The crowds are still waiting

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This article is the second in a three-part series on the JOBS Act. You can read Part One here.

Title II of the Jumpstart Our Business Startups (JOBS) Act has already opened the door to new early-stage investors, but there is one catch—you must be an accredited investor.  That will soon change once Title III of the Act is enacted.  When that will actually happen, however, is still up in the air.

The Securities and Exchange Commission is currently reading and reviewing comments submitted during an open comment period that came to a close earlier this year.  Since then, the SEC has been working to create the next component of the JOBS Act that will open up early-stage investing to smaller investors.  After Title III of the Act is passed, small businesses will have the ability to raise up to $1 million from the general public.

More companies will succeed, leading to a stronger economy and the creation of more jobs.

This new exemption to securities registration marks a paradigm shift in the marketplace.  Small businesses, which have traditionally raised money through contributions from friends and family, will be able to reach outside of their social network to raise capital.  Using social media tools and online solicitation, small businesses will have the ability raise the money they need expeditiously.  By the same token, small investors will be able to run with the big dogs and snag equity in early stage start-up companies.

In effect, Title III will create a new class of investors that can participate in equity crowdfunding.  An estimated 543,000 companies are formed each month, and only a select few receive funding from venture capital firms or large investors.  By expanding the number of investors, the goal is to increase small business funding across the board.  In turn, more companies will succeed, leading to a stronger economy and the creation of more jobs.

Raising capital may be easier, but trading expertise and experience for a quick buck could be a bad deal.

Crowdfunding has so much potential to revolutionize the marketplace for the better, so it is hard to see why an early stage start-up would turn its back on the millions of would-be investors for the more traditional venture capital route.  For one, these small companies may be apprehensive to give up equity in their company to a large number of investors.  A large pool of equity shareholders could present problems down the road, especially if another funding round takes place.  Companies with hundreds, or even thousands, of equity stakeholders might turn off would-be funders.  Taking money from small investors is one thing, but dealing with those investors is another.

Some criticize the next phase of the JOBS Act as opening the floodgates for “dumb money” that would flow from unsophisticated investors.  A start-up company that takes small investments from many different investors has the potential to accelerate funding, but the young company will lose the advantage that comes from having a small number of experienced investors in their corner.  Raising capital may be easier, but trading expertise and experience for a quick buck could be a bad deal.

There are other concerns that the Title III will allow bad actors to take advantage of amateur investors, raise capital, and then fold up shop.  However, it is even more likely that small businesses without viable business plan may attract the attention of investors who unwittingly pour money into a company doomed for failure.

The potential for overregulation and high costs for compliance has stopped the new law in its tracks.

These are just some of the concerns that may have been brought to the SEC’s attention during the open comment period.  The SEC has already proposed rules that would protect small investors.  Measures such as requiring issuers to file disclosures with the SEC, describe the business and anticipated business plan, and disclose the names of officers and directors were to be expected.  There are also limitations that would be imposed on the investors, preventing them from investing more than they can afford to lose.  Most importantly, there are proposed regulations for online intermediaries that will facilitate the crowdfunding efforts.  These intermediaries will be required to perform due diligence to authenticate both the investors and businesses.

While the prospect of Title III is cause for excitement, the potential for overregulation and high costs for compliance has stopped the new law in its tracks.  As it stands, legal analysts do not foresee Title III becoming effective until 2015.