishes and restraints from FINRA, and it would have been a nonfunctional piece of rulemaking,” says Alon Hillel-Tuch, a co-founder of New York City-based crowdfunding platform RocketHub. Hillel-Tuch has been intimately involved in the birthing of the JOBS Act as far back as 2009, doing everything from briefing lawmakers and the Securities and Exchange Commission to actually writing the language of the second generation JOBS Act that is currently waiting in the wings.
Conceived of during the depths of the credit crisis in the U.S., the JOBS Act, or Jumpstart Our Business Startups Act, was aimed at making it easier for entrepreneurs to get access to capital to launch, run and grow their businesses. Title 3 aimed to open up equity crowdfunding to nonprofessional investors, or investors who aren’t accredited. Currently, entrepreneurs who want to raise money by selling pieces of their company to investors can only engage with accredited investors. Accredited investors, as defined by the Securities and Exchange Commission, are individuals who have earned more than $200,000 in each of the previous two years and are expected to earn the same in the current year, or individuals who have a net worth of more than $1 million, either alone or with a spouse, excluding the value of the their primary residence.
One fatal flaw in Title 3 is a requirement for a business to have a financial audit in order to equity-crowdfund from nonprofessional investors. From the outside, that sounds reasonable. However, consider that a financial audit costs between $35,000 and $50,000. As Hillel-Tuch explains, for a struggling coffee shop seeking to raise $700,000 through equity crowdfunding, laying out that much money on an audit beforehand would be unrealistic. “That’s fundamentally a problem. Fundamentally, that is a nonstarter,” he says.
An alternative to requiring a business to pay up front for a financial audit would be to hold the money raised in escrow and pay for a company’s financial audits out of the money earned before releasing the funds out of escrow to the business owner, says Hillel-Tuch. “While these are great consumer protections, consumer protection doesn’t matter when there is nothing to protect the consumer from.”
Another requirement of Title 3 is that equity-crowdfunding campaign owners have to submit to a background check before raising money. Again, while that sounds reasonable, it’s a fairly nebulous point to regulate. “What prohibits somebody from running a campaign? Let's say you are a cop and you have substance abuse on your record when you were in high school. Does that prohibit you from raising funds? Maybe? I don’t know,” says Hillel-Tuch.
Further, the JOBS Act dubs campaign owner omissions a responsibility of the platform hosting the crowdfunding campaign. That, says Hillel-Tuch, is “insane.” For a platform like RocketHub to have enough staff to check every factoid that a campaign owner submits, the cost of crowdfunding would become excessive to the point of making it fruitless for campaign owners.
Don’t hold your breath -- but don’t give up, either.
Realistically, it will take five to six years for equity crowdfunding to be implemented. That’s almost three times as long as lawmakers initially forecast. That said, key stakeholders haven’t given up. “I do believe that there will be a JOBS Act 2.0,” says D.J. Paul, the co-founder and board member of two crowdfunding industry organizations, the Crowdfunding Intermediary Regulatory Advocates and Crowdfunding Professional Association. That means both sides of Congress will need to agree on a single piece of legislation and send it to Obama’s desk -- again.
Republican congressman Patrick McHenry from North Carolina, along with members of the House Financial Services and Senate Banking Committees, are expected to introduce the new securities legislation in the upcoming weeks and months, according to Hillel-Tuch. McHenry hopes to see legislation make it to the House floor sometime this year, according to a spokesperson from his office.
And while Congress is historically unproductive and epically divided, Paul says that if there is anything that Democrats and Republicans can come to the table over, it is getting access to capital into the hands of entrepreneurs. “We have a divided government. There are very few issues where there is a chance of bipartisan support. This issue is one of them. I would be hard pressed to come up with another one,” says Paul, who was recently appointed by SEC Chair Mary Jo White in a formal advisory position to liaise between the industry and regulators.
In the meantime, individual states are bypassing Washington and passing laws to make it legal for entrepreneurs to raise capital from unaccredited investors on intrastate equity crowdfund raises. This past fall, Texas became the 13th state to adopt its own equity crowdfunding rules, which allow businesses in the state to raise up to $1 million a year through crowdfunding. Any Texas resident can now participate, but those who are unaccredited can invest no more than $5,000 per company. The provisions give businesses access to 20 million potential investors living in Texas who were previously closed off.
So far, businesses and investors in Texas have been treading carefully. Aside from it being a very early concept, nobody quite knows how state equity crowdfunding rules will mix with federal rules, if and when they are formalized. “There’s a great demand and desire among states and various government entities to help entrepreneurs, to help small businesses,” says Kiran Lingam, legal counsel at startup investment platform SeedInvest. “It is just very early in this space and it is hard to do anything with intrastate only.” SeedInvest, which works to link angel investors with entrepreneurs seeking capital, has yet to begin working with unaccredited investors in its Texas branch.
Another reason that investors haven’t fully embraced intrastate equity crowdfunding is that it requires a lot more work. After all, having seven investors put $5,000 in a pot is harder to manage than having one investor drop a check for $35,000.“So you are going to have to get seven nonaccredited investors in to make up for one average accredited level” investor, says Marc Nathan, the managing director of SeedInvest in Texas.
Even as regulators, lawmakers, and industry watchers lose hair getting a version of the JOBS Act over the finish line, there are already countries where crowdfunding is working internationally with remarkable success. Paul, for example, points to Australia. “It looks like once we get it going, it will be a vibrant and fraud-free market,” he says. Let’s hope.