Nish Acharya, 3/28/04
On March 25, the U.S. Securities and Exchange commission finally announced rules for several aspects of the 2012 America JOBS Act, which legalized “crowd funding” as we know it. The announcementby the SEC has the potential to unleash large amounts of new capital into American startups. It could also spell the end of venture capital as we know it. Don’t get me wrong, investors in startups, whether they are institutional or individual, will continue to make large amounts of money. But the control exerted by early-stage angels and venture capitalists, along with the structure of deals, could change significantly.
The SEC has ruled that early stage startup companies, categorized as Tier I offerings, could raise up to $20 million through equity-based crowdfunding with only “reviewed” financial statements and minimal government compliance. Tier II offerings will require 2 years’ worth of audited financial statements and more significant documentation and compliance, but could raise up to $50 million from unaccredited investors through equity crowdfunding. A great summary of the SEC ruling can be found in this posting on Forbes by Chance Barnett.
I had the opportunity to work on the JOBS Act in the Obama Administration, and its passage, during an election year no less, was proof that equity-based crowdfunding was an idea that was so ready to be legalized that even conservative Republicans and progressive Democrats could agree. Democrats liked that it empowered the little guy – the entrepreneur without deep pockets or deep connections. Republicans like that it removed government restrictions on the private sector. (Another, equally important section, removed Sarbanes Oxley requirements on pre-IPO emerging growth companies).
The legislation was supposed to bolster the nascent entrepreneurial ecosystems around the United States during the Great Recession. If you follow the tech or business media, you would think that the entire country looks like Silicon Valley today. There are regional entrepreneurship efforts everywhere – led by university labs, accelerators and policy makers looking for strategies to drive economic growth and job creation.
But a review of data released by organizations like the National Venture Capital Association reveal that most investment in high-growth companies continues to be clustered in the Northeast and West Coast – California, Massachusetts and New York in particular. One recent national assessment showed that the vast majority of startup investment went to just eight states, while 31 states had only one or no venture capital deals at all.
Crowdfunding is supposed to change that. Crowdfunding is how the entrepreneur in Chicago (not a traditional startup city) could raise money from her vast personal networks and leverage a large city like Chicago. She would only have to go to VC’s when she had product and revenue ready for the next stage.
In addition to supporting entrepreneurs outside The Two Coasts, crowd funding would be the way we fund more complicated technologies. There is a perception, although not necessarily accurate, that venture capitalists are only funding information technology companies because the pathway to strong returns is clearer than that of life sciences, manufacturing or energy startups. They only way we would find investment for riskier technologies was by creating a very large base of small investors to distribute the risk, i.e., to crowd fund.
In the three years since the JOBS Act was signed, crowd funding sites have proliferated, and the concept has joined the mainstream lexicon. But these sites struggled to attract the best startups without clarity from the SEC. Early-stage angel investors were worried that they would be diluted by later-stage venture capitalists. The fees that crowdfunding sites could charge were not enough to sustain their business model. And high-profile law suits like those around Oculus, where crowd funders received minimal proceeds from a $2 billion sale to Facebook, have created the impression that crowd funding might not change anything.
But this week’s SEC announcement means that everything could change. Very early stage companies can raise up to $20 million with little more than an idea and a prototype. The most important relationship a startup might have is with the person who can manipulate social media to manage a crowdfunding campaign. It used to be the well-connected angel investor. Indeed, startups can skip right past the friends and family round, the angel round, and even a Series A round, depending on how you define each. It also means that more expensive sectors, like biotech and clean tech, can now look to crowd funding as a viable option. For Tier II offerings, the side lining of venture capitalists could be even greater. Companies can raise up to $50 million with a minimal track record. To date, Silicon Valley was the only place in the world were this was happening. Even in Boston and New York, companies seeking to raise $50 million would have to show product traction, several million in revenue and a strong management team.
So does that mean your VC friends will have to get new careers? Probably not. Startup companies will still need smart, connected and experienced investors and board members in order to succeed. But whether or not a VC firm can use their investments to control companies through equity, board membership and strategy may change.
Startups companies also shouldn’t view this as a radical change from their modus operandi. Despite the stories we hear about projects in Kickstarter, Indiegogo or other sites, the reality is that a startup company won’t be able to raise more than a few million dollars based on hype and buzz. Hitting $20 million or $50 million through crowdfunding will still require companies to show strong traction and impact – and to be able to explain their work to the unsophisticated investor.