How to save crowdfunding before it’s dead on arrival

Equity crowdfunding is about to come to unaccredited investors the United States, but some of the Securities and Exchange Commission’s proposed rules are hugely impractical.

If we don’t push the agency to implement some fixes, crowdfunding may be dead on arrival.

It’s historic when Congress passes legislation with nearly unanimous bipartisan support. Such was the case with crowdfunding in 2012: It passed the House with 96 percent approval and the Senate as part of the JOBS Act with 73 percent approval — not too bad in an era of “broken Washington.” It has been almost two years since President Obama signed the bill into law. In October 2013, the SEC released 585-pages of proposed rules for debt and equity crowdfunding.

While there are a lot of good rules, there are several proposed rules that we believe could make crowdfunding more difficult to use than other forms of financing. Here are four fixes that we believe will protect investors while increasing the utilization and effectiveness of crowdfunding by both Main Street businesses and high growth startups.

Decrease lawsuits by making investors acknowledge the risk and allow crowdfunding sites to curate deals

The legislation allows for transactions to take place via broker-dealers or crowdfunding portals. Both types of firms need to be registered with the SEC and are overseen by the Financial Industry Regulatory Authority. The intent of the legislation was to allow funding portals to operate with lower costs and regulatory burdens, much like perks-based crowdfunding platforms (think Kickstarter). They list campaigns but leave the diligence and funding decision up to the crowd. Under the proposed rules, however, funding portals face a unique dilemma.

In the rules, issuers must complete disclosures mandated by law (business plan, use of proceeds, valuation and how it was determined, capital structure, etc). Funding portals must verify that these items exist, but cannot prepare them or get paid to vet them like broker-dealers — this could be considered investment advice, which falls under additional regulation. So they are forced, by the regulation, to play a “hands off” role.

Yet, according to the proposed rules, funding portals are liable for any material misstatements in the disclosures. So portals can’t dig into the details, but they’re accountable for them.

This situation is like if you were a gym instructor and weren’t able to remove pieces of equipment that you thought could be dangerous for your members. If they used the equipment and hurt themselves, they could sue you, even if you did not want the equipment in your gym in the first place. If this were the case, given our litigious society, pretty soon there would be no more gyms.

The rules need to maintain the ability for investors to sue for fraud, while reducing lawsuits against companies that just fail. Even though the legislation mandates that investors complete an education series on crowdfunding, investors should also be required to sign a document acknowledging they could lose all their money, that they are responsible for reviewing the investment materials prior to investing, and if they can’t afford to lose that amount of money, they should reduce the amount or not invest in the deal at all.

Funding portals should also be allowed to fully curate deals, not just have generic exclusion criteria in their terms of service. They need the flexibility to keep deals off their platform that they do not deem worthy. This can benefit investors by keeping out deals that are not ready to raise capital, not fundable, or not worthy from the portal’s perspective for listing.

Add a “test the waters” safe harbor provision so companies can measure interest in their campaigns

Under current proposed rules, companies must spend thousands (or potentially tens of thousands) of dollars on preparations to raise capital, even before they know if there’s any interest in their campaigns.  Many people do not have this money prior to their campaign, which is usually why they’re raising money for their business in the first place.

Businesses should be able to post their proposed deal on a crowdfunding site and be flagged “testing interest.” If enough interest exists, it is a good indicator that the company may proceed with the offering and its associated costs. If not, it’s back to the drawing board. This will save time and money for everyone.

Reduce the cost to crowdfund by modifying accounting requirements and the thresholds for CPA reviews & audits

Initial and ongoing costs to raise capital cannot be totally out of whack with how much one is trying to raise. The JOBS Act mandates a CPA review for raises over $100,000 and audits for raises over $500,000. After talking with several auditors, we’ve learned that accounting reviews are almost as costly as full audits. The most expensive part is making sure the systems are in place (review) to account for and document the money flows (audit). We also learned that for companies using crowdfunding, an audit of this size will provide minimal investor protection because there’s usually little (if anything) to uncover.

The legislation gives the SEC discretion to adjust these limits. While the cap in the bill restricts issuers from seeking more than $1 million per year, we suggest the following ranges for accounting oversight:

• Capital raise of $1 – $499,999: CEO sign-off
• Capital raise of $500,000 – $900,000: CPA review
• Capital raise of over $900,000: CPA audit

This satisfies the need for an audit per the law, while dramatically reducing the costs of raising capital under $500,000. It also prevents startups from having to use accrual accounting methods (more expensive and complex) from day zero.

If the audit requirement must remain, another possible solution could be the creation of a format for a “crowdfunding accounting review / audit” to streamline the process and reduce the costs while protecting investors. Audits and reviews need to scale to the size of the entity.

Scale the disclosures to the size of the offering

The rules require onerous levels of ongoing disclosures. For startups and small businesses, the current disclosure requirements will be a burden and a distraction. The rules should decrease the volume of filings and provide standard disclosure forms for issuers to use. The point of periodic disclosures is to inform investors of any “material” changes in a company or its financials. This can be accomplished with a modified annual disclosure form that should include these three questions:

1) Have there been any material changes to the business operations (customers, vendors, suppliers, competitors, product issues, market conditions, etc.) from what you originally put in your offering documents or since you last filed this form?

2) Have there been any material changes to your cash position that would affect the operations of the business going forward?

3) Have there been any material changes to your expenses from what you originally put in your offering documents or since you last filed this form?

Companies that are raising under $300,000 shouldn’t have to comply with current proposed annual SEC filings because the costs will outweigh the benefits. But following best practices (and the desire have a solid crowdfunding reputation and the ability to go out and get follow-on investment), these companies should provide regular updates on the status of the business to investors. Companies raising between $300,000 and $5 million should file a modified form in which they answer the three questions above.

Is this a comprehensive list of everything we’d change? No. But for now, this is a short list of common sense, bipartisan changes that we believe that all parties (House, Senate, SEC and White House) can consider seriously because everyone wants the same thing: efficient capital formation and investor protection. Now that the SEC is finalizing the rules, we hope they will consider scaling their requirements so small business and entrepreneurs can finally get the help they need that is aligned with the legislative intent of The JOBS Act.

Sherwood Neiss (@woodien) and Jason Best (@CrowdCapAdvisor) helped lead the U.S. fight to legalize debt and equity based crowdfunding, and co-founded Crowdfund Capital Advisors, where they provide advisory and implementation services to investors, governments, multi-laterals, and entrepreneurs seeking to create effective strategies in this new form of early-stage finance. They co-authored Crowdfund Investing for Dummies, as well as the World Bank report Crowdfunding’s Potential for the Developing World. They are also both Entrepreneurs-In-Residence at the UC Berkeley Center for Entrepreneurship and Technology.