Is crowdfunding to be crowdless?

The JOBS Act has the potential to help entrepreneurs finance their small and emerging growth businesses through “crowdfunding,” but only if we get the costs right. In the year since the measure was signed into law, online technology platforms have continued to successfully disrupt the costs of fundraising, necessitating a reevaluation by the Securities and Exchange Commission of some components of the law before completing the regulations. 
{mosads}As of today, entrepreneurs are essentially limited to selling ownership in their company to accredited investors using private placements. An entrepreneur can hire a securities attorney, create the written materials and peddle the deal directly to wealthy individuals. Total costs  — primarily legal fees — for raising $1 million or less run 2-4 percent. Online platforms like Angelist, Gust and EquityNet are new and exciting options where costs can run 4 percent or less because of the efficiencies of bringing the audience to the issuer and the deal flow to the investor with standardized offering materials and, more recently with the launch of Angelist Docs, closing documents. More than $2 billion has been raised to date on these sites, and the total amount per deal is growing. raised $7.9 million, of which $4.4 million was through Angelist. Another choice is to utilize a broker-dealer or investment bank at a total cost of 8-10 percent, including legal fees. This option is practical only for firms raising millions of dollars, as it isn’t cost-effective for these intermediaries to get involved at $1 million.
Friends and family are believed to be the primary source of capital, but this is generally done under the radar with very few individuals as a result of legal restrictions. The upshot: entrepreneurs turn away people who want to invest because there is no cost-effective way for them to invest under current law.
The JOBS Act is designed to remedy this. Anyone would be able to invest a limited amount of money (based on income and net worth) in start-up companies in exchange for ownership in the form of debt, equity or revenue-sharing. The problem is that based on what is written into the law, it looks like crowdfunding will be the most expensive option, with fees projected to be 8-20 percent.
The largest costs to complete a $1 million fundraising campaign — the maximum allowed under the JOBS Act — include: $40,000-$80,000 to the online platform (assuming the same 4-8 percent fee structure of donation-based crowdfunding platforms); $20,000-$40,000 in legal fees to create the offering document and closing statements; accounting fees of $15,000-$75,000 for an audit (required for offerings of $500,000 or greater); and due diligence costs of $1,000-$10,000 to complete background checks for all officers, directors and persons owning more than 20 percent of the company.
These high costs are potential “market killers” for three reasons. First, if up to 20 cents of every dollar is spent on fundraising, the entrepreneur will have a difficult time achieving the business-building objectives envisioned by the business plan. Second, these costs are significantly higher than other options available today. Third, the success of a crowdfunding campaign comes down to the entrepreneur’s ability to “socialize” the campaign to their network. Unlike the online private placement alternatives, the entrepreneur has to bring the audience to the crowdfunding platform, resulting in considerably more effort.
To enable equity crowdfunding to be competitive, the cost of capital needs to be, and can be, lowered by:

Raising the $1 million cap. The current limit is impractically low. Given fixed fees associated with complying with regulatory requirements, the current $1 million cap creates an extremely unappealing cost ratio.

Eliminating the need for an audit. The currently required auditor involvement is an unnecessary constraint. Today, most start-ups funded through friends and family have little if any historical financial results of any significance. They sell their story on business models and financial forecasts, neither of which are appropriate subjects for review or audit by an independent accounting firm. Accredited-investor-only private placements have no audit requirement and are much more likely to involve companies with meaningful financials.

Requiring uniform selling and closing documents. This will substantially reduce legal costs and will facilitate greater transparency to the average small investor if all crowdfunding campaigns are presented in a standardized fashion. Crowdfunding portals including those without a broker-dealer partnership should be allowed, if not required, to offer these templates.

Many details of the JOBS Act crowdfunding provisions have been left to the SEC to design and implement through rulemaking. We suggest that our new commissioner, Mary Jo White, consider the spirit of the JOBS Act and promulgate regulations that will encourage use of the crowd and expand the pool of investment capital and thus create jobs, while walking the balance beam to keep fraud in check. To do so, some thoughtful and creative tinkering with the base model will be necessary to make it cost-effective. No easy task, but Chairwoman White is no stranger to getting tough jobs done.
McIlwain is CEO of, and Murray is a securities attorney and partner at Covington & Burling LLP.


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