“One cannot resist an idea whose time has come.”
— Victor Hugo
“This bill is exactly the kind of thing Americans have been asking for, greater freedom and greater flexibility.”
—Sen. Mitch McConnell (R-KY)
“It’s a piece of legislation that moves from a legacy economy to an innovation economy. I think it was a moment when the Senate worked the way the Senate is supposed to work.”
—Sen. Michael Bennet (D-CO)
History may record that a new era in small business capitalization was ushered in by the House of Representatives overwhelmingly passing the Crowdfunding Bill as part of the JOBS Act on March 8, 2012.
The legislation, which sailed through the House and was subsequently passed by the Senate after some brief maneuvering, promises a “democratization of capital” by allowing startups to use the rapidly growing online fundraising technique called crowdfunding to sell securities on social networks and other websites. It now awaits president Obama’s expected signature this week.
The Crowdfunding Bill exempts “emerging growth” companies – firms that promise fast growth and a healthy return on investment – from certain financial regulations for up to five years.
A New Form of Financing
Crowdfunding, the practice of drawing capital from many smaller sources instead of a few larger ones, traces its origins to the microlending revolution that began in Bangladesh in the 1970s as a way to make funds available to borrowers too poor to meet the standards of conventional lenders.
More recently, the idea of raising money via large numbers of small online donations for everything from personal projects to political campaigns (e.g. the “money bombs” of Ron Paul’s groundbreaking 2008 presidential campaign) has taken off. This trend has been most pronounced in the United States, the country where the Internet was invented and which continues to see the most online innovation, despite lagging behind other jurisdictions such as South Korea, where a larger proportion of the population enjoys high-speed Internet access.
Harnessing the power of small investors has the potential to transform the way that new companies, products, and services are created. Until now, however, U.S. government regulations limiting the means by which companies can seek financing have largely prevented entrepreneurs and start up businesses from taking advantage of the crowdfunding boom.
What the legislation passed by Congress essentially does is to allow companies to solicit equity investments through the Internet or elsewhere. The Crowdfunding Bill removes antiquated SEC restrictions dating from 1934 that limited entrepreneurs’ ability to raise equity capital from a large pool of small investors who may or may not be accredited by the Securities and Exchange Commission.
Specifically, the ban on so-called “general solicitation” which has prevented businesses from advertising their need for funds to potential investors, is eliminated. For companies with less than $1 billion in revenue, the number of audited financial statements required for an initial public offering would be reduced, and they would be exempted from having to hire an external auditor prior to the offering.
Companies will now be allowed to raise up to $1 million annually without being required to register the shares for public trading under the aegis of the SEC, or up to $2 million if the company provides investors with audited financial statements. Individual contributions are limited to $10,000 or 10 percent of the investor’s annual income, whichever is less.
The legislation also provides for “mini” public offerings, exempting companies raising $50 million or less from some of the financial disclosure requirements to which most publicly held companies are subject. Private companies, which are currently limited to 500 investors, will be able to take on as many as 2,000 investors before triggering securities regulations.
Public Debate
While the crowdfunding legislation has strong transpartisan appeal based on the widespread public embrace of this innovative Internet development and its obvious potential, it has nevertheless drawn criticism from the likes of the SEC, state securities regulators, pension funds, and lobbying organizations like the American Association of Retired Persons. Critics argue that the bill’s provisions open the door to investment fraud.
Some Senate Democrats, among them Rhode Island’s Jack Reed, claimed investor protections were lacking and vowed to block the legislation. Media outlets like Bloomberg and The New York Times voiced strong editorial opposition to the House version of the Crowdfunding Bill, invoking the stock market crash that preceded the Great Depression and drawing comparisons to the less regulated era prior to the formation of the SEC in 1934. They argued that the legislation would usher in a new era of scams and bilking as regulations for capital-raising in small companies are scaled back.
The Crowdfunding Bill nevertheless attracted strong support from the business and investment communities. “The JOBS Act will help revitalize an IPO market that has suffered in recent years under the weight of market volatility and one-size-fits-all regulation,” said Paul Maeder, general partner at Highland Capital Partners and chair of the National Venture Capital Association. “The passage of this legislation sends a strong and welcome signal to our most promising companies that the U.S. capital markets system is open for business.” Business advocates say these reforms will enable more small companies to find the capital they need to grow.
