“Friend” for Funding: Are social networks the future of startup funding?

by Matt Diamond November 10 2011, 16:40

Soon, entrepreneurs may be able offer their Facebook “friends” and Twitter “followers” more than just virtual friendship and updates on what they had for breakfast.  They may also be able to offer equity stakes in their business.  In an increasingly rare instance of bipartisanship, last Thursday (Nov. 3) the House passed both the Entrepreneur Access to Capital Act (“Entrepreneur Act”) and the Small Company Capital Formation Act (“Small Company Act”), each aimed at spurring small business growth through the method of “crowdfunding,” “a form of capital raising whereby groups of people pool money, typically comprised of very small individual contributions, to support an effort by others to accomplish a specific goal.” If approved by the Senate, the bills would allow entrepreneurs to use online social networks to solicit small equity investments in enterprises, a capital raising strategy that is illegal under current securities law. However, some warn that, if passed, the legislation will increase the risk of securities fraud and speculative risk to investors among other things.

            Crowdfunding’s roots can be traced to the practices of microlending and crowdsourcing. Microlending, or the lending of small amounts of money to, most often, low-income individuals, has inspired ventures like Kiva, which connects small individual investors with low-income entrepreneurs, while crowdsourcing has been harnessed to create things like Wikipedia, a user-generated online encyclopedia. Combine the two and you get crowdfunding, essentially the funding of projects with the combined small contributions of people. The numerous microlending and crowdsourcing projects have, in turn, inspired crowdfunding ventures such as Kickstarter, launched in 2009, which enables “large groups of people to pool their money to help fund an idea.” Such ideas range from documentary films to consumer products like iPod Shuffle watches, but investors are precluded from expecting any return on their investment by current securities law. Instead, entrepreneurs offer rewards for patronage such as their band’s album, a digital copy of their documentary, or an assortment of random goods. While these transactions, motivated primarily by patrons’ personal interest in individual projects, would likely continue even if the bills are passed in the Senate, the scale of the crowdfunding marketplace could soon dramatically increase to include investors with little or no interest in projects other than their financial success.

            The call for securities regulation reform has grown louder as the economy and lending market have struggled. Small businesses have been touted as a grassroots solution to job growth and economy turnaround by both Republicans and Democrats, but many small businesses cannot make it past the idea stage because of the lack of currently available funding. "Our current system tells businesses 'go out and create jobs' but don't tell people who might want to invest in your company," says New York Democrat Carolyn Maloney. The proposed legislation aims to help solve this problem by changing “how much [small] businesses can raise, who they can raise it from, and how they can raise it without . . . registering a public offering with the Securities and Exchange Commission (“SEC”).” The federal legislation that governs these areas is the Securities Act of 1933 (“Securities Act”).  In particular, the bills target the reform of Regulation A titled “Conditional Small Issues Exemption” and Section 4(2) of the Securities Act. Despite its title, Regulation A no longer offers any “exemption” for small equity offerings. Though Regulation A was originally intended to “provide an almost unconditional federal exemption for small offerings,” the exemption was eliminated when the SEC failed to reinstate the provision after making changes to the Securities Act in 1999.[1] As it currently stands, Regulation A requires entrepreneurs to file a Form 1-A Offering Statement with the SEC if it intends to make an equity offering.[2] Section 4(2) of the Securities Act prohibits entrepreneurs from soliciting equity offerings in private companies.[3] The Entrepreneur Act would amend Regulation A by exempting companies raising up to $1 million annually ($2 million with audited financials) from SEC registration and would limit individuals’ investments to the lesser of $10,000 or 10 percent of their annual income.  The Small Business Act would eliminate the ban on general solicitation of private business securities, allowing solicitation over social networks. For entrepreneurs looking to raise relatively small amounts of money (i.e. less than $2 million), the Entrepreneur Act’s regulatory changes would make the previous barrier to doing business, Regulation A, a viable option for raising capital (“only three companies made offerings under Regulation A in 2010”). Additionally, the Small Business Act would vastly expand both the pool of potential investors for entrepreneurs as well as the pool of potential investments for investors. Despite these positives, skeptics feel that the proposed legislation raises several concerns.

        Not all lawmakers and regulators are sold on the proposed crowdfunding legislation as a win-win stimulant to job and economic growth. Skeptics’ main concern is the risk of securities fraud stemming from an increase in securities offerings by small businesses paired with the circumvention of SEC oversight. The North American Securities Administrators Association, LLC (“NASAA”) president Jack Herstein was initially concerned stating that, “[i]f I'm a crook, I'd be licking my chops over [the Entrepreneur Act].” Additional concerns include the risk that unsophisticated investors will lose their shirts in the crowdfunding market and that small and inexperienced businesses will have difficulty administering securities. In response to the concerns of NASAA and others, members of the House Financial Services committee, which supported the bill, worked to add safeguards to the legislation, ensuring state notification of all crowdfunding offerings, barring securities or financial regulation violators from using the crowdfunding exception, and limiting the amount individuals can invest in crowdfunding ventures. Even with these added safety measures significant questions remain unanswered. 

        In the current financial environment, even entrepreneurs with good ideas and successful track records are finding it difficult to raise capital. Total angel investment in startups has declined steadily (from $26 billion in 2007 to $17.6 billion in 2009) and less than three percent of the thousands of entrepreneurs seeking angel investment funding each year actually receive any.[4] The capital-raising challenges faced by entrepreneurs who lack these credentials are worse still. Even traditional sources of money for inexperienced entrepreneurs like bank loans and friend and family investment have been choked off by the tough economy.[5] The proposed legislation will bridge the gap between the few who receive venture capital and the everyman entrepreneur. Securities law as it stands was mostly drafted in a different time. Today, business models available to entrepreneurs should mirror and integrate the technological advances that have been made since the Securities Act was enacted in the 1930s including the use of social networks such as Facebook and Twitter to reach customers, create community, and, perhaps most importantly, raise capital. This is not to say that there should be no regulation of crowdsourcing and solicitation of private company equity stakes, but that current small equity offering regulation is akin to “killing a mosquito with a machine gun.[6]” With the goal of protecting investors and preventing fraud, regulators have restricted a potentially enormous vehicle for investing in and growing businesses. Though questions such as whether crowdsourcing will create jobs, how much transparency will exist, and how crowdsourcing investors will sell shares remain, the weighing of the positive influence to business growth against the negative of increased risk to investors weighs heavily in favor of approving the proposed legislation.

 

[1] Nikki D. Pope, Crowdfunding Microstartups: It's Time for the Securities and Exchange Commission to Approve A Small Offering Exemption, 13 U. Pa. J. Bus. L. 973 (2011)

[2] Id.     

[3] Id.

[4] Pope, supra at 996.

[5] Id. at 973.

[6] Id. at 982.

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