Read The Fine Print Before You Turn To Equity Crowdfunding

tl;dr: JOBS Act equity crowdfunding sounds great, but for startups it could be more tripwire than blessing.

Today’s article was written by Alex Mittal, co-founder and CEO of FundersClub. After a chat on the phone concerning equity crowdfunding we realized that we’d reached similar conclusions. Enjoy!

The rollout of the JOBS Act has been delayed for years, but on May 16th, 2016, one of its most controversial parts goes live. True equity crowdfunding is coming. Times are changing, and there will be blood.

Every entrepreneur, angel investor, venture capitalist, startup incubator and accelerator needs to understand what’s changing next month. Although designed with good intentions, the new law implicitly sets up adverse selection filters. That’s not good.

Back in 2012, my team and I launched the first legal online startup investing platform and first online VC in the United States, FundersClub. We rely upon the existing regulations of the offline VC industry. Our LPs are all wealthy accredited investors and qualified purchasers. We never needed or used the JOBS Act, but did wish for it to solve some of the ills in the broader startup investing landscape.

There were high hopes for the JOBS Act from most of the industry. However, what matters is the final result and not early promises.

The Raw Deal Of Title III

Let’s get back to May 16th. What’s changing? The equity crowdfunding provisions of Title III of the JOBS Act will finally take effect. For the first time in more than a generation, Americans who are not accredited investors will be permitted to invest in private companies. That’s the headline.

However, companies who opt in for Title III fundraising must comply with regulatory filing requirements and incur overhead costs far above and beyond those applicable were they to have raised under existing regulatory frameworks.  

Raising money under Title III requires GAAP accounting [Editor’s note: Yipee!], reviews by public accounting firms, in some cases auditing by public accounting firms, as well as additional disclosures, compliance, and filings. This is an annual, recurring requirement for life, not a one-off inconvenience. Overhead costs to startups run in the double-digit percents according to both SEC estimates and private observers.

Protections like audited GAAP financials and periodic regulatory filings may sound good for investors, but only in a penny-wise, pound-foolish manner. This is due to the adverse selection filter these requirements create.

If the above issues were not enough of a deterrent to startups with other capital options, it gets worse. Companies are forced to directly accept many small investors on their cap table with little skin in the game. These investors will also have statutory rights that can slow down or impede a company’s development. The rotten cherry atop this quagmire is that once the company reaches 500 unaccredited shareholders and $25 million in assets, it will be forced to go public.

Startups that opt for Title III funding will also close financial doors that might have been otherwise opened in the future. Many (most?) sophisticated startup investors will avoid companies with Title III fundraises. This is because they will carry restrictions that resemble “dirty termsheet” time bombs that could kick in at any time and lead to negative outcomes (for example, going public at an undesired time, or future disputes with hundreds of unsophisticated shareholders that changes one’s economic outcome from what’s expected).

From the investor side of the table, it won’t be top venture capitalists and their wealthy limited partners who will be left holding the bag on ill-advised investments. These investors will overwhelmingly pass on investing in companies who use the new provisions by equity crowdfunding portals. It will be regular Americans losing their hard-earned cash.

From the founder side of the table, entrepreneurs will be one button click away from committing to a new level of regulation and overhead for the lifetime of their companies—potentially without fully comprehending the impact. We’ve already seen a version of this, with some online investing platforms pushing startups to generally solicit, committing them to a lifetime of increased liability with no warning.

You may be wondering how the situation could possibly have become this convoluted. No single group is specifically at fault. The intention of those writing the JOBS Act was pure. Congress had to follow the messy process of democracy, yielding a heavily modified but passable piece of legislation. The SEC then had to balance consumer protection group interests, business interests, the intent of Congress, and existing regulations.

Democratized Access To The Adversely Selected

Doing well in venture investing requires being incredibly selective in an environment where thousands of businesses will gladly accept your money. Even with careful curation, most of your profits will ultimately come from a relatively small set of companies. Startup returns follow a power law distribution. To deliver an outsized return, the math of tech venture capital requires grand slams—single investments that can return 50x, 100x, or more. Startup investors that target non-tech companies also face the pareto principal: they may not be seeking grand slams, but they’re still seeking the signal in the noise.

The overhead cost and extra compliance of taking on Title III funding creates an adverse selection filter for startups; it will tend to attract startups with no other options. These are the startups that fail to attract sufficient capital from angel investors, venture firms, and online startup investing platforms that follow the same regulations as venture capitalists and angels, and who are searching for the best companies to back.

Only after exhausting these much less burdensome capital sources would a company sign up for the restrictions and overhead of Title III. So yes, for the first time in history, unaccredited investors will be able to invest in startups. However, they will be mostly picking over the leftovers of the entire private company financing ecosystem, offline and online.

Some businesses will knowingly and willingly endure the overhead of Title III for philosophical, marketing, or other reasons, even though they have capital available from other investors. This will be a calculated bet that the brain damage is worth whatever upside those businesses expect to realize. Regardless, Title III will have the most appeal to startups with insufficient interest from virtually everyone else searching for the next great business.

—

While there have been calls for amendments to Title III to make it more palatable, there is likely no way to regulate a way around the adverse selection filter it incentivizes.

The reason for this is natural selection. Any law that increases the overhead of capital beyond that of existing financing options will naturally tend to select for those startups that fail to attract existing, less burdensome capital. Given where it’s at today, it’s likely that Title III funding is slated to become the startup option of last resort.

Featured Image via Flickr user Diego Quintana under CC BY-SA 2.0. Image has been cropped.