The Fuzzy Front End of Small and Medium Enterprise Funding: Linking B to B Lending To Reg A Equity Crowdfunding

By Thomas E. Vass, CrowdFundBeat Sr. Guest Editor and President, The Private Capital Market, Inc.

“There appears to be a decided shift in focus by the SEC Chair and the Commission to addressing the needs of

SME’s,” noted Samuel Guzik, in his March 11, 2015 article in CrowdFund Insider. “Not only has the SEC’s

SME Advisory Committee come out of hibernation after 15 months of inactivity, but there are strong indicators

 

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that these issues are becoming a priority.”

One possible explanation for the recent interest in SME’s by the SEC may have to do with the growing recognition that small businesses are not getting the funding they need to grow, and that without business growth, the U. S. economy is simply spinning its wheels.

Guzik offers his opinion that the recent rules on Reg A, linked to new rules by the SEC on private equity exchanges, may be one possible solution being considered by the SEC for getting more capital to the economy’s SME growth engine.

Another idea for the SEC to consider is to take a page from the world of product innovation called the “Fuzzy Front End.”

Fuzzy What?

In the world of product innovation, the fuzzy front end is the confusing time at the front end, when product design and commercialization professionals are trying to figure out how the new product will serve the market.

Translated to capital markets, equity crowdfunding and Reg A are in currently in the fuzzy front end.

Product designers finally find their way out of the fuzzy front end by doing something the product designers call “listening to the market.”

Mary Jo White, the Chairwoman of the SEC is currently listening to the market, when she suggests her interest in tying private equity exchanges to the new rules on Reg A. Private equity exchanges will be a great benefit, but they still do not get at the problem that SME’s are having in raising capital.

If she listens even harder, she may hear the tree toads chirping about the upfront costs of raising capital in the front end.

The New Costs of Equity Crowdfunding

In the old business model of funding, a small business generally did not have out of pocket cash expenses to obtain capital. In either the case of a bank loan, or in the case of venture capital, the business owner escaped forking over cash to obtain capital.

In the newer model of capital, the business owner has two big expenses that were not there in the older model.

First, the business owner has about $12,000 in upfront legal costs to prepare the offering documents of a Reg D crowdfunding raise, and about $18,000 in a Tier One Reg A raise.

And, unlike the old Reg D Rule 506(b), the business owner has about $15,000 in marketing and promotional costs to attract investors to the crowdfunding deal.

If Chairwoman White listens hard, she will hear the sounds of another unexpected cost borne by small business owners that is caused by onerous and un-needed government regulations imposed by FINRA on broker dealers who distribute private securities.

The Added Costs of Capital of Worthless Government Regulation

In addition to funding the direct legal costs of preparing the offering documents, the business owner who chooses to employ a FINRA broker dealer to distribute the private securities is hit with about $10,000 in costs related to the broker dealer’s compliance with FINRA rules on private securities.

For no logical reason, FINRA in requiring broker dealers to inspect a private company’s offering with the same level of due diligence as a public offering.

In other words, under most crowdfunding projects, there is a lesser level of broker dealer due diligence called objective due diligence. Objective due diligence is a document and historical check of the company’s history, and this investigation can easily be outsourced to third party investigators, like CrowdCheck.

The estimated cost of objective due diligence for third party due diligence is about $1500.

Objective due diligence serves the public purpose in crowdfunding by protecting the public from charlatans.

However, FINRA is now requiring broker dealers to conduct “subjective” due diligence on private offerings, which can not be outsourced to independent third parties. In subjective due diligence, the broker dealer engages its own legal team to assess the moral integrity of the offering.

Just like a private offering was a public offering.

The broker dealer absorbs about $10,000 to conduct subjective due diligence, which is immediately passed on the private company in unnecessary upfront costs.

In other words, the total legal fees for a company go up from around $12,000 to about $25,000 to do a crowdfunding project, using a FINRA broker dealer.

Can You Hear Me Now?

Two of the most fascinating developments in crowdfunding are the big interest in real estate deals, and the wild-fire enthusiasm for peer-to-peer business loans for existing established, operational companies, aka SMEs.

Both developments are related to both SMEs and investors trying to avoid the increased costs imposed by worthless government regulations.

The solution to getting SME’s more capital is not related to worthless government regulations.

The solution is to examine what the private markets are doing with regard to real estate deals and crowdfunding lending. The markets are talking but the SEC is not listening.

What the markets are saying, in their garbled and confusing fuzzy front end, is that small companies need about $35,000 to finance a crowdfunding capital raise. SME’s do not have $35,000 laying around in their fuzzy front end bank account.

Private equity exchanges are not going to solve that problem.

A fast and efficient crowdlending deal for about $50,000 will solve that problem because it would allow a company to seek up to $20 million in equity crowdfunding under Reg A Tier One..

The SEC Reexamination of Peer to Peer Lending Rules and FINRA Rules on Broker Dealers

Several peer-to-peer crowdfunding platforms offer a variety of hard money loans and hybrid factoring that would solve this small capital gap of $35,000.

The idea for the SEC staff is to analyze how a private sector solution that already exists can be implemented by relaxing the 2008 rules on peer to peer lending, as they may apply to SMEs, and calling off the FINRA dogs.

Linking crowdlending to equity crowdfunding would get the capital juices flowing again.

Increased SEC oversight of FINRA would open the distribution chain for raising capital, with no detriment to the public purpose, or the Congressional intent on the 2012 JOBS Act.

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