To cut down on fraud in the wake of the 1929 stock market crash, Washington banned private companies from soliciting investments from the general public. Since then, only relatively wealthy people — those who qualify as “accredited investors” by virtue of income or assets — have been able to buy shares of companies not listed on a public stock exchange.
The passage in early 2012 of the federal JOBS Act was intended to change that. Among other things, the JOBS Act embraced “crowdfunding” as a way for privately held companies, usually startups, to raise money from ordinary investors through online fundraising campaigns.
A year and a half after President Barack Obama signed the JOBS Act, the federal Securities and Exchange Commission has released the rules of the game for public review and comment. The reasons for the delay are more complex than a federal agency stiff-arming the president and Congress.
Crowdfunding in the Internet era has largely been a province of artists, causes and special projects that don’t come with an expectation of profit. You might get an awesome T-shirt or a front-row ticket out of your crowdfunding investment, as well as some warm feelings about your involvement, but not a lot more.
That changed with the advent of “equity crowdfunding,” through which small companies may sell small pieces of their company in return for the cash needed to move from startup to success. The expectations for investors are very different: Instead of a T-shirt, they look for a return on investment.
The concept was embraced by the JOBS Act, within certain investment limits, but it ran headlong into the SEC’s historic concern about society inventing new ways to swindle grandmothers and other unsuspecting investors.
So, while most of the nation waited for the SEC rules, several states moved ahead with crowdfunding on their own — including Wisconsin, where lawmakers recently passed legislation to rewrite state securities law. To get a crowdfunding exemption under the pending Wisconsin law, a company would need to:
• Be a Wisconsin business selling stock to state investors.
• Not raise more than
$1 million, or $2 million if the company issuing stock is willing to be audited and make the audit available to investors.
• Not sell more than $5,000 in stock to anyone who is not a Wisconsin-certified investor. Certified investors have to earn more than $100,000 per year, or $150,000 for married couples, or have a net worth of $750,000 or more. That’s a different standard than set by the SEC.
• Issue the stock through an Internet site registered with the state Department of Financial Institutions; file disclosure statements; and share those disclosure documents with investors. Investors would be told they could lose the entire investment.
• Have stock payments held in escrow by a Wisconsin bank.
• Not have offered or sold other stock through the exemption in the past year.
The advantages of the state bill begin with the democratizing of equity investments in private companies. Mom and Pop could invest in mom-and-pop businesses. It also brings money off the sidelines for deals too small or early for angel and venture capitalists to consider.
There are potential pitfalls, as well. The Depression-era idea of protecting investors from themselves wasn’t entirely Rooseveltian paternalism. People can fall victim to fraud — even in public markets.
A proliferation of state rules could create a patchwork quilt of laws that might hamper commerce rather than encourage it. Can a global portal like the Internet truly screen out non-Wisconsin investors if they’re determined to get around it? Upstream investors might shun buying out crowdfunded deals if the list of previous investors is too hard to unravel, which could leave those initial investors stranded.
Perhaps the biggest danger is adverse selection. If the best deals are attracting experienced money from venture capitalists or angel groups, does that mean crowdfunding investors are left to pick from a less desirable pool?
If so, the advent of crowdfunding could give way to disappointment among an entire class of investors who aren’t accustomed to the stark reality that many startups fail, even when backed with institutional money.
Now that proposed SEC rules are out, a whole new class of investors will soon be able to take part in startup deals. Wisconsin should make sure its rules don’t make things harder for investors and companies here by contradicting federal rules that should be allowed to work nationally.