Sherwood Neiss, principal of Crowdfund Capital Advisors
Now that 2013 is here let’s recall the one thing Washington agreed on last year – the JOBS Act & Crowdinvesting. Crowdinvesting is a new way (based on an old tradition) to allow a large group of people to pool small amounts of money together to help fund an entrepreneur. In exchange, they will own a piece of the company. It is only possible now given advances in the Internet and technology. In particular, the social web allows us to bring together communities of like-minded people interested in funding an entrepreneur and it also gives them a medium to discuss the opportunity/risk with others which leads to transparency.
There’s much discussion over the pros and cons of crowdinvesting and the related risks and rewards. However, there isn’t enough attention as to “why” this was necessary. In this piece, we aim to set the stage so that if you thought there was no need, we can clear the air. It also helps understand fraud in a historical perspective and why with the Internet and Social Media as the foundations for Crowdinvesting, this will be one of the most transparent and efficient forms of investing ever to take place.
Crowdfunding Isn’t New
The practice of pooling resources to help individuals is an ancient one. As early as 3,000 BC, there existed a system of people with money and people who needed it. Terms were negotiated based on how well individuals knew each other (aka trust), and this immediate fiscal fidelity set the interest rate (aka risk of default). While trying to visualize how this practice operated in 3,000 BC, we rarely can envision what life was like back then, so let’s fast forward to recent history.
Investors have been putting money into startups and small businesses since the Industrial Revolution. In the early days, most investors came from wealthy families (the Morgans, the Vanderbilts, the Rockefellers . . .), but smaller investors got involved, too. Starting in 1911, the process of raising capital from the public was enforced by each state under so-called blue sky laws. With these laws, states regulated the offering and sale of stocks to protect the public from fraud. The specific provisions of these laws varied among states, but they all required the registration of all securities offerings and sales, as well as the registration of every stockbroker and brokerage firm. Because the markets weren’t regulated at the federal level, shady stockbrokers started to issue stocks in dubious, fictitious, or worthless companies and selling them to people in other states, using the mail as their means of communication. During the 1920s, approximately 20 million large and small shareholders set out to make their fortunes in the stock market. Of the $50 billion in new securities offered during this period, approximately half became worthless as a result of the stock market crash in October 1929.
Ushering in the Securities & Exchange Commission (SEC)
During the peak year of the Depression, Congress passed the Securities Act of 1933. This law and the Securities Exchange Act of 1934 (which created the U.S. Securities and Exchange Commission [SEC]) were designed to increase public trust in the capital markets by requiring uniform disclosure of information about public securities and establishing rules for honest dealings. The main purposes of these laws can be reduced to two common-sense notions:
* Companies publicly offering securities for investment dollars must tell the public the truth about their businesses, the securities they’re selling, and the risks involved in investing.
* People who sell and trade securities — brokers, dealers, and exchanges — must treat investors fairly and honestly, putting investors’ interests first.
The 1933 and 1934 laws set the way the capital markets would function for about the next 50 years when it became obvious that the laws were inhibiting the flow of capital to startups and small businesses. In 1982, the SEC adopted Regulation D, which established three exemptions from the registration requirements under the Securities Act of 1933. The term exemptions is used because the updates enabled some companies, in certain situations, to issue securities without the requirement to register them with the SEC. Included within Regulation D’s definitions was the term accredited investor. The SEC adopted two definitions of the term, one based on net worth ($1M in liquid net assets) and the other based on income ($200k/year or $300k/year if married).
The exemptions allowed a small business that was raising less than $5 million in securities and seeking equity investors to have only 35 unaccredited investors. (There could be an unlimited number of accredited investors.) This structure allowed for an entrepreneur’s closest supporters (her mom and a handful of other cheerleaders) to become equity owners in her business while preventing her from roping hundreds or thousands of other people into investing in a company that might carry loads of risk.
Unintended Consequences of Sarbanes-Oxley & Dodd-Frank
Public yet completely opaque companies Worldcom and Enron brought about a concept called financial engineering, further loss of capital, and loss of confidence in the markets. The solution, Sarbanes-Oxley (SOX), ushered in a wide range of corporate governance, accounting, industry analyst relations, and financial reporting requirements. Because SOX treated all companies (regardless of size, industry, geography, or market) exactly the same, all companies faced a similar burden related to regulatory costs. This setup may seem reasonable at first blush, but imagine a mom-and-pop store trying to achieve the same reporting and accounting standards followed by a Fortune 500 company; it can’t be done. Effectively, SOX ensured that if your business is worth less than $100 million, it makes zero financial sense to go public. That’s because in order to execute an initial public offering (IPO), you’d spend millions of dollars, and then your annual compliance fees would be well over $1 million. That fact effectively closed the IPO market for all but the largest corporations and dramatically reduced small businesses’ access to capital.
The financial crisis of 2008 was rooted largely in real estate and sub-prime mortgages (and financial engineering and leverage). The financial regulation that responded to it was called the Dodd-Frank Act. Among its consequences, Dodd-Frank significantly limited homeowners’ ability to use credit cards or lines of credit on their homes to finance new businesses. Granted, many people had been getting into trouble because they used such lines of credit like free ATMs, so regulation seemed necessary. But prior to Dodd-Frank, equity lines of credit and credit cards were very common (and in some cases viable) ways to access capital to start or grow a business.
Look for PART 2 later this week, where Sherwood explains the role of the internet age and emerging technologies played in further developing Crowdinvesting.
Sherwood Neiss is one of the principals of Crowdfund Capital Advisors (CCA), founded the crowdfund investing movement in the United States, lobbied for its passage, and wrote the framework signed into law by President Obama. He and Jason Best are both Inc500 entrepreneurs and understand how to incubate ideas, mentor them, and match funding to winning ones. Their upcoming book, “Web 3.0 – How Crowdfund Investing will Transform Global Communities Locally” will be released in mid-2013.