How Crowdfunding Made It Through Congress
Originally introduced in September 2011 by Rep. Patrick McHenry (R-SC) as H.R. 2930, the Entrepreneur Access to Capital Act (or the Crowdfunding Bill) was passed by the House of Representatives on November 3, 2011.
When President Obama unveiled his Startup America Legislative Agenda on January 31, crowdfunding legislation was included among his proposals. The White House endorsed the original Crowdfunding Bill when it cleared the House, and the president said he would sign it. Obama also supported efforts by Senate Democrats to increase protections for investors as a condition of reducing government limitations on investment transactions.
Eventually bundled into a legislative package known as the JOBS (Jumpstart Our Business Startups) Act, the Crowdfunding Bill was again approved by the House earlier this month in a vote of 390 to 2.
After this House action, the legislative spotlight shifted to the Senate, where two crowdfunding bills had been introduced. The Democratizing Access to Capital Act of 2011 (S. 1791) was introduced by Sen. Scott Brown (R-MA) on November 2, 2011. The Brown bill, which closely mirrored the House bill, was subsequently referred to the Senate Committee on Banking, Housing, and Urban Affairs. The committee held a hearing on several pieces of capital formation legislation, including crowdfunding.
Meanwhile, a more restrictive bill, S. 2190 , the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act (or CROWDFUND Act), was introduced by Sen. Jeff Merkeley (D-OR). The Merkeley bill included many of the fundamental reforms of the other legislation, but imposed investment caps, limiting investors with an income of less than $100,000 to stakes of $2,000 or 5% of income, whichever is greater. Those with income over $100,000 would be allowed to invest up to 10 percent of their income, to a maximum of $100,000. Merkeley’s bill also required crowdfunding portals to provide investors with educational materials on illiquidity and the risks associated with small issuers.
As the legislative pace accelerated in the days following House passage of the Crowdfunding Bill, Senators Brown, Merkley and Michael Bennet (D-CO) introduced “bipartisan compromise” legislation called the CROWDFUND Act on March 13, 2012.
On March 21 however, a day after the Senate blocked a Democratic alternative, the Senate voted 76-22 to limit debate on the House measure, easily clearing the 60-vote hurdle necessary to move the bill forward. The successful cloture vote meant final passage of the bill was virtually assured.
After adding provisions intended to bolster investor protections, the Senate approved the legislation the next day, March 22, by a vote of 73-26. The Crowdfunding Bill had passed both houses of Congress.
Under the Senate amendments, any company using crowdfunding methods must still file some basic information with the SEC, including the names of directors, officers and holders of more than 20 percent of the company’s shares, plus a description of the business and its financial condition.
Companies seeking to raise less than $100,000 must also provide tax returns and a financial statement certified by a company principal. For companies raising $100,000 to $500,000 financial statements reviewed by an independent public accountant must be provided, and for those raising over $500,000, those statements must be audited. The Senate also inserted requirements that intermediaries seeking to help companies raise money through crowdfunding must register with the SEC, make sure investors are advised of the risks they are taking, and take measures to prevent fraud.
What Happens Next?
Crowdfunding’s legal future in the U.S. looks promising. The JOBS Act, which includes the Crowdfunding Bill, has been one of the few bipartisan bills to pass Congress during this election year. “The bipartisan JOBS Act represents an increasingly rare legislative victory in Washington where both sides seized the opportunity to work together, improved the bill and passed it with strong bipartisan support,” House Majority Leader Eric Cantor (R-Va.) said upon passage by the House of the Senate version of the JOBS ACT.
A number of new crowdfunding portals have sprouted online in recent months, and the pace has accelerated in the few weeks following House approval of the Crowdfunding Bill. Expect the number of these sites to keep pace with the blooming of spring flowers now that legislation removing many of the restrictions on crowdfunding as an investment option appears set to become law.
Could crowdfunding eventually shake up the banking industry and threaten large institutions like Goldman Sachs and JPMorgan Chase? Will there be a backlash against allowing the masses this much clout in the traditionally top-down world of high finance? What are the implications of crowdfunding for overseas investing? Visit CROWDFUND NEWS regularly to keep abreast of continuing developments.