Crowdfunding comes up short: Why the final part of the JOBS Act will never work

Crowdfunding is great in theory, but messy in reality. Just ask the SEC, which is bogged down in approving the final phase of the Jumpstart Our Business Startups Act, a 2011 law meant to goose the economy by loosening rules for investing and fundraising.

While other parts of the JOBS Act have been in place for nearly a year, the final — and most-hyped — part of the law, known as Title III, is way overdue. Title III is the part of the JOBS Act that will let startups use Kickstarter-style campaigns to offer investors not just gifts, but actual shares in the company.

So why is the SEC, which recently completed a comment period on Title III, taking its time? According to lawyers and investors familiar with the rule-making process, the agency is trying to achieve a balancing act in which a balance may not be possible in the first place.

The problem, in short, is that the SEC is being asked to create a crowdfunding regime that does three things at once: 1) provides an easy, low-cost way for startups to raise money online; 2) protects investors from new forms of fraud; and 3) creates incentives for financial firms to run crowdfunding websites.

The SEC may be able to write rules to achieve two of these three things; achieving all three is a long shot. The result will be a crowdfunding system that falls short of what blue sky boosters imagined — but is still revolutionary.

“You won’t want to do that”

18 Rabbits is a San Francisco company that makes organic granola bars. These types of consumer retail companies can find it hard to attract institutional capital, so 18 Rabbits turned to CircleUp, a crowdfunding site for accredited investors. There, the company raised $500,000 to expand its production of “bunny bars.” 18 Rabbits’ story seems a testament to the power of crowdfunding — but there’s a big caveat: The company’s fundraising didn’t come from the crowd, exactly. Instead, it took place thanks to an existing section of the JOBS Act that permits sites like CircleUp (there are numerous others) to advertise crowdfunding opportunities to a special class of investors who can verify that they are worth at least$1 million.

Title III of the Jobs Act, by contrast, would let 18 Rabbits sell shares to anybody on the internet. Therein lies the problem: While the prospect of an unlimited pool of internet investors sounds appealing in theory, CircleUp co-founder Rory Eakin argues that, in reality, companies like 18 Rabbits aren’t going to tap this type of crowdfunding in the first place. That’s because, under the SEC’s proposed rules for Title III, companies must disclose a raft of tax, financial and employee information that most startups would prefer to keep under wraps. The disclosure process could compromise a company’s business strategy, and it isn’t cheap either: it requires lawyers, accountants and, if the company seeks more than \$500,000, a full-blown audit.

“In an effort to prevent fraud, the SEC wants open information,” Eakin says. “But if you’re a company and you have to disclose your trade secrets and financials on the internet, you won’t want to do that.”

Eakin says small companies would prefer to follow in the footsteps of Ben & Jerry’s or the Boston Beer Company, which grew big with the help of a select group of passionate, knowledgeable investors and aren’t accountable to dozens or even hundreds of investors from all corners of the internet. For this reason, Eakin thinks the best part of the JOBS Act is already in place: “It’s as good as it’s going to get for the likes of 18 Rabbits.”

Muppet protection & the risk of “affinity fraud”

Companies in search of funding aren’t the only ones skeptical of Title III. In 2012, Goldman Sachs drew criticism for a report in which it referred to its own clients as “muppets.” The episode was a reminder that even sophisticated investors can be treated as rubes, and underscored why the SEC regulates securities in the first place.

Financial blogger Felix Salmon used the Goldman episode to warn about potential perils of the JOBS Act, noting at the time that it could unleash of a wave of “crowdmuppeting” and that there was “enormous scope for outright fraud.”

The SEC appears aware of such concerns. When the agency announced proposed rules to govern Title III last October, Commissioner Luis Aguilar stated that the “use of crowdfunding to reach potentially vulnerable segments of society is a particular concern.”

In particular, Aguilar called out the potential for “affinity fraud,” in which charlatans might use the JOBS Act to exploit religious or ethnic communities by selling them scammy investments. Such scams are hardly new, of course, but a crowdfunding website written in a community’s own language or geared towards a specific religious group could make such fraud easier than ever before.

Concerns like these led the Consumer Federation of America, in the recent comment period, to demand that the SEC impose more oversight of websites that aspire to be the Kickstarters of equity-crowdfunding. But while such oversight could reduce fraud, it could also dissuade legitimate Title III websites from launching in the first place.

“Challenge for…a viable market”

On sites like Kickstarter, it doesn’t matter if you’re rich or poor: Anyone can make a donation to support a project and receive a reward in return. With Title III crowdfunding, the stakes are higher: When people hand over money, it’s akin to investing in the stock market, and funders receive shares — not just a T-shirt, meal or early admission ticket (common rewards in Kickstarter campaigns).

This distinction between donations and investments is the reason that the SEC is writing rules for the would-be Title III websites in the first place. The idea is that this new breed of websites, unlike Kickstarter, must take steps to ensure that the startups raising money on the platform are legit, and that the people investing in them don’t pour in more than they can afford.

The SEC’s proposed rules for Title III websites are complicated, but they do provide one key break: unlike the “accredited investors” of Title II, the new class of Tom, Dick and Harry investors can “self-certify” — meaning that websites won’t have to ask people for tax returns or bank statements to prove how much they are worth. Instead, the websites can just ask investors to tick a box acknowledging that the JOBS Act limits Title III investors from spending more than five percent of their income on crowdfunded offerings.

This concession on self-certification may not, however, be enough to make operating a crowdfunding website worthwhile. The sites still face a number of other obligations related to educating investors and screening for “bad actors” among the the companies that use the sites. The sites are also barred from charging commissions — unless they become broker dealers, which are even more heavily regulated.

“The challenge is not so much for the SEC but for this to be a viable market in the first place,” says Noreen Weiss Adler, an attorney at Barton LLP who has written and spoken extensively about the JOBS Act.

According to Adler, the relatively small offerings that could take place on a Title III crowdfunding site are unlikely to generate enough fees to make it worthwhile to operate a public portal. This, in turn, could make the debate over fraud a moot point: why should the SEC impose additional obligations if the whole thing is unattractive from a business perspective in the first place?

What happens if Title III crowdfunding falls short?

The last part of the JOBS Act appears simply unworkable, but not everyone is pessimistic. People like Kiran Lingham, the general counsel at funding platform SeedInvest, are lobbying the SEC to tweak the proposed disclosure obligations for companies — making the process both cheaper and more attractive.

Meanwhile, New York startup hatchery Betaworks just launched “Alphaworks,” a new crowdfunding platform tailored for the arrival of JOBS Act Title III investors. The new entity promises Tom, Dick and Harry investors “equity gifts,” which sounds like an oxymoron, but the company claims to have the answers (its FAQ describes a “creative way to include everyone as a potential owner” but provides few details).

Relaxed SEC obligations and the success of new public investment platforms like Alphaworks could make the last part of the JOBS Act a success after all. For now, though, legitimate fraud concerns and the lack of a proven business model makes this seem unrealistic.

If the law does prove unworkable, that doesn’t mean that the dream of crowdfunding is lost. Instead, we may come to realize the crowdfunding revolution is here after all: the mainstream presence of donation sites like Kickstarter and the general solicitation rules means that the world of fundraising and investment is already transformed. Or to put it another way, as Om explained last year, the internet has changed everything  — including venture capital and money — and many of those changes are here already.

Feature image from Thinkstock/Argonavt