The Exchange

The JOBS Act: Could It Create a Two-Tiered System?

The Exchange

By Daniel Gorfine and Ben Miller

The Jumpstart Our Business Startups (JOBS) Act, passed into law in April of this year, has the potential to help startups and small businesses raise capital through numerous, small investments from "the crowd." This widely discussed crowdfunding exemption is found in Title III of the Act. But the Act also created the possibility that the biggest benefit from the legislation will go not to the crowd, but rather to traditional investors that have long had access to the best startup and small business investment opportunities. Here's how.

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Once new SEC rules are finalized, Title II of the JOBS Act allows startups and small businesses for the first time to advertise their investment offerings as long as only "accredited investors" are permitted to invest. Accredited investors are mainly corporate entities and individuals with liquid net worth of more than $1 million or an annual income greater than $200,000; the same exclusive group that the SEC allows to invest in hedge funds. By opening this pipeline, Title II may end up diverting significant crowdfunding opportunities away from the Title III "crowd," and thus create a two-tiered, less democratic investment system.

The Rule 506 Effect

To get a sense of how big a pipeline that may be, let's look at the significant capital-raising impact of Rule 506, the SEC accredited investor exemption that has proven superior to other securities registration exemptions. Even without the ability to solicit investments generally, approximately $895 billion was raised in 2011 under Rule 506, more than five times the $169.9 billion raised in global IPOs in the same year. And the estimated $2.8 billion that will be raised worldwide via crowdfunding this year is a comparative trickle.

Why is Rule 506 so popular? Because the SEC presumes that accredited investors can protect themselves and adequately detect fraud, there are far fewer disclosure and investor protection requirements as compared to the crowdfunding exemption or IPO registration. This, in turn, reduces transaction costs and limits issuer liability. Moreover, unlike with crowdfunding, there is neither a statutory cap on the amount of money a startup or small business can raise with Rule 506, nor a cap on the amount of money an accredited investor can invest.

What Does Title II Mean For the Crowd?

Once implemented, Title II will likely further increase the attractiveness of Rule 506 to startups by increasing the pool of capital available from accredited investors since companies will be able to market their investment opportunities directly to investors, and in some instances make investors aware that they qualify for accredited status. Our hunch is that many professionals and retirees are not even aware that they would be deemed "accredited" by the SEC and thus able to take advantage of the Rule 506 investment mechanism.

If a startup or business is able to utilize a Rule 506 general solicitation, it will be able to raise more money, from fewer people, and with less litigation and regulatory risk. Thus, it is likely that many of the best high-growth ventures will pass over the requirements of the crowdfunding exemption in Title III, and instead crowd-fund from an upper tier of accredited investors.

Not all ventures, of course, will seek capital from accredited investors. Some entrepreneurs may want to steer clear, because these investors are likely to demand more control and ownership for their investment than the crowd. Moreover, certain types of ventures, such as consumer product companies, sports teams, or local businesses will benefit from crowd-based investments because the validation from "the crowd" can translate to a strong marketing hook. Nevertheless, it will be unfortunate if the JOBS Act falls short in its promise of democratizing finance.

The SEC Needs to Clarify

To level the playing field, the SEC will have to be careful not to make regulatory compliance costs associated with the crowdfunding exemption so great that startups and small businesses immediately turn their back to the crowd in favor of the easier path of a Rule 506 capital-raise. It would be better for the SEC to take an entrepreneurial approach and respond rapidly to the market rather than trying to anticipate it.

Moreover, the SEC needs to allow Title III Internet crowdfunding portals, which will serve as the central websites to facilitate crowdfunding, to provide some degree of investing guidance or vetting to the crowd so that the public has information with which to make informed decisions. If only registered broker/dealers can provide investors with key investment information, then these broker/dealers will gravitate to Rule 506, where large fees can be generated from limitless raises and funding portals will be unable to do so for the crowd.

Ultimately, if the SEC is not careful, the net effect of the JOBS Act may be to further empower more affluent investors, while leaving the crowd behind.

Daniel Gorfine is the Washington-based Director of Special Projects & Legal Counsel for the Milken Institute.  Ben Miller is Co-Founder of Fundrise, an investment platform that enables direct investment in local real estate and businesses.

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