April 12, 2011
If starting or growing a business weren't hard enough before the financial crisis, try doing so today.
BACKGROUND:
According to the Small Business and Entrepreneurship Council, Small businesses represent over 99% of the employer firms in the U.S., and employ half of the private sector employees. Between 1993 and 2009, small businesses accounted for 65 percent of the 15 million net new jobs created. Bureau of Statistics data shows that since the 1970s small businesses hire two out of every three job seekers and the Ewing Kauffman Foundation has noted that in the last 30 years, all net job creation in the U.S. took place in firms less than five years old.
According to the Department of Labor, prior to the financial meltdown, 76% of small businesses received traditional funding (ie: bank loans, credit card advances, finance companies, etc). Any entrepreneur will tell you that cash is king. Without it you cannot grow or hire employees. Part of this comes from working capital (cash on hand) and the other part from financing (traditional funding just mentioned). With the financial meltdown, our economy stalled, over 8 millions jobs were lost and unemployment rose to its highest level in recent history.
Economists and politicians are in agreement. Jobs create prosperity. With the launch of Startup America in February 2011, the White House stated that, Startups bring a wealth of transformative innovations to market, and they also play a critical role in job creation in the United States. Those entrepreneurs who are intent on growing their businesses create the lions share of these new jobs. Jobs create taxable wages and spending which stimulate the economy and replenish the government coiffeurs.
CURRENT ENVIRONMENT:
Since the financial meltdown traditional financing has virtually disappeared. Banks are holding on to their cash, credit card companies are charging exorbitant interest rates and according to the private financing group Angelsoft, only 2.3% of startups receive private (VC, PE or Angel) financing.
Since money isnt available to the other 97.7% of startups today, they need to find other avenues to raise capital namely their friends, family and community. However, if that startup offers any kind of financial return, it just might be breaking the law. That is, unless they hire a lawyer, spend tens of thousands of dollars and countless hours completing forms.
According to the Sustainable Economies of Law Center1, the current registration requirements under Section 5 of the Securities Act of 1933, as well as existing exemptions from registration, impose considerable hurdles on small businesses. The securities laws were written to address the abuses of large corporations. However today, these laws, written before telephones were widely available, require a small start-up raising $50,000, to follow the same filing requirements as a large corporation seeking to raise millions of dollars.
Even if a startup were to complete these filings, the current regulations also include:
- Limits on startups in seeking capital outside of their immediate state
- Requirements of additional costly and burdensome state filings
- Restrictions on the amount of unsophisticated investors to 35 individuals and/or
- Requirements for complete audited financials and state filings
In 1933 when these laws were written, 4% of Americans invested in the markets. Today that number is over 50%, clearly showing that the majority of individuals understand the basics of investing.
NEW IDEAS FOR FUNDING BUSINESSES:
Crowd Fund Investing (CFI), where groups of people invest in startups and provide the capital where it otherwise isn't available, is one such solution. Over the past 5 years, users of websites like Kiva Kickstarter have donated over $350M to crowd fund projects including art, films, software development and books. The success of these crowd funding sites demonstrates the desire of the public to support projects that they believe in. Enabling the additional motivation of possible financial return would only reinforce this economically healthy impulse, says the Sustainable Economies of Law Center.
THE SOLUTION:
Update the 78-year-old Security and Exchange Commissions (SEC) rules that impact how entrepreneurs can raise capital. These rules require filings that are beyond the capabilities of entrepreneurs or small businesses. They require tens of thousands of dollars of legal and accounting professionals timemoney that small businesses do not have. (Please Note: This is not a new idea. Proposals to update these rules have been recommended to Congress every year, for the past 18 years).
We support creating common sense modifications to existing regulations to enable small businesses to raise capital through debt or equity. The reforms are modest and follow the spirit of the 1933 and 34 Security Acts including:
1) Strong anti-fraud provisions
2) Limited risk and exposure for unaccredited investors
3) Transparency
4) Standards-based reporting
5) Limit to the amount of seed capital a company can raise in this type of offering.
a) We propose the creation of a funding window for the creation of debt or equity instruments for entrepreneurs and small businesses.
Small Business being defined as:
- Less than 50 employees
- Annual gross sales of less than $5M
a) This funding window could be accessed by small businesses in one or more tranches, to raise up to an aggregate of $1M as long as until they no longer meet the "small business" criteria. Two examples follow:
1) Small Business A is an entrepreneur with an idea for a business. He raises money in the following tranches:
Round A: $5,000 to do market research and create the business plan
Round B: $50,000 to build a prototype
Round C: $200,000 to expand operations
This company now chooses to use traditional means of financing for subsequent rounds.
2) Small Business B is a dry cleaner that needs additional working capital to open a second location and cannot get traditional financing:
Round A: $250,000 for construction
Round B: $100,000 for working capital and equipment
Round C: 5 years later, they prepare to open a 3rd branch and raise an additional $650,000.
