The JOBS Act has passed both House and Senate, and all signs point to it being signed into law sometime this week. The JOBS Act does a few things, but the two big ones that will be widely publicized are 1). it allows companies to “crowdfund” by selling securities to nonaccredited investors for total funding amounts below $2 million, and 2). it raises the number of shareholders that trigger a company to file SEC disclosures from 500 to 2000.
First off, let’s get one thing out of the way: This isn’t going to create many JOBS. Despite the title, this is not a “jobs” bill. No money is being spent on anything (you can imagine the pitch and see why it passed: will you vote for this bill that has JOBS in the title but doesn’t increase the deficit or raise taxes?). The crowdfunding portion of the act will likely increase the misallocation of money in the economy, and the increase in the shareholder limit doesn’t have any clear connection to increasing jobs at all. So ignoring the blatant pandering by the Act’s title, is it a good law?
I’m going to focus on the crowdfunding portion of the bill for now, and save the shareholder number increase for another time. I’m also only going to talk about equity – crowdfunding small business loans will likely catch on as well, but people seem to be more interested in the equity side of the equation. Anyway, two obvious questions spring to mind:
What sort of company will raise money this way?
Not the Facebooks of the world. The startup/technology world probably won’t go the crowdfunding route very often. There is already plenty of angel and VC money available to promising startups in major cities, and startups tend to burn through cash pretty quickly before they become profitable, so few will have a business plan where $2 million is sufficient to get them to profitability. Furthermore, raising 100k from 100 people is going to be less attractive than raising it all from 1 angel who can add some value through expertise and connections. It’s also not going to be pretty to raise a Series A after taking investments from a few hundred random people, and VCs will probably be less than excited to get onboard with that cap table. I wouldn’t be surprised if mainstream VCs never back crowdfunded businesses. So forgetting startups, that leaves your regular ye olde small business, and they are probably the sort most likely to avail themselves to crowdfunding. But….
Who wants to invest in crowdfunded companies?
In an era of Shark Tank and The Social Network, it is no surprise that everyday people want to invest in young companies. But keep in mind, these aren’t going to be the sexy startups that regular Joe American has heard about. The companies that pursue a crowdfunding route will either be less-known startups that are struggling to raise money through traditional channels (which you’d think would lower the potential IRR for a portfolio of such companies, but more on that in a second), and small businesses. I’m no expert on the state of small businesses in the majority of the country, and I can’t say I really have a clue whether this crowdfunding option will be appealing to them as an alternative to other fundraising options. But I just have this gut feeling that if you want to start a small restaurant in a suburban neighborhood, it’s gonna be really really hard to convince a random person on the internet to care, let alone invest. The business plan on the investor side just doesn’t make a lot of sense: investors in startups (Angels and VCs) have one basic premise – if you invest broadly in enough startups, you’ll get a solid return by losing money on 80% of them, breaking even on 10-15% of them, and hitting homeruns (10x+++ returns) on 5-10%. The ability to get the homerun return is absolutely essential to a portfolio where 80% of the investments go bankrupt, but what small business can reasonably project a world where they offer their investors those kind of returns? The local restaurant/crafts store/yoga studio sure can’t.
This is the main problem I have with the crowdfunding plan: In a few years, we will probably say that no rational investor should invest in companies this way. The Act offers low net-worth investors the chance to make small investments in a number of small companies. This is essentially what high net worth investors do at the angel stage for startups, but the companies in the crowdfunding portfolio are 1) less likely to be wildly profitable, as most small businesses can’t even project 10-15x returns with a straight face, and are 2) more likely to be fraud [and this isn't being alarmist - states first passed securities regulations specifically to combat fraud]. Oh, and the portfolio is even less liquid than an angel portfolio, because angel portfolio companies will be acquired or go public with some frequency, something no small business will do. Plus small businesses fail at an extremely high rate. What rational investor would take this portfolio of high-to-extremely-high risk, low upside, illiquid investments over a 5-year treasury? When the stock market is doing well, I just can’t imagine this being an attractive way to invest money.
In conclusion, I think the sale of equity through crowdfunding platforms just won’t catch on. I don’t think investors will want to put money into the sorts of businesses that will use the platforms, and over the long run those investors that do will realize they aren’t making a reasonable return. Maybe debt financing through crowdfunding will take off, but I just can’t see the equity side ever becoming popular.