Proposed “Regulation Crowdfunding” = disappointment
In an earlier post, I described the major points of the proposed crowdfunding rules issued by the SEC (known as “Regulation Crowdfunding”) pursuant to the JOBS Act. Now, I’d like to offer my reactions.
My basic reaction is this: you have got to be kidding me.
To me, the idea of crowdfunding is that if a company is raising only a modest amount of money, and is not accepting any more than a small amount from any single investor, then (1) the company should be allowed to accept money from people who are not as wealthy as “accredited investors,” and (2) the regulatory and reporting burdens on the company should be minimized.
Unfortunately, only one of these two ideas made it into the law and the regulations as proposed.
Yes, under the proposed Regulation Crowdfunding, anyone – not just the wealthy – can invest a small amount in a crowdfunding round. A company can raise up to $1 million, subject to limits on individual investments ranging from $2,000 to $100,000, based on the financial means of the investor. That’s the good news.
However, the SEC’s proposed rules call for more and more frequent disclosure – conceptually more akin to a public offering. The regulatory burdens are significant. The SEC forthrightly admits in its discussion of the proposed rules that the disclosure requirements it proposes for crowdfunding rounds “are more extensive in terms of breadth and frequency than those for other private offerings.”
As discussed in my previous post, Regulation Crowdfunding would require disclosure of financial and other information at the time of the offering. Given that most crowdfunding companies are likely to be startups, you’d at least expect that the information required would be limited, but to the contrary, it includes financial statements that – in the case of funding rounds of between $500,000 and $1 million – have to be audited by independent public accountants. And there’s more: Unlike any other private offering exemption, proposed Regulation Crowdfunding would additionally require ongoing annual reporting, of the same thoroughness as the disclosure given at the initial offering.
Given the regulations as proposed, my opinion is that a company that has any possibility of doing a round with higher-income “accredited” investors would be crazy to use crowdfunding instead of Rule 506 of Regulation D. The advantages of Rule 506 are overwhelming:
- No limitation on the total amount of the raise.
- No limitation on the amount that can be accepted from each investor.
- No requirement to use (and pay for) the services of a funding portal.
- No disclosure requirements to the SEC or to investors at the time of the offering or on an ongoing basis.
The material legal and administrative costs of a Rule 506 round are limited to paying a lawyer to draft the investment documents and file the very simple Form D.
By contrast, look at the potential costs for a crowdfunding round for a hypothetical $1,000,000 round, as estimated by the SEC (page 358 of the proposed regs):
- $50,000 to $150,000 (5% to 15%) of the offering amount as fees to the funding portal.
- About $6,000 for preparation of information to be disclosed on Form C.
- $28,700 for professionally audited financial statements. (Even though the SEC argues that audited financials are “self-scaling” to the size of the company, this cost estimate comes from the SEC itself. I thought it seemed high but one accountant I spoke to said $30K for audited financials is reasonable to expect even for an early-stage company).
These are just the costs at the time of the offering; since the proposed regulations contemplate ongoing annual reporting, significant additional expenses are incurred each year. A company is facing tens of thousands of dollars in costs – not to mention a lot of lost time, which is arguably more precious – to comply with these regulations.
This whole approach is, I think, misguided.
No, we don’t want to encourage fraud in small deals any more than in large ones. But outright fraud can always be prosecuted when it happens. The issue is how much regulatory burden is appropriate to impose up front, on all crowdfunding rounds, given that no investor is permitted to put up a sum of money that would do them meaningful harm to lose.
Nor do I think that the required disclosure will help investors much in any case. The crowdfunding universe is made up overwhelmingly of startups and small companies. Their operating history is extremely limited, and in many cases, zero. The disclosure required by the SEC will cost much but have little value. It’s just expensive and burdensome hoops for companies to jump through. It would have been sufficient to stop with the SEC’s requirement that crowdfunding platforms provide investors with general precautionary information explaining just how risky it is to invest in startups in general.
I – and I suspect many others – would have preferred that the SEC impose tighter limits on the amounts that individual investors could put at risk in these rounds, in return for a much less onerous regulatory framework.
It’s not entirely the SEC’s fault. As the New York Times points out, the basic framework is mandated by Congress in the JOBS Act itself. But the SEC does not seem to be using its regulatory discretion to lighten the impact in any meaningful ways. The JOBS Act, for example, left it to the SEC to determine the precise scope of disclosure required at the time of the offering or on an ongoing basis, and it was the SEC that decided to require audited financials from many companies at each and every point of disclosure.
So, those who like me were hoping for a very simple and inexpensive regulatory framework for small crowdfunding rounds should be disappointed.
If you want to let the SEC know your views about this, it is accepting comments until February 3.