Crowdfunding has gained a lot of press over the last few months with the passing of the crowdfunding bills in the House in November and then again a few weeks ago. The bills have generated numerous opinions about how this will spur economic growth by unlocking capital from investors who have never had the opportunity to invest in startups and making it easier for startups to raise capital.
While I generally agree with the benefits of crowdfunding, very few opinion pieces have discussed the risks associated with passing the bill. As the only broker/dealer in the US that is currently allowing investors access to startups through a crowdfunding model, I would like to break down the bill and talk about the risks that crowdfunding brings.
The Entrepreneur Access to Capital Act is the new law that will give startups the ability to raise capital from many investors, both accredited and non-accredited, who can invest smaller amounts than they normally would through traditional venture capital models. The law removes the need to register the offering in each state, which can be very complicated and expensive for the startup. It also will exempt the crowdfunding investors from the company official shareholder count which is critical because after you hit 500 shareholders the company must start reporting your financials to the SEC, which is an expense most startups can’t afford.
Here are some of the issues I see with the law as written.
1. In the House bill, the total amount that you can invest in a crowdfunded investment is either $10,000 or 10 percent of your income, whichever is less. I think it is a good idea to put caps on investments, but whose responsibility is it going to be to monitor the total amount invested in one year? There are hundreds of crowdfunding websites that are ready to open their doors when this law passes and investors are going to be members in several of them. Who is going to be adding up the investments they’ll be making on multiple sites to make sure they don’t go over the limit? Congress added this in to protect the amount of money that an investor puts into these high risk investments and it is a good idea but unless there is some sort of regulated system where these investments are collected the oversight is not going to happen.
2. Who can be an intermediary? Under current regulations, a broker/dealer would have to be an intermediary in these types of transactions. Microventures has been doing this as a broker/dealer for over a year. With the new regulation you would no longer need to become a securities broker dealer to broker these types of deals. It means that really anyone can broker these transactions as long as they follow the guidelines some of which include creating risk disclosures, giving the commission access to the website and outsourcing the capital management. I am for opening up the ability for others to broker these deals but there needs to be some additional guidelines that the intermediary must meet. As a broker/dealer I must submit my financials every month to FINRA, have an annual independent financial audit, and get audited by FINRA periodically. For the industry to be safe for investors there must be some form of checks and balances. Otherwise fraud will become rampant and crowdfunding will be repealed, leaving startups and investors right back where they all started.
3. Who decides whether an investor can make a qualified decision to fund a startup? I don’t think the answer is how much money you have in the bank, as it is currently defined, but should instead include someone qualified to review the investor’s profile to determine if they are suitable. I’ll walk you through what an investor on Microventures goes through, so you can get an idea of how we determine if an investor is suitable:
- The investor first fills out a suitability form which asks education, investment background, financial, and other questions to help us determine if investing in startups is something we are comfortable allowing the investor to do.
- Once completed we review each questionnaire and then call the investor and have a conversation about the risks before we give them access to our website. During that call we make sure that the investor knows the risks, which means there is a high probability that they might lose their money, and if they can review the deal to make sure it is right for their portfolio.
We are qualified to determine if someone is suitable for an investment because we have gone through the year-long process of becoming a broker/dealer, worked in the industry for several years and have taken several exams like the Series 7, 63, 79 and more. Congress wants to remove this step and let anyone make the determination if an investor is suitable. You don’t have to be in the industry to see the issue here. With no one regulating who is approved on your site and the financial incentives that you get for bringing in more investors people who are not qualified are going to invest, make bad decisions and lose a lot of money.
4. One item I completely agree on is outsourcing the cash management. That is something that a broker/dealer is required to do and it works great because it protects the investor’s money while the funding is being completed. If the deal doesn’t go through for any reason you are able to have the escrow company return the funds to the investors.
The one issue I have with this is that escrow is expensive. It can cost $5,000 to escrow a deal, which is not typically an issue for a $5 million deal. But a lot of the companies that are going to raise money through crowdfunding will be raising a much smaller amount, say $20,000 to $50,000, and the expense of setting up an escrow fund for each raise or idea will certainly take a big bite out of the money they’re needing to make their business successful.
For escrow, the more raises you do the less expensive the escrow fees get, but I have not figured out a way to get them below $3,000 per deal. The bill could probably address what type of escrow you use, for instance removing the requirement that a bank hold the funds, which might make it less expensive.
5. One of the interesting restrictions I found in the law is that after an investor makes the investment, they must hold the securities for at least one year without selling, unless you sell to an accredited investor. The holding period is not something new, but I think it is strange to allow a non-accredited investor the ability to invest any potential risky investment, yet restrict them from the ability to sell to other non-accredited investors within the first year.
I hope you don’t think that after reading this I am against the crowdfunding regulations. I am actually for them, because I think crowdfunding is the future of early-stage capital raising. It is why I started my business over two years ago. My current business, Microventures, has even more to gain if these regulations pass. The red tape is immediately cut from raising capital, I can advertise my deals on my website to get more investors interested and I can raise money faster for the startups using my platform. My concern is the lack of oversight being promoted in the bill, and that if the government just opens this up like the wild west, the fraudsters will take over and we will all lose in the end.
Bill Clark is the CEO of MicroVentures, which is a securities broker dealer that helps startups raise capital by allowing investors to invest small amounts of capital similar to crowdfunding. You can follow him on Twitter @austinbillc.
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