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To Encourage Crowdfunding, Change the Definition of an Investment Company Equity crowdfunding is hampered by regulations designed to curb stock-market abuse.

By Scott Shane Edited by Dan Bova

Opinions expressed by Entrepreneur contributors are their own.

Andrew Pons | StockSnap.io

Since June, non-accredited investors have been allowed to make equity investments through crowdfunding portals under Title IV of the Jump Start Our Startups (JOBS) Act. But several Securities and Exchange Commission rules are holding back that activity. Among them is the definition of an investment company under the Investment Act of 1940, which has ensnared startups trying to use special purpose vehicles (SPVs) in crowdfunding efforts as a way to keep their capitalization tables clean.

To encourage equity crowdfunding, the SEC should explain that it does not view SPVs used in crowdfunding efforts to be investment companies. This clarification will make it easier for new businesses financed by equity crowdfunding to subsequently raise money from angel groups and venture-capital firms.

Some entrepreneurs would like to raise initial capital from the crowd and later seek financing from business angels and venture capitalists, much the way that other entrepreneurs tap friends and family before seeking money from angels and VCs. Unfortunately, this crowdfunding-first approach risks creating a messy capitalization table that may scare off later investors who fear the cost and difficulty of managing a company with numerous investors. To avoid this problem, some entrepreneurs raising money from the crowd would like to use SPVs. Rather than investing directly in the startup, the crowd would buy shares in a limited liability company that, in turn, would buy shares in the startup. Because the startup would only have one investor in the crowdfunding round – the SPV – its capitalization table would look clean to later-round investors.

This is a good solution to the problem unless the company has 100 or more crowdfunding investors. If they do, then the SPV becomes an investment company under the Investment Company Act of 1940 and has to be registered as such with the SEC. That's a real problem for startups that need to raise a sizeable chunk of money in their crowdfunding round or if the investors in that round are only willing or able to make small investments. Registering an investment company with the SEC is neither simple nor cheap.

Related: Why Kickstarter and Indiegogo Won't Go Into Equity Crowdfunding

When it passed the JOBS Act, Congress's goal was to get more capital flowing to startup companies. But, as is the case with many of our legislators' efforts, those in Washington didn't pay enough attention to the details. Specifically, they didn't anticipate that high-potential startups seeking to raise money first through equity crowdfunding and then from venture capitalists or angel groups would get snagged by this regulation.

The SEC can remedy the problem by clarifying that the SPVs entrepreneurs are using to raise money aren't "investment companies" the way that the authors of the 1940 law thought of them. The Investment Act of 1940 wasn't intended to regulate investment vehicles that hold only a single security and make no investment decisions, or to regulate venture-capital funds, angel groups or equity crowdfunding. Back in 1940, venture-capital funds, angel groups and equity crowdfunding hadn't been envisioned.

The purpose of the 1940 statute was to prevent sellers of shares in public companies from engaging in ownership structures that led to problems and abuses in the stock market crash of 1929. The SPVs used by entrepreneurs to raise money through crowdfunding have nothing to do with those problems or abuses.

The SEC should exempt these SPVs from the definition of an investment company under the Investment Act of 1940. Doing so will make it easier for startups raising seed money through crowdfunding to tap angel groups and venture capitalists in subsequent financing rounds – a goal which Congress sought to achieve in passing the JOBS Act.

Related: Is Student Debt the Reason Millennials Aren't Starting Companies?

Scott Shane

Professor at Case Western Reserve University

Scott Shane is the A. Malachi Mixon III professor of entrepreneurial studies at Case Western Reserve University. His books include Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live by (Yale University Press, 2008) and Finding Fertile Ground: Identifying Extraordinary Opportunities for New Businesses (Pearson Prentice Hall, 2005).

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