By Scott Shane
Nearly two years ago, I championed the idea of making it legal for entrepreneurs to raise money by selling equity stakes in their companies online. This kind of crowdfunding came much closer to becoming a reality when President Obama signed the Jumpstart Our Business Startups (JOBS) Act into law in April. It was one of the few bipartisan efforts to support small business that emerged from Washington in recent years.
The businesses that stand to gain the most from the crowdfunding provision in the law are those seeking small sums—less than $100,000. The goal is for the undercapitalized owners of the local car repair shop or restaurant to be able to inexpensively raise money from individuals without getting engulfed in red tape.
These kinds of investments don’t interest angel groups and venture capital firms. In fact, less than 1 percent of all the small companies in the U.S. get venture capital or angel group funding annually. Moreover, the legal costs of private placements under the Securities and Exchange Commission’s existing rules (which date back decades) are too high to be worthwhile for small raises.
The SEC, which was required to write the regulations for the crowdfunding portion of the law by yearend, is still hammering them out. Its staffers have a noble goal—to ensure ordinary investors are protected from scammers. But too much investor protection will make crowdfunding unworkable because the businesses won’t be able to afford to comply. Overdo it, and this new source of financing gets crushed under the weight of its own rules.
Why am I worried this could happen? Remember, the SEC came out strongly against the crowdfunding clause in the JOBS Act, even after it was clear that our elected officials were going to make the tool possible. And the agency has become very conservative after its embarrassing failure to catch fraudsters like Bernie Madoff.
On the other hand, the SEC has never been known for putting new rules in place swiftly. Short one commissioner, and split two Republicans to two Democrats, the commission has to focus on consensus issues to avoid deadlock.
The bottom line is the SEC shouldn’t overthink fraud risk. The amount investors can lose through crowdfunding is small—people whose income or net worth is less than $100,000 may invest the greater of $2,000 or 5 percent of their income or net worth annually, while richer people can invest as much as $100,000. This is far less than the amount most Americans will lose the next time a housing bubble pops and their homes decline in value, or the stock market crashes, taking with it much of their 401(k)s.
Besides, anyone can already lend money to small businesses through peer-to-peer lending sites such as Prosper and the Lending Club. Buying $5,000 in equity doesn’t expose an investor to much more risk of fraud or default than lending $5,000 to the same business.
Whether the SEC is trying to kill equity crowdfunding or just acting slowly, the situation is problematic. If the agency is trying to write regulations that technically permit crowdfunding but make it practically impossible, then it’s defying Congress and President Obama, whose intent was to provide a new mechanism for entrepreneurs to raise small amounts of equity. Federal regulators should not be allowed to write regulations that are inconsistent with the intent of our elected officials.
But just being slow is also a problem. Entrepreneurs and investors need to know the rules before they can act. Washington needs to remember that uncertainty hampers hiring and investment, as I’ve explained here before.
By Scott Shane | Businessweek