With the completion of Round C, this funding window is now closed to this business.
Crowd Fund Investing is based on the experience of Crowd Funding sites for charitable and art-related projects. It provides a way for unaccredited investors to pool their individual small contributions (likely between $50 - $500 each), in companies and entrepreneurs they believe in. In order to limit investor risk, we support the creation of caps on the amount each individual can invest in an entrepreneur or small business.
b) We support limiting the contribution of an individual unaccredited investor to no more than $10,000 or 10% of their prior years Adjusted Gross Income, whichever is less. The $10,000 limit is in line with other established financial disclosure limits like those on banking transfer reporting requirements.
c) Require a set of standardized and automated procedures for these financing offerings to reduce time and expense for all parties while maintaining transparency.
d) Have investors complete a questionnaire to determine their aptitude to participate in crowd fund investing and a series of disclosures that they must indicate they understand.
e) Allow the creation of online platforms where ideas, individuals, companies and investors can meet, be vetted by the community and crowd fund investing can take place. These platforms would provide standards based reporting to the SEC on the entrepreneurs and small businesses utilizing the platform.
The SEC has the authority to make these changes today:
According to Section 3(b) of the Securities Act, the SEC grants the commission the power to:
Add any class of securities to the securities exempted as provided in this section, if it finds that the enforcement of this title with respect to such securities is not necessary in the public interest and for the protection of investors by reason of the small amount involved or the limited character of the public offering
It is time our Government eased the restrictions on capital formation for startups/small businesses in order to create the jobs our country needs to rebuild itself.
1 This independent article submitted to the SEC provides a concise understanding of the challenges facing startups wishing to raise capital: http://www.sec.gov/rules/petitions/2010/petn4-605.pdf).
How to Provide Investor Protection in Crowd Fund Investing (CFI)
Creating prudent investor safeguards is an important part of enabling a vibrant and effective crowd fund investing ecosystem. With this in mind, we propose a series of steps to increase transparency and accountability while limiting the opportunity for fraud and abuse.
Q. How can you prevent large scale fraud?
A. Limit the maximum amount any one entrepreneur/company can raise via crowd fund investing platforms to an aggregate of $1 million.
Q. How can you prevent large corporations using this as a loophole for cheaper financing?
A. Limit the types of companies that can utilize the platform to those that are less than 50 employees (and not a majority owned or wholly owned subsidiary of another entity) with less than $5 million in revenue in the previous calendar year.
Q. How do you prevent Grandmom from investing her whole retirement?
A. Limit the amount that anyone can invest to either $10,000 or 10% of their prior years Adjusted Gross Income (whichever is lower).
Q. Can limited disclosure requirements increase risk?
A. Have the crowd vet the entrepreneur. Create a standards based set of data that each entrepreneur must complete in order to attempt to seek funding. Then enable a communication channel for investors and entrepreneurs to communicate about their questions, ideas and solutions. Investors only invest in entrepreneurs that have complete information and a product or service that the investor believes in. Connecting this service to social media groups whereby the entrepreneur and investors are part of the same group, the investors can ask questions of the entrepreneur and the entrepreneur can solicit the investors for help, experience, contacts, etc. Investors can rate the entrepreneur following their investment and entrepreneurs can rate investors.
Q. How do you deal with professional scam artists?
A. Just like when financing a major purchase or renting an apartment, Crowd Fund Investing entrepreneurs must agree to credit checks that match their name, social security number and receive a credit score that the crowd can view. Make the initial money loans that the entrepreneur is personally responsible for. If he/she defaults it appears on their credit report.
Q. How do you prevent someone from raising funds without proper planning?
A. Crowd Fund Investing must be an all or nothing platform. If the entrepreneur doesnt raise all the requested funds within the specified timeframe, the funding round closes and the investors keep their money. By limiting the amount of money individuals can contribute, an entrepreneur has to be careful about how much money he is asking for (if he asks for too much and doesnt reach his funding target, he doesnt get funded).
Q. What about nondisclosure/lack of transparency?
A. Make the entrepreneurs fill out standards based information about themselves and how they will use the capital. Have them attach links to their social proof from various online communities (LinkedIn, eBay, Amazon, Facebook, etc) profiles that show how the crowd views them. Most of these investments will be made to individuals that are already known to the investors via social media platforms. Investors will be provided with standards based agreements and this information will be stored within the community, and a data set of relevant investor and entrepreneur data will be transferred to the SEC on a quarterly basis. Examples of this dataset might include: company name, entrepreneur name, funding rounds attempted, funding rounds successful, number of investors, total investment raised, investor names, etc.
Q. Is there a way to prevent identity theft?
A. To protect against identity theft a third party government monitored platform should be created to do background and identity checks to avoid scam artists from raising money under different peoples names.
We are open to a dialog and debate to help make crowd fund investing work within the spirit of the securities laws so that capital can flow to entrepreneurs and investors can be protected.