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Summary:

Is new legislation that is aimed at allowing startups to raise money from individuals really going to help the economy — or is it just going to increase the number of stock scams and help fuel a dangerous kind of bubble mentality around investing?

It sounds like a great idea: change the federal legislation that governs investing in startups and small companies so that they can raise money from just about anyone, instead of being restricted to a small cabal of investment firms, venture capitalists and angel investors. That idea gave rise to what is now known as the JOBS Act — a bill that is making its way through the Senate this week and could become law in a matter of days. But is the new legislation really going to help startups and the economy as a whole, or is it just going to increase the number of stock scams and help fuel a dangerous kind of bubble mentality around investing?

In a sense, the JOBS Act is an attempt to take the lessons learned from new startup-financing engines like Kickstarter — which has raised millions of dollars for everything from iPod-based watches to graphic novels and dozens of independently-produced movies — and apply them to the economy as a whole. Supporters such as AOL founder Steve Case (now the chairman of the Obama-created Startup America project) and a startup-financing matchmaker service called AngelList argue that if more startups and small businesses can raise funding at an earlier stage, greater numbers of them are likely to succeed.

Startups could raise more without going public

The Act, an amalgamation of similar bills that have been put forward in both the Senate (PDF link) and the House (which passed its version earlier this month), would make a number of changes to existing securites regulations in order to make it easier for startups — or “emerging growth” companies, as the bill calls them — to raise money from a broader group of people. For one thing, it would increase the number of shareholders a company can have before it has to file public financial documents, from 500 to 1,000 (a rule that has helped push companies such as Google and Facebook to go public). The bill would also:

  • Allow small businesses to sell up to $10,000 in stock to “non-accredited investors,” provided it doesn’t amount to more than 10 percent of their annual income.
  • Allow small or emerging growth companies to publicly advertise for investors for the first time.
  • Phase in financial reporting and regulatory compliance rules over five years for small companies that have gone public

As CNET’s Rafe Needleman points out, these changes will allow some of the incubators and other startup-funding platforms that already exist — including AngelList and the funding competitions at conferences like Launch — to breathe a little easier, since many of them are skirting the rules by publicizing attempts to raise funding by private companies or connecting them with funders. And it would allow platforms like Kickstarter and IndieGoGo (both of which the Obama administration has mentioned in its support of the legislation) to expand their range of offerings to include actual companies, and to share financial information with potential investors.

So what are the critics of the bill concerned about? One fear is mostly philosophical, in the sense that some believe reducing the barriers to investing in startups will encourage a gambling mentality, and that this could help to inflate a bubble that some are already worried may be occurring in technology stocks. The reason investing in private companies is currently restricted to “accredited” or “sophisticated” investors, they argue, is that these individuals are typically more restrained — and they also have a high net-worth and can afford to lose their investments.

Would the bill open the barn door too wide?

The other criticism, which has been raised by some Democrats despite the President’s stated intention to support the bill, is that the legislation would exempt many of the small companies covered by the law — defined as anyone with less than $1 billion in revenue — from the strict financial-reporting requirements that were introduced with the Sarbanes-Oxley Act in 2002. Even some technology industry and startup supporters (including my colleague Om) have said this goes too far, and would leave the barn door open for too many potential scam artists and hucksters. Senator Richard Durbin (D-Ill.) has said of the bill:

This half-boiled concoction of ill-conceived ideas skirts, evades, and nullifies investor protection in market transparency standards that were enacted in response to the dot-com crash, the Enron debacle, and the litany of bubbles and bursts that have cost legions of unsuspecting Americans their savings, their jobs, and their retirement.

The bill’s supporters argue that this same definition applies to virtually any public market for investing, including the stock market — since even with the regulatory restrictions and reporting requirements that are in place, stock scams and flameouts of public companies do occur. And since the investment limit for individuals is restricted to no more than $10,000 or 10 percent of someone’s net worth, the risk of anyone losing their life savings or going bankrupt because they funded a startup is relatively small.

The biggest problem with the Act seems to be the exemption of newly-public companies from the Sarbanes-Oxley reporting rules. Even many of those who support the idea of making it easier for startups to raise financing from individual investors don’t seem to like the idea of removing those reporting restrictions. Whether the beneficial parts of the bill can be separated from the riskier aspects remains to be seen, as it makes its way through the Senate and ultimately to the President’s desk.

Post and thumbnail images courtesy of Flickr users Mark Strozierand Cliff

  1. I think the crowdfunding bill, if passed as is in the Senate will be good for jobs in the long haul. Businesses need easier access to capital and the jobs bill that passed the House earlier this month is the way to go. I wish America wasn’t so scared of change while countries like the UK pass us by because they pass these types of laws more easily and are first movers on most of the real issues affecting society at large.

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  2. To your Twitter question of whether I support the JOBS Act, the answer is Yes. While I have some concerns about making sure investors have enough information to make smart decisions about private companies, I believe the American economy is undergoing a structural change via technology and globalization. To me the greater danger is to look at our necessary future through incrementalism. I think if you were designing from scratch you would of course allow the notion that private companies could have a broader investment pool then they do today without having to “go public” in the traditional sense. To that extent, i rather open the barn doors in a “best-intent” fashion and then evolve, rather than move in small steps.

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    1. Thanks, Hunter — I tend to agree that we should open things up to generate those kinds of benefits, instead of trying to anticipate every potential roadblock. Thanks for the comment — and for your post on the arrival of the “Kickstarter economy” http://www.hunterwalk.com/2012/03/crowdfunding-becomes-crowdbuying-why.html

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  3. First thing about Sarbanes Oxley, is it was put in place for Enron, not for the dot coms. Take a look at Enron–it was huge before it started misbehaving. Far larger by several orders of magnitude than the companies the JOBS Act contemplates helping.

    Second thing to comtemplate about SOX is it is the financial reporting equivalent of airport security–taking off our shoes and walking through full body scanners does little to make us safer. It’s pablum to convince the masses someone is doing something.

    Certainly SOX did absolutely nothing to prevent the Wall Street-fed housing bubble from coming along and doing more to destroy the savings of Middle America than anything the stock market ever remotely considered.

    Tell these congressional windbags to get out of the way of progress. They’ve done little to stimulate the economy and much to feather their own nests.

    Sincerely,

    BW

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    1. Thanks, Bob — that’s a good point about Sarbanes, and a good comparison with airport security rules :-)

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  4. Reblogged this on Sasa Marinic.

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  5. If you follow Charles Morris’ (The Trillion Dollar Meltdown) portend that the mortgage-backed securities market needed more regulation, then I’m sure it applies here. I would be interested to here his take on this new financial market and how it might evolve. I don’t believe there’s any language in the bill that prevents these holding companies from bundling assets, just as investors did with CDOs. And, how will these companies and markets be rated, and by whom?

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  6. Creating so many scams with this. I’m pumped – kony2016.com here we come.

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  7. I love the comment about the bubble and gambling. That doesn’t exist right now? It always seem when opportunity comes to the masses those who cede control suddenly look out for our best interests. Main Street will be the new Wall Street again. Finally! I’ve got several endeavors waiting for this to pass. Enough with the bankers, analysts and geniuses sitting around a conference room at their VC looking at decks they have no interest in investing because they money involved doesn’t even cover their overhead. Access trumps capital.

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  8. Wow, Awesome perfect sutff
    [img]http://i1069.photobucket.com/albums/u476/marry38382/xray.jpg[/img]

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