I don’t mean to beat a dead horse with all the articles about crowdfunding, but the JOBS Act with its CROWDFUND Act provision is definitely this week’s hot legal topic with its signing into law by President Obama earlier this week. I promise this will be the last article on this topic for a while (I hope).
Although the entrepreneurial community is enthusiastic about the prospect of crowdfunding, that enthusiasm might need to be tempered once one looks at the actual provisions of the CROWDFUND Act. I had a good friend, an entrepreneur himself, who read my last post breaking down the CROWDFUND Act to a room of other entrepreneurs — according to my friend, reactions ranged from disappointed to outright livid at what they perceived to be excessive regulations placed by Congress. Those regulations will only multiply in number as the SEC promulgates additional rules over the next few months. However, I believe that crowdfunding faces two other hurdles to success.
The first hurdle is NASAA — no, not the space agency with an extra A, but the North American Securities Administrators Association, the association of state and provincial securities administrators from across Mexico, the US, and Canada. In the US, NASAA acts as the voice of all 50 state securities regulators. NASAA recently released a statement decrying the CROWDFUND Act as weakening investor protections by fully preempting state securities laws and leaving enforcement solely in the hands of the SEC. The full extent of the interactions between the CROWDFUND Act and state securities laws are still being mapped out, and will depend to a large extent on the additional regulations issued by the SEC, but it appears that the CROWDFUND Act does preempt state registration of securities — states still have enforcement powers against fraud and other violations of the securities laws. However, practically speaking it is the preemption of state registration that has caught of the ire of NASAA; in particular, state regulators are miffed at missing out on the filing and registration fees from crowdfunding businesses. You can almost bet that as the full extent of crowdfunding rules and regulations are enacted over the next couple of months, NASAA will try to get themselves a piece of the pie. Of course, this would increase the cost of crowdfunding, which defeats the whole point of the exercise as a reduced cost and red-tape way for small businesses to engage in capital formation through the sale of equity. If the pendulum swings too far in the direction of NASAA, it may have a chilling effect on crowdfunding if it becomes too expensive and/or difficult for small businesses and startups to engage in.
The second hurdle for crowdfunding is the potential for public disillusion. What I mean by that is this: in addition to making the sale of equity easier for startups and small businesses, it also allows the average person the opportunity to passively invest in startups and small businesses. However, the average person’s experience with investing is in the regular stock market, where shares can be sold at any time to take a gain or limit a loss, and where even if a person takes a loss, he or she rarely loses everything. In contrast, the CROWDFUND Act places restrictions on transfers of crowdfund-purchased shares, and it is unclear at this point whether actual exchanges will or can arise to facilitate trading of startup shares (highly unlikely for all but the biggest and most prominent startups). Furthermore, unfortunately most startups fail, and when they fail they often leave little for the equity holders to recoup. Even if a startup takes off, it can be years before the investors in a particular stage are able to exit and realize a return. The reality of investing in a startup or small business is foreign to the majority of the investing public, and may be a turnoff to many when they realize they may not see a return, or even get to touch, their investment for several years, and it may likely be gone before that. If the public in general becomes disillusioned with crowdfunding and the pool of investors dries up, startups are right back where they started having difficulties accessing capital from all but angels and VCs.
The entrepreneurial community may need to undertake an educational campaign to prepare potential investors for investing in startups and small businesses, particularly the illiquid nature of startup equity and the risk for total loss of investment, but presented incorrectly the truth can also be a turn off before people even try their hand at crowdfunding — it is a fine line to walk between encouraging people for the best but preparing them for the worst.
I don’t mean to sound like a killjoy when it comes to crowdfunding; I am in fact (cautiously) very optimistic about crowdfunding. These two hurdles I’ve discussed may never come into play — I hope they never do — but they are obstacles that crowdfunding proponents should be aware of and ready to address.