Equity crowdfunding bill would create path for smaller funders

By Chris Gautz ,

Chris Miller, Adrian’s downtown development authority and economic development coordinator.

Chris Miller, Adrian’s downtown development authority and economic development coordinator, will testify Wednesday before the House Commerce Committee for a bill allowing equity crowdfunding for smaller investors.

There are plenty of entrepreneurs with good ideas to fill any number of the vacant storefronts in downtown Adrian, but there’s always one big problem standing in the way.

“It’s the story you always hear: ‘We just can’t find the money to do it,’ ” said Chris Miller, the city’s downtown development authority and economic development coordinator.

Since the recession, traditional lenders have tightened their loan standards, and many startups and even some existing businesses looking for capital to expand cannot get the green light, he said.

One newer idea Miller thinks has great potential for not just the city, but the state, is equity crowdfunding. It is different than using a website like Kickstarter.com where people can invest in a business, but in order to get around federal regulations, the investment is considered a donation. In return, the investor receives gifts of some kind, rather than equity in the company.

Equity crowdfunding was included in the JOBS Act signed in 2012 by President Barack Obama, which brings together social media and venture capital. It opens up investment opportunities for those who previously were not allowed to receive a request to invest, because their annual income or net worth were not large enough to be considered an accredited investor.

The Securities and Exchange Commission defines an accredited investor as someone with a net worth of at least $1 million, or who has income of more than $200,000 in the previous two years. An unaccredited investor is someone who falls below those financial thresholds.

“It allows us to invest the way wealthy investors have always been able to do,” Miller said.

Anything that’s gone on so far in Michigan is not true crowdfunding; businesses are not allowed to put out requests to the public seeking investments. An example would be a small-business owner going on Facebook and asking customers to chip in on a new venture to possibly receive investment income in return, Miller said.

While eventually crowdfunding will be allowed nationwide, it might not be until next year or later before the SEC finishes writing and agreeing to the regulations to make it happen, Miller said.

So he has been working with a group of students at the Gerald R. Ford School of Public Policy at theUniversity of Michigan to study the concept and worked with the area’s state representative, Nancy Jenkins, R-Clayton, who has sponsored House Bill 4996. Jenkins and Miller will testify Wednesday before the House Commerce Committee in support of the bill.

The bill would do the following:

• Allow an unaccredited investor to invest up to $10,000 in a project.

*Allow a business to raise up to $1 million from unaccredited investors if the business has not completed a financial audit and supplied that to the investors. Miller said this would largely apply to startups, because they do not have a financial audit since they have not begun operations. A company that has a financial audit and shows it to investors can raise up to $2 million.

*Require that the business seeking the investment has to be opening in the state and that all unaccredited investors have to be from Michigan.

Concerns over fraud remain from skeptics, Jenkins said, but she feels they have built in a number of safeguards.

The bill requires the invested funds be placed in an escrow account that cannot be accessed by the business until the minimum amount specified in the business plan is reached. If that amount is not reached in the time frame the investors all agreed to, they can cancel their commitments.

The business also has to have a business plan and a financial plan for the investor to see, and the investors have to sign a document stating they understand they are investing in a high-risk, speculative business venture, and it could result in the loss of their entire investment.

One difference in the Michigan legislation is the $10,000 cap. In the JOBS Act, it is capped at the greater of $2,000 or 5 percent of the investor’s net worth or annual income.

Other comparable details are not known, such as whether the feds will include the need for a business plan or financial plan, because those are things the SEC regulations would create.

Miller said he has heard there is some concern about the bill from the venture capital community, but that crowdfunding is not trying to supplant what traditional lenders do and could help with the capital stack needed for deals.

High risk

Area venture capitalists say they support the bill in theory and don’t see it as competition, but they worry that because there is a high failure rate for all new businesses, there will also be a high rate of loss for investors for whom $10,000 is a lot of money.

“There certainly is a capital shortage, especially for the kinds of companies that are never going to receive venture capital, which tends to be limited to fast-growth companies with extremely high acquisition potential,” said Chris Rizik, fund manager and CEO of the Ann Arbor-based Renaissance Venture Capital Fund.

“That’s less than 2 percent of the companies out there trying to raise money. The other 98 percent of the companies are still valuable. How do you address the capital shortage? I like the idea of putting forth a straightforward, non-bureaucratic way for companies to raise money,” he said. “But I do worry about the non-accredited investor. There’s going to be a high risk of losing your money.”

“I’m always in favor of things that free up the flow of capital, especially to start companies,” said Charles Rothstein, senior managing director at Farmington Hills-based Beringea LLC. “But there’s a reason laws protecting investors exist, which is to create safeguards.

“It’s really difficult to take an idea from the drawing board to the finish line. I’m not sure many of the people who are going to be subject to pitches understand the risk,” he said. “The goal to free up capital? Good. But it’s worrisome, too. And it’s not just that people who are making pitches to you aren’t going to tell you the risk factors, they may not know the risk factors themselves.”

“It’s always a good thing, the freer flow of capital, but as I tell my students, if you want a risk-free deal, you’re not going to find it,” said Rajesh Kothari, managing partner of Southfield-based Cascade Partners LLC. He is an adjunct professor at the University of
Notre Dame and teaches one class each fall on the fundamentals of venture capital.

Risk comes in the form of a marketplace where many startups do fail, and in the form of fraud, he said.

“There’s an ability in crowdfunding for someone to commit real fraud because the process isn’t rigorous,” Kothari said. “People need to know what they are getting into. Even sophisticated investors can get taken. Look at Bernie Madoff. He took all that money from incredibly sophisticated investors.”

Starting small

But Miller said local bankers he has spoken with are excited about the idea, and the emphasis on small-business support is a selling point.

If an entrepreneur came to a bank needing a $100,000 loan to start a new business, it’s not likely to get it no matter how good the business plan, Miller said. But if that entrepreneur were to secure $50,000 through crowdfunding, banks or other investors are likely to be more interested because they would not be carrying all the risk.

“It’s going to make capital a lot more available. It could be a game changer,” Miller said. “It’s a real opportunity to inject a lot of opportunity in our entrepreneurial markets.”

Two states, Georgia and Kansas, have allowed crowdfunding through administrative rule changes, Jenkins said. Michigan would be the first to allow crowdfunding legislatively.

“This is a very exciting new tool,”said Elisabeth Gerber, a professor of public policy at UM whose students have been working with Miller since August to investigate the use of crowdfunding.

She said landing the big, new factory is not the way most small cities are looking to grow anymore.

“Small businesses are really the job creators, especially in cities,” Gerber said. “Getting a couple of new startups, each of which employ a dozen people … that’s really the key to building the economies of cities that are really struggling right now.”

Chris Gautz: (517) 403-4403, cgautz@crain.com. Twitter: @chrisgautz 
Tom Henderson contributed to this story.

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