The Crowd and the Regulator: How a Few Rule Changes Could Accelerate Entrepreneurship

july crowdCrowdfunding has captured the public’s attention and support and to date more than 16 states across the United States now offer state-based crowdfunding. But as regulators work on rule modernization, we should be careful to balance the exuberance with clarity around different types of crowdfunding and precision around what we are trying to accomplish.

Crowdfunding as a source of capital has exploded since 2011, with dozens of new platforms coming online every month. It is still restrained, however, by Depression-era rules until the Security and Exchange Commission (SEC) finalizes all rulings called for in the JOBS Act of 2012.

Narrowing down on equity crowdfunding

Crowdfunding is an umbrella term that means different things in different contexts. In general, there are four different types of crowdfunding: donations, rewards, debt and equity – only the last is an “investment.”

Donation-based crowdfunding platforms, such as Kiva, do not offer the giver a return. Rewards-based platforms, of which Kickstarter is the most famous, offer the giver the opportunity to participate in the activity. For example, a giver may receive a ticket to the opening of a film they contributed toward. Debt-based platforms, such as Prosper and LendingClub, are those where the giver is making a loan and can expect to be repaid (usually with interest) if the venture succeeds.

Until just a few years ago, equity-based crowdfunding was not permitted in the United States. It is still rare, in part because it is subject to high levels of regulation. But, because crowdfunded entrepreneurs have proven to be extremely innovative in the high-tech sector, it inspired legislation such as the JOBS Act.

States responding faster

Intrastate crowdfunding is gaining traction as you will see from this list of active, proposed, and rejected intrastate crowdfunding exemptions by state. According to Michael Pieciak, corporate finance chair of the North American Securities Administrators Association (NASAA), “in the very near future . . . a majority of states will have state-based crowdfunding up and running.”

While state laws governing crowdfunding vary – some allow companies to raise up to $1 million, others up to $2 million, some require audited financial information, others do not – the objective of recent legislative action in favor of crowdfunding is clear: enlarging the pool of investors for new enterprises.

The next frontier is modernizing Rule 147, most agree. Under the Securities Act of 1933, Rule 147 (17 CFR 230.147), securities sold within a single state are exempt from federal registration. This is commonly known as the the "Intrastate Exemption". It currently requires that the sellers offer only to residents of the same state. As a result, those who use the internet and social media to announce equity crowdfunding opportunities are reluctant to take advantage of it.

“Even though intrastate crowdfunding seems small, it will actually be quite important,” according to Small Business Administration (SBA) Associate Administrator Javier Saade at a recent SEC Advisory Committee meeting on small and emerging companies. And, significantly, reports that crowdfunding has helped women entrepreneurs in particular to raise capital for their new ventures. All this positive impact could be multiplied by reforming Rule 147 and unleashing state-based crowdfunding.

The entrepreneurs’ perspective

Even under current rules, intrastate crowdfunding has a number of major benefits to entrepreneurs over more traditional equity offerings. One is that the issuer may sell securities to both accredited and non-accredited investors. Since only a small percentage of the population qualify as accredited investors, this increases the pool of potential investors enormously. But, as per Rule 147, only if both the seller and buyer reside in the same state.

Another problem, especially for e-commerce startups, is complying with the Rule’s “80 percent” requirement, which requires a business to show that 80 percent of its gross revenue is generated from within the same state of operation, or that 80 percent of its assets are located within the state.

Given the large benefits to entrepreneurs, however, why aren’t there a great deal more intrastate offerings? In fact, it is estimated that only about 100 successful “intrastate” crowdfunded transactions have occurred to date. The answer, as Mr. Pieciak noted, is probably because more would-be issuers fear running afoul of Rule 147.

The federal response

The SEC has begun to address the new reality created by growing numbers of state-level crowdfunding regulations. While there is an emerging consensus that Rule 147 needs to be updated in recognition of the many benefits that crowdfunding brings to an entrepreneurial economy, the debate about how to do so has only just begun.

In April 2014, the SEC issued new Compliance and Disclosure Interpretations relating to intrastate securities offerings made pursuant to this rule. As many already project, developments in state-based crowdfunding may in the end make it easier for companies to comply with such intrastate requirements than to comply with the much expected new crowdfunding rules of Title III of the JOBS Act of 2012.


Photo Credit: Flickr


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