“The Senate is the place where bills go to die.” –Bill Maher
On November 3, 2011, the U.S. House of Representatives voted 407-17 to pass the “Entrepreneur Access to Capital Act,” a crowdfunding bill which permits startups to offer and sell securities via crowdfunding sites like Kickstarter or social networking sites like Facebook. Indeed, the bill was enthusiastically supported by the White House, and there were high hopes that it would be passed quickly in the U.S. Senate.
Nearly four months later, however, it appears that the House bill has been bludgeoned to death in the Senate. Below is a Q&A on how we got here and how politics is once again undermining entrepreneurship in our country. It is an update to my prior crowdfunding posts: House Passes Crowdfunding Bill: FAQ’s For Entrepreneurs (11/9/11), Crowdfunding Update: FAQ’s For Entrepreneurs (12/1/11) and Crowdfunding Bill Stuck In The Senate (1/13/12); and it was published yesterday on the Huffington Post.
What is Crowdfunding?
As the term implies, “crowdfunding” is funding from a crowd of people – i.e., many people provide small amounts of money to finance something. Crowdfunding has its roots in charitable causes (including the advent of microfinancing to provide financial services to poor people), but has progressed to the online funding of creative projects via sites like Kickstarter and RocketHub.
May Startups Raise Funds via Crowdfunding?
No, startups are currently prohibited from selling stock or other securities via crowdfunding sites or social networking sites; they may, however, accept donations. This is because of federal and state securities laws which have been in place (in one form or another) since the 1930’s, including the following:
- A prohibition against advertising or “general solicitation” – which means that a company may not offer or sell securities unless there is a substantive, pre-existing relationship between the company (or a person acting on its behalf) and the prospective investor (see “Can I Raise Money For My Startup Via Twitter?” );
- Disclosure and state law compliance requirements if the investors are not “accredited investors” — which usually makes the offering of securities too costly and onerous for a startup (see “Ask the Attorney – Securities Laws”);
- A requirement that any intermediaries (including websites) must be registered with the SEC and applicable state securities commissions as a “broker-dealer” in order to legally accept any transaction-based compensation in connection with the sale of securities (see “Ask the Attorney – Beware of Finders”); and
- A requirement that any company that has 500 or more shareholders and total assets exceeding $10 million must register with the SEC and file periodic reports.
How Does the House Bill Address These Issues?
The crowdfunding bill passed by the House lifts all of the foregoing prohibitions and requirements and allows a company to sell securities via crowdfunding sites and/or social networking sites so long as the company (and its intermediary, if applicable) comply with the following key restrictions:
- The company may only raise a maximum of $1 million (or $2 million if the company provides potential investors with audited financial statements);
- Each investor is limited to investing an amount equal to the lesser of (i) $10,000 or (ii) 10% of his or her annual income; and
- The issuer or the intermediary, if applicable, must take a number of steps to limit the risk to investors, including (i) warning them of the speculative nature of the investment and the limitations on resale, (ii) requiring them to answer questions demonstrating their understanding of the risks, and (iii) providing notice to the SEC of the offering, including certain prescribed information.
Would Crowdfunding Be Beneficial to the U.S. Economy?
[Crowdfunding] is so critical for our country right now because innovation is not limited to the folks in New York or Silicon Valley… And because people who are not millionaires should be free to spend — or gamble — their money however they like: be it betting on sports, playing poker, gambling on a mutual fund, speculating on gold coins or — gasp! — investing in startups!
Anyone who has used Groupon, Farmville, Facebook, Angry Birds or LinkedIn in the first year knew they were good investments and should have been allowed to invest. Only the rich were allowed to invest. How is that fair?
Finally, there are thousands of people out of work who also have a great idea for a sustainable business who would give it a shot if they could just get their hands on $10k to try. What’s the harm in letting those folks swing the bat?
How Has the Senate Responded to the House Bill?
Rather than adopt the House bill, two different crowdfunding bills have been introduced in the Senate. The first bill, called the “Democratizing Access to Capital Act of 2011,” was introduced by Senator Scott Brown of Massachusetts and has four drastic differences with the House bill:
- The Brown bill only permits the issuance of securities through a “crowdfunding intermediary”; accordingly, startups would not be permitted to raise funds via social networking sites like Facebook, Twitter or LinkedIn (as permitted under the House bill);
- Under the Brown bill, each investor is limited to investing up to $1,000 per company for each 12-month period;
- Similar to the House bill, the Brown bill caps the total amount of capital that may be raised during any twelve-month period at $1 million, but does not raise the cap to $2 million if the issuer provides potential investors with audited financial statements; and
- Finally, the Brown bill permits some form of registration by the State in which the company is organized and/or “any State in which purchasers of 50 percent or greater of the aggregate amount of the issue are…residents.” (The House bill preempts State law and, accordingly, there is no State registration requirement.)
A second crowdfunding bill, called the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2011 (or the “CROWDFUND Act”), was introduced Senator Merkley and is another knife to the heart of the House bill for the following reasons:
- The Merkley bill only permits the issuance of securities through a registered broker-dealer or “funding portal” (which is a new term generally defined as any individual or entity engaged in the business of effecting securities transactions that does not offer advice or recommendations or solicit sales);
- Under the Merkley bill, each investor is limited to investing up to the greater of (i) $500 or (ii) 1% or 2% of his or her annual income (depending upon the amount of such income), per company for each 12-month period;
- The Merkley Bill creates an aggregate annual cap on the amount of all crowdfunding investments by an investor of (i) $2,000 or (ii) 4% of the investor’s annual income if such income is above $50,000 or (iii) 8% of the investor’s annual income if such income is above $50,000;
- Similar to the House and the Brown bills, the Merkley bill caps the total amount of capital that may be raised during any twelve-month period at $1 million; however, it requires the delivery of audited financial statements to the SEC and investors if the company seeks to raise more than $500,000; and
- Finally, the Merkley bill grants investors a new cause of action against the issuer’s directors or officers personally in the event of fraud.
What Is the Status of these Bills?
Hearings were held on both bills, which focused not on the job-creation possibilities and economic upside of crowdfunding, but instead on the potential for fraud. Moreover, in typical Washington D.C. fashion, a turf battle ensued as the North American Securities Administrators Association, a trade group for State securities regulators, lobbied hard against the House bill to prevent the preemption of State law.
There is, however, breaking news yesterday via Reuters:
Senate majority leader Harry Reid announced plans on Tuesday to push forward legislation to spur capital formation for small businesses… The Nevada Democrat said the Senate Banking Committee would hold a hearing on small business growth next week and he applauded the House of Representatives for its own progress on related legislation….
While he did not elaborate on the bills, he noted that Senate Democrats have been working on them “for months.”
Let’s keep our fingers crossed and hope that this push will include passage of the House crowdfunding bill.