On Thursday, President Obama signed into law the Jumpstart Our Business Startups Act (JOBS Act). This Act, comprised of several bipartisan-supported bills designed to ease capital-raising for small businesses, will undoubtedly be a major game-changer for capital raising and the business of investing in startups. What follows is an analysis of the most important sections and what these changes will mean for startups.
“Crowd funding” typically connotes a way of financing a project or business, usually through online means of bringing investors and capital-raisers together. Congress in its ever-clever acronymous legislative action gave Title III a short title of “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012” — or the CROWDFUND Act.
The CROWDFUND Act allows companies to raise startup capital from a large number of investors each investing just a small amount. Investors are limited in the amounts they can invest: if the investor’s annual earnings or net worth is less than $100,000,they can invest the greater of $2,000 or 5% of their annual income; if their net worth and annual earnings is greater than $100,000, they can invest 10% of annual income or net worth, not to exceed $100,000.
On the issuer’s side, the aggregate amount of stock sold to all investors cannot exceed $1 million per year. The Act also imposes other disclosure requirements on the issuer such as providing investors with certain company information and a stated purpose describing the uses for which the capital raised will be used. Most notably, the Act requires the issuer to sell its stock through an intermediary “broker or funding portal,” who must register with the SEC.
The usefulness of this is still unclear and we’ll have to wait until the final regulations are released (due in 270 days) to really know. There is cause for doubt, though, in the act itself. First, the Act requires a great deal of information to be provided about the company, its issuers, the founders, and the securities being offered. In most cases, to get this right is going to require a lot of time by lawyers and accountants (who, by the way, still bill by the hour). Second, the bill provides a pretty broad cause of action against the issuer, AND its officers and directors, for material misstatements or omissions. Given that most startups fail, the real winners here may be plaintiffs attorneys, who will undoubtedly be reviewing with a fine-tooth comb the offering materials of every failed crowd-funded startup looking for some technical misstatement.
General Solicitations in Regulation D Offerings
Regulation D of The Securities Act of 1933 allows companies to avoid costly SEC registration for certain securities offerings. Before the JOBS Act, companies could only offer Reg D securities to persons with whom they had a pre-existing relationship, what is termed a “private offering”. Now, the Act expands this exemption to allow for general solicitations, whereby companies and their brokers can advertise the offering to the general public, although importantly, only accredited investors can purchase.
Every entrepreneur who has ever tried to raise capital (according to the rules) has experienced the frustration stemming from the inability to tell people about the opportunity. This will indeed make it easier for startups to get the word out. Critics though, worry that this allows brokers too much freedom to aggressively advertise stocks to unsuspecting investors — for example, the elderly. I also worry about the noise investment scheme advertisements will generate and the likelihood that it may actually drown out the voices of entrepreneurs seeking capital.
“IPO On Ramp” and “Emerging Growth Companies”
In what has been dubbed the “IPO on Ramp,” the Act designates a new category of “emerging growth” companies and outlines a streamlined IPO process for those companies. The classification for an “emerging growth company” is simple: businesses earning under $1 billion in gross revenue fall within this category’s scope. This classification allows companies to publicly issue stock while exempting them from burdensome disclosure and governance requirements to which larger public companies are subject. It also exempts these companies from Dodd-Frank rules giving shareholders a non-binding vote on executive compensation. The real winners here are VC’s and angel investors as this will create an opportunity for earlier liquidity events. In theory, this should “trickle down” in the form of more active angels and VC’s and perhaps better valuations for the startups.
Private Company Flexibility and Growth
Title V of the Act raises the threshold level on the number of shareholders before a company must go public from 500 to 2,000, thus encouraging a company’s marginal growth without it facing the prospect of filing costly disclosure documents. The need for this stems largely from startups using equity compensation for their employees. Think Facebook.
Regulation A Offerings
Companies who raise under $5 million through an IPO could file under Regulation A to avoid filing periodic reports to shareholders, which conventional publicly-held companies must do. The JOBS Act raises the $5 million ceiling to $50 million, thus easing one burden in issuing an IPO. Regulation A was originally designed as a simplified way to go public in a small way. It has been used rarely in the last decade, however, as the $5 million limit was seen as too low given the costs of compliance with the still someone onerous rules, both before and after the offering. There hasn’t been much attention to this, but we suspect this could generate a new cottage industry of service providers promoting direct private offerings (DPO’s) as again a viable option to raising capital from the public without going through an investment banker.
Should the startup community be happy that legislation permitting crowd funding has finally passed? The bottom line is that it is too soon to tell what kinds of regulations the SEC or state regulators will impose and how the markets will react to these new freedoms. But it is certainly is going to be an exciting couple years watching this play